Many investors make the mistake of associating value investing with buying stocks that have a low price-to-earnings (P/E) ratio. Its true that stocks with a high P/E ratio have produced above-average returns over long periods in the past. But it is not always the ideal method to use for valuation.
Intrinsic value is the calculated value of an investment. But they also have a perceived value. In many cases, the calculated intrinsic value is the value used for valuation. But investors must perceive the value of the investment, as well. Thus, intrinsic value is calculated and then perceived as valuable.
- The definition of the intrinsic value of an asset is simple: It is all the cash flow that will be generated by that asset, discounted back to present value.
- Investors must distinguish between the reported net income and true, owner earnings. This is the amount of cash that the owner could take out of the business.
- Return on equity is another important measure that indicates the profit earned after taxes to the total amount of shareholder equity.
Intrinsic Value Gives a Business Different Valuations
At its core, the basic definition of the intrinsic value of an asset is simple: It is all of the cash flows that will be generated by that asset, discounted back to present value. It is also at an appropriate rate that factors in opportunity cost and inflation.
Opportunity cost is often measured against the risk-free U.S. Treasury.
How Do You Apply Intrinsic Value?
Figuring out how to apply present value to individual stocks can be difficult. It depends upon the nature and economics of the business.
Benjamin Graham was the father of the security analysis industry. He believed you had a much higher likelihood of good investing results over long periods by focusing only on those opportunities within your areas of expertise that you know are better than average.
All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks could have more intrinsic value than a steel mill that requires tens of millions of dollars in startup capital.
All else being equal, an advertising firm deserves a higher P/E multiple. This is because the shareholders aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment in an inflationary environment.
Net Income and Profit to Earnings
Smart investors must distinguish between the reported net income figure and true, “economic” profit or “owner” earnings, as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out and reinvest elsewhere or spend.
In other words, it doesn’t matter what the reported net income is. Thats because reported net income can be fudged. Rather, what matters is how many hamburgers the owners can buy relative to their investment in the business. This is also known as return on investment (ROI).
ROI is the measure of what you receive for the capital you give.
That is the reason capital-intensive enterprises are typically anathema to long-term investors. They realize very little of their reported income will translate into tangible, liquid wealth. This is because of an important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity (ROE) generated by the underlying company.
ROE is another important measure for investors. It indicates the profit earned after taxes to the total amount of shareholder equity. This profit to equity metric demonstrates how different variables (revenue, taxes, interest, asset turnover, etc.) contribute to the returns on equity. When using return on equity as a measure to value a stock, you should also be mindful of the amount of debt carried by the company. This leverage would inflate the figure reported in the ROE metric.
The result of this fundamental view is that two businesses might have identical earnings of $10 million. Company ABC might generate only $5 million; the other, XYZ, $20 million in “owner earnings. In this case, Company XYZ could have a P/E ratio four times higher than its competitor ABC. Yet, it could still be trading at the same valuation.
Remember that financial ratios should not be looked at as performance indicators on their own. Rather, they should be used in conjunction with each other. This provides a more holistic view.
Stocks With a High P/E Ratio and the Margin of Safety
The danger with this approach is that if it is taken too far, any basis for rational valuation is quickly thrown out the window. For instance, lets say you are paying more than 15 times the earnings for a company in an ordinary interest-rate environment. Or, you are paying 20 times per earnings in a sustained, record-breaking-low-interest-rate environment. In that case, you need to examine the underlying assumptions you have for its future profitability and intrinsic value.
With that said, a wholesale rejection of shares over that price is not wise. In the 1990s, the cheapest stock in retrospect was a major computer manufacturer at 50 times the earnings. When it came down to it, the profits it generated meant that—had you bought it at a price equal to a mere 2% earnings yield—you would have crushed nearly every other investment.
But ask yourself this: Would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry? Or if you didnt know about the future drivers of demand, the commodity nature of the personal computer, and the low-cost structure that gave the business an advantage over its competitors? Probably not.
The Ideal Compromise of P/E Ratios
The perfect situation arises when you get a business that produces large amounts of cash with little or no capital investment.
Heres a test you can use. Try to imagine what a business will look like in 10 years. Both as an equity analyst and as a consumer, do you think the business will be bigger and more profitable? How will profits be made? What are the threats to its competitive landscape? If you asked yourself these questions around 1990, you might have chosen not to invest in companies that made typewriter ribbons, for instance.
If you had been asking these questions around the year 2005, you might wonder about the efficacy of a large video rental franchise. Other technologies had begun to render that business obsolete. Businesses in some sectors are now in the position that a video rental franchise was then. Technology is changing the way that businesses and consumers interact. And this is causing uncertainty in some industries.
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