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truthisntstupid (92.27)

Valuation Is Overrated

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August 05, 2010 – Comments (17)

 I said I wouldn't do this any more.  And after this, maybe I won't.  But......

 I will get this out of my system. Tonight.  There are any number of people who have never had an accounting class who are led to believe they can read a few books and memorize a handy formula or two and start looking for undervalued companies.  Or calculate something called "intrinsic value."  Or perhaps believe they're prepared to dive into a company's financial statements and calculate its  "liquidation value,"  so that they can try to build a margin of safety into their value picks. 

So you think you can value a company?  A big, multi-million or -billion dollar company?   With lots and lots of moving parts?  Because I don't think most of us can.   There are too many pitfalls.  Someone like Warren Buffet knows what to watch out for.  You aren't going to read a few books and know things it took him fifty years to learn.  Quit fooling yourself.  I don't think most of us stand a chance in hell at coming up with a correct valuation for a large company. 

People can put a lot of work into this pursuit.  They can do their computations, try to figure out exactly what the liquidation value of a company's assets is, take into account that there may be equipment or buildings with decades of depreciation on the books, leaving a book value far understating the market value, etc.

What happens to all this "value"  sometimes when a company goes under?  Does the "value"  that can be arrived at by generally accepted accounting principles ever get realized; do the debits and credits balance out in the end?  After all the debtholders are paid, how often are the shareholders left holding the bag, and why?

From  "Free Cash Flow:  Seeing Through The Accounting Fog Machine To Uncover great Stocks"  by George Christy

Many investors think all the accruals and cash flows "even out in the end."  A viable company has no "end,"  every company is continually booking new accruals and modifying existing accruals and reserves.

What if a company goes out of business?  Will accruals and cash flows finally coincide?  No, because in liquidation the accrual mirage is finally revealed for what it is not.  The accruals and shareholders' equity balance are flushed down the drain.  All that is left is whatever cash can be generated by the sale of assets.  But before the owners get a dollar of the sales' proceeds, taxes and creditors must be paid.  The company's owners know one thing for sure:  The amount of cash they end up with will not equal the shareholders' equity number on the balance sheet.  The owners learn that in the end, only cash counts.

So much for the "liquidation value"  and the "intrinsic value"  mirage.  We're not all as smart as the people that actually can come out ahead in this kind of scenario.  Do you think you can see all the pitfalls and trapdoors just because Ben Graham or Warren Buffet could?  We can't learn everything they know just by reading a stack of books.  They have a lifetime of business and investing behind them, and some things that may be  'common sense'  to them may not be 'common sense'  to you.

I've read too many times that in liquidation, the shareholders usually get little if anything.  You don't calculate 'liquidation value'  just in case your company goes under.  You satisfy yourself that the company's financially healthy by looking at its debt coverage, cash flow, current ratio, competitive advantages, and so on.  If the company's in that bad of shape, why try to calculate 'liquidation value?'   Stay away from it!!!!

Most people have no business thinking they can accurately, correctly value a viable company, much less come out ahead in liquidation!

This is from The Money Game by 'Adam Smith':

(Interestingly, 'Adam Smith' is the pen name of the person who wrote it and the book doesn't give his true name)

It really ought to be easy. You pick up the paper, and Zilch Consolidated says its net profit for the year just ended was $1m or $1 a share. When Zilch Consolidated puts out its annual report, the report will say the company earned $1M or $1 a share. The report will be signed by an accounting firm, which says that it has examined the records of Zilch and "in our opinion, the accompanying balance sheet and statement of income and retained earnings present fairly the financial position of Zilch. Our examination of these statements was made in accordance generally accepted accounting principles."

The last four words are the key. The translation of "generally accepted accounting principles" is "Zilch could have earned anywhere from fifty cents to $1.25 a share. If you will look at our notes 1 through sixteen in the back, you will see that Zilch's earnings can be played like a guitar, depending on what we count or don't count. We picked $1. That is consistent with what other accountants are doing this year. We'll let next year take care of itself."

Funny. Hilarious. True, also, for the most part. 

Two companies start up. Same business, making widgets. They both buy the same $5M machine.

Company A says it can get 10 years of useful life out of its machines. So using straight-line depreciation, it will charge $500,000 per year to its income during the 'useful life' of the machine. If it is still using that machine twelve years later, its profits will certainly look better, since it will be no longer be writing off $500,000 a year for depreciation. 

Company B says it can run its machine for twelve years. So it's depreciating its machine over twelve years, and its depreciation charge this year will only penalize its earnings $416,666 instead of $500,000, and on that basis appears to have made more money this year than company A.

Be careful when comparing company A to company B.

It gets worse. Companies have more than just the simple straight-line depreciation method to choose from, and they have considerable freedom in choosing the time period over which they depreciate a piece of equipment.

