Valuation Is Overrated
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.