There is just as much variation in revenue recognition methods, inventory valuation methods, accounting for R&D costs as they're incurred versus amortizing them over several years....

All these uncertainties are why I believe "valuation" is overrated for evaluating an investment. For example, "inventory." The value shown on the balance sheet can't simply be taken as is.  If you're trying to come up with a liquidation value you'd better find out what inventory valuation method the company is using. FIFO? LIFO? What is their inventory valuation method? Why did they choose to do it that way?

If they're using LIFO (Last In First Out) what if a significant part of the number you're seeing really represents a lot of old, obsolete, inventory that no longer has much if any real value? 

If they're using FIFO (First In, First Out) during a period of rising costs, how much is this causing their cost of goods sold to be understated?   Naturally, this would cause the income to be overstated, which would affect intrinsic value calculations.

With all the choices a company has regarding inventory valuation methods, revenue recognition methods, depreciation methods, etc, I don't try to value a company. There are whole books on financial shenannigans companies have pulled. Earnings and values may be either overstated or understated any number of ways.

And most of us have limited time and knowledge to ferret them out.

Back to The Money Game:

In short, there is not a company anywhere whose income statement and profits cannot be changed, by the management and the accountants, by counting things one way instead of another.

What does all this mean?  Does it mean I totally ignore financial statements as being just too arbitrary in what they tell us and what they don't? No. But it does mean that none of us can come close to accurately valuing a multimillion-dollar corporation, so I don't try.

The methods of valuation aren't the problem. Anyone can read, study, and learn various methods of arriving at an 'intrinsic value' or 'liquidation value' number. That isn't the hard part.

My problem is that many people doing intrinsic value calculations would probably get a totally different result for company A than they would for company B, even though the only difference is in the accounting methods.

I don't think average people with no background in accounting should be led to believe it's so simple.

Similar assets purchased at similar prices can be carried on the books of different companies at significantly different values even if they've been owned for the same amount of time.

The same income can be made to appear much different even though it isn't. A company choosing an accellerated depreciation schedule or using a longer write-off period will appear to be more profitable, although it really isn't.

The fault isn't in the formulas and methods of calculating intrinsic or liquidation values. The failure is in the deceptive nature of the numbers we're given to plug in to them. Comparing the numbers from one company to the numbers from another company is usually like comparing apples and oranges.

Still think you can value a company?  I am not  saying it can't be done.  But are you prepared to spend days or maybe weeks understanding what its numbers are telling you so that you actually can?  Most of us just don't have that kind of time. 

I think I'm better off assuring myself of its financial health by looking at its debt coverage, cash flow, competitive advantages,  dividend yield, payout ratio, dividend growth rate,and other types of analyses, then simply deciding if it seems attractive to me at its current price.  I may be willing to pay more - or less - than somebody else.  And you know what?  I actually do ok.

If I haven't changed any minds, maybe I've given you something to think about.

   =Truth

17 Comments – Post Your Own

#1) On August 05, 2010 at 1:42 AM, MegaEurope (< 20) wrote:

The first reply that popped into my head was:

Valuation is the worst way to invest, except for all the other ways that have been tried.

 

But honestly my style is also "ad hoc fundamental", similar to what you describe in your last paragraph.  No point in making decisions with overly precise models based on difficult assumptions.  Just trying to find comparatively cheap stocks and understand their business models gets you 99% of the way there.

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#2) On August 05, 2010 at 2:27 AM, djshagggyd (74.34) wrote:

Truth-

I'm so glad you made this post! It's a great expansion on what we've been discussing lately. And I'm really looking forward to seeing what kind of commentary it may generate.

It's late and I've got to get to bed... but I'll definitely be back to read this one a second time.

Thanks for writing!

~justin 

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#3) On August 05, 2010 at 3:10 AM, Valyooo (99.54) wrote:

I always look at value as a back up plan....if this company is making nice profit, even if the overall market drags the price down, atleast it has some intrinsic value.

But if the company is not making any money then why the hell are you investing in old depreciated machinery?

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#4) On August 05, 2010 at 6:18 AM, truthisntstupid (92.27) wrote:

MegaEurope

Thanks for reading!  I really liked this:  No point in making decisions with overly precise models based on difficult assumptions. 

I couldn't have said it better myself!

dj

This has really been bugging me.  I stayed up late finishing it and now I.m up getting ready for work on three hours' sleep.  The editor must have weirded out on me.  I just hit "post"  and went to bed.  Some things that were supposed to be in italics aren't.  Oh well.  It's readable.  Thanks for reading!

ValyooRLholdings

Why invest in old depreciated machinery?

Indeed.

 

Thanks for the comments everybody!  I've got to be heading out the door now.  Have a good day!

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#5) On August 05, 2010 at 6:33 AM, lorteungen (99.74) wrote:

Great post, but I think there is some ambiguity as to how people use the term valuation and value investing. To me, what you're doing IS using valuation to pick your investments. By looking at debt coverage, cash flow, competitive advantages, dividend yield, payout ratio, dividend growth rate and so on, you are evaluating the earnings power of the company to arrive at an intrinsic value of the company. The intrinsic value doesn't have to be a very accurate figure, I don't believe it can be. Instead it should be a range which should be as wide as your preferred margin of safety. I don't think of margin of safety as to have anything at all to do with liquidation value. I would not buy a stock in which liquidation could be anything more than the result of some freak accident.

You are clearly a very well-informed investor and seems to have read a lot about valuation. It's probably second nature to you to use valuation in your investing decisions. So much so that you may think you're not. In my experience however, most people simply do not use valuation AT ALL when investing. They use justifications like "people will always need x, therefore company y will do well" and usually chase the most hyped companies without the slightest regard of the companies financial position. Those people get crushed in every market cycle, and in most cases they could have avoided so by doing what you do. If anything, I think valuation is underrated. Just my 2 cents, sorry about any broken english.

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#6) On August 05, 2010 at 7:14 PM, truthisntstupid (92.27) wrote:

thanks, lorteungen

That's a fascinating notion.  Sort of like being able to do certain mathematical problems in my head but when asked, I myself can't figure out what I did?  HaHa

But honestly, I do know that some of what I do does in fact tend to have much the same result as the over-complicated approach I'm campaigning against in this blog.  My message is,  "keep it simple." 

There's another, less apparent message, too.  MegaEurope said it perfectly.  "...overly precise models based on difficult assumptions."   

Assumptions.  Educated guesses.  Educated guesses are still guesses.  They go by another name...speculation. 

One must keep hacking away at the speculative component if we don't want it there. 

This blog could very well have been titled,  "Why I Am A Dividend Investor." 

Thank you for your insightful comments!

 

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#7) On August 05, 2010 at 7:38 PM, goalie37 (92.17) wrote:

Great, great blog.  +1 rec.

I figure that if I'm looking at liquidation value, then I'm probably looking at the wrong company.  I want a business that will dominate the world, not one that will sell off it's assets by order of a court.

The benefit of their system, however, is that their intrinsic value will usually be a very conservative number.  If the company is ultimately successful, they will usually have bought in at a very cheap price.

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#8) On August 05, 2010 at 7:52 PM, truthisntstupid (92.27) wrote:

goalie37

Thanks!  Yes, there is that...but it's always impossible to know if the value they come up with is so far off the mark that it will keep them out of terrific investments! 

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#9) On August 05, 2010 at 9:45 PM, HarryCaraysGhost (99.70) wrote:

Truth, nice post as always,

I prefer to think of intristic value more in terms of what your willing to pay for said company. If the company is liquidated well then you made a really bad choice.

Can I figure it out perfectly,(or in some cases even somewhat remotely close)  absolutley not. But it gives me a number to work with.

Then when Mr. Market makes his wild mood swings you can pick up shares at the price you want, and sell at a price that is profitable.

Hope that made sense, when it comes to investing I think of my brain as a five pound sack that I'm trying to put ten pounds of information into.

Thanks for posting.

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#10) On August 05, 2010 at 10:54 PM, truthisntstupid (92.27) wrote:

msftgev

Thanks for stopping in!  Mr. Market will always have those wild mood swings.  Maybe he's a lot like me, with my manic-depressive passive-dependent obsessive-compulsive neurotic bipolar psychosis!   I can relate to the 5-pound sack.  I read and understand far more than I can retain as well as I'd like.  I think I was smart once but it may just have been a dream I had.

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#11) On August 05, 2010 at 10:58 PM, SockMarket (42.06) wrote:

truth,

excellent post. I agree, almost completely. A couple thoughts:

1) most companies large enough to be on a major exchange use LIFO. 

2) with the A vs. B example I think you demonstrated the value of operating cash flow. Which is personally one of my favourite metrics for just that reason. (yes I am going with English spellings)

3) check out Anticitrade's post on the subject "Don't think liquidation value is relevant. Neither did I." I found the results a bit surprising, and against what I believe, but nevertheless interesting. 

4) I am far younger than most and have never taken an accounting course. Nevertheless I think that I can understand a fair amount of the info. I don't know what goes into earnings but I don't think it could take more than 10 or 20 minutes to find out, for non-financial companies.  

For the record my first true attempt (ie reading more than just 1 annual report and really digging into the company) is with CNI. I did it back in 07 and valued the company at $75/share (expected by 2010). I don't think we will make it there but it has been a fun project. 

Also I think that some industries are easier to value than others. For instance a utility will always be able to sell assets, as, likely, will a railroad and neither will have massive swings in earnings power. So those companies are easier. 

That said, my general valutation tool is my gut, which generally sends me in the right direction but not necessarily to the right price. 

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#12) On August 05, 2010 at 11:26 PM, truthisntstupid (92.27) wrote:

daniel

Thank you for reading and commenting!   Yes...cash flow/free cash flow is very important for me as a dividend investor to look at.

All the problems I detailed here are what gradually turned me toward dividend investing.  I believe it minimizes the speculative component. 

 I will check out Anticitrade's post although I'm doubtful it will change my mind. 

As a dividend/income investor, I want a combination of

the highest-yielding companies that I can convince myself are safe (got that from you, by the way) 

and the best-yielding companies that I believe have great potential for high dividend growth.  In addition to all the metrics I mentioned, I also like to see a high return on equity.  A lower return on equity might be ok if a company doesn't have a lot of financial leverage involved.

Thank you for commenting!   I bet you would enjoy an accounting class if you ever take one. 

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#13) On August 05, 2010 at 11:49 PM, HarryCaraysGhost (99.70) wrote:

Truth

Do you ever value the market as a whole when buying your Div stocks or do you simply rely on dollar cost averaging?

 

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#14) On August 06, 2010 at 12:05 AM, truthisntstupid (92.27) wrote:

msftgev

Hi again!  I don't know that I invest often enough to call it DCA.  When I have money to spare I simply put it to work before it disappears!  But the market as a whole?  No, I don't care what the market's doing.  Look through some of the all-time most-recced blogs from around Mar, Apr, May, or June of 2009.   Read the comments.  Those folks had the sky-is-falling syndrome bad.  It was a real good time to be buying all you could, though.  Later, in Dec 2009 I needed some money and sold enough OKE to get all the money I had put into it out.  My remaining stock in OKE is still worth 2/3 of the money I put into it in the first place.  It was not a good time to listen to the crowd,,,and it probably never is.

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#15) On August 17, 2010 at 9:26 PM, brokhernowhysher (75.23) wrote:

Sorry I'm late to the party.  I have noticed some of your comments on other posts, and decided today was the day to check out your blog.  We have a similar investing style and I did enjoy your last comment about the sky is falling syndrome.  The best time to buy is when everyone else is selling and the best time to sell is when everyone else is buying.  

We had a value investor speak at our local investment club.  The amount of time he spent looking into a probable buy was enormous.  Calling the CEO for insight, traveling to inspect buildings and inventory.  Hundreds of hours looking for the perfect buy.  When finished he was still at the mercy of a market that doesn't see what he sees, or worse still just decides to dump on every stock.

Still, I wish him well, he deserves a winner for all his hard work. 

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#16) On August 17, 2010 at 10:13 PM, truthisntstupid (92.27) wrote:

Brokhernowhysher

Hi!  How strange to be looking at the computer and suddenly see this blog that I thought had gotten as much attention as it was going to get a week-and-a-half ago pop up.  Usually by that time it has long since gaded away into oblivion.  Thanks for the comment!  If we have similar investing styles maybe you'd like to check out a couple of my others that are actually my favorites.  They were written in Feb of this year and give a better idea of what I actually do look for in a stock, and why I gradually came to choose dividend investing over value investing. This one only tells part of that story.  For all the work that guy did, he probably wasted much of all that effort.

http://caps.fool.com/Blogs/dividends-vs-capital/344638

This is the rest of the reason I grew away from value investing.

Thanks for reading and commenting!

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#17) On September 14, 2010 at 6:46 AM, TMFTypeoh (84.20) wrote:

From my post reply:

 

@truthisn'tstupid,

 Great post!  Yes again, we seem to be on the same page here.

The truth of the matter is, you are right.  However, i do think that:

1) It is easier to value some companies more so than others (ex, a straight forward retailer like GES is easier to value than a super complex beast like GS).

2) Having an approximate guess at valuation is more important than being precisely right.  

Will you ever know the exact value of a company?  Never.  It is impossible.  As you say, accountants can pull all kinds of levers to make any "earnings" number that they want.

They don't, however, have as much control over the cash flow numbers.  This is the main reason the motel fool focuses MUCH more highly on free cash flow (or "owners earnings") than simple earning metrics.

Also, its good to focus on the simple parts of the balance sheet, like cash, recieveables, and debt.

Yes, there is much we can't, and will never, know about any given compnay we can invest in.  But having SOME insight into an APPROXIMATE value of a company still probably makes you 10 times better off than simply looking at the chart to determine value.

Also, this is one of the main reasons i "out-source" my stock picking to the motley fool.  I am a member of stock advisor, hidden gems, and global gains.  Their research goes FAR beyond anything i could find (or understand).  95% or more of my stock picks come directly from them.  It is in that last 5% or so that i play with my own picks.

Still, good point.  Thanks for the comment.

 

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