Valuation

I am writing this to have a written record of my current valuation methods and to instruct those who are perhaps looking for a fresh viewpoint.

I started reading about investing two years ago this month.  In my search for new investment knowledge, it seemed as though the timeless principles of investing all dealt with how to think about investing, and less with how to apply it.  The principles laid out by Benjamin Graham created a framework from which to make decisions, but he spent little time on how to value companies.  Frameworks are vital and it is necessary to read the likes of Graham, Buffett, etc… but you also need to find a way to apply the principles in a manner suitable to you.

Most research work and investment ideas I look at seem to have a slew of statistics meant to show how under- or over-valued a company is.  I see investors listing P/E, P/book, P/cash flow, liquidation value, replacement value of assets, P/sales, discounted cash flow models, enterprise value, etc… all at the same time.  These metrics take away from a valuation and replace intuitive thought with various multiples paid for a company.  It is all “noise” to me.  In looking further into P/E, P/book, and all the others, I wanted to determine how best use them and which of these metrics is the best for valuation.  With these multiples, the investors who have done consistently well used them in diversified portfolios.  They figured that buying enough companies at a low multiple for P/E, P/book, or P/sales would yield them the returns they desired over time.  This makes sense to some & the idea of diversification sits well with them.  If you are interested in a simple strategy of diversifying into statistically cheap companies, this is a decent way to invest your money.  However, the idea of understanding the companies you own deeply aligns much more with my thinking, so these strategies are not helpful in valuing a business.

Where, then, is one to go looking for valuation?  I have seen many investors attempt to tackle this discussion, and although many have tried, few have succeeded.  I’ll let you be the judge of which category I fall into.

I have thought long and hard about the importance of different sections in a company’s financial statements.  For example- what is the importance between operating earnings and net income?  How about operating cash flows and free cash flows?  Why use EBITDA sometimes, and EBIT in other situations?  In comparing the different ways to measure performance, I believe the best place to look is the cash flow statement.  Although the Income Statement is designed to match expenses to revenues earned in the same period, it is somewhat open to manipulation and I often question the reported net income figures.  I find that the Income Statement is much better used for comparing one period to another in terms of the margins and how they change across the years.

The distinction between cash flows vs. reported income matters based on what can be pointed at as truly “earned” by the owners of a business.  As a shareholder, you are most concerned with what is truly earned for you, so this is what I focused on.  Income statement attempts to show what was earned by the business, regardless of how much they actually were paid in cash.  The cash flow statement doesn’t pay attention to whether it was earned or not, it just shows the amount of cash received by the business.  Cash flows are not open for discussion and are almost impossible to manipulate for a business, so I prefer the cash flow statement.  Also, all the debt and liabilities a company has are non-negotiable.  They must be paid in cash, so the cash from operations are what matter to me.  Even if the business earned the money, if they don’t have the cash, they will have a lot of trouble in covering liabilities.

“Operating cash flows” is the cash earned by the business during the year.  Although 99+% of businesses use the “indirect method” in reporting operating cash flows, this is what it would look like as a direct statement:

Cash received from customers       $XXXX
Cash paid to suppliers                      $XXXX
Cash paid to employees                    $XXXX
Cash paid for operating expenses $XXXX
Cash paid on interest                        $XXXX
Cash paid in taxes                              $XXXX

Cash flow from operations             $XXXX

This can be recreated from any business, even if they use the indirect method.  Check it out on the Internet if you’re interested, it is explained in full on many different websites.  This is much closer to the true economic reality of a business than when they performed services for someone, especially if they will be paid later.  These are the figures most commonly reviewed by owners of small businesses.  They care most about where the cash has gone within their business.  Some people value companies purely based on this amount of cash created by the operations of the business.

Others make the distinction of valuing the company based a “free cash flow” basis.  Free cash flows equal the operating cash flows minus the capital expenditures (capex).  Capex can be subdivided into two main categories- the maintenance capex and the growth capex.  Maintenance capex is the money spent on maintaining the assets, whether it is fixing a leak in a factory or replacing a furnace.  Growth capex is my term for what most companies call “purchases of property, plant, & equipment”.  It is the money spent on investing cash into things such as new restaurants, more railroad lines, or a new factory.  The idea behind cash flow is that the assets of a business need to be updated or maintained to continue operations, and therefore should be subtracted from the company’s annual earnings figure.  The “free cash flow” is the most pure measure I can find for the annual creation of shareholder value each year.  To see how management is deploying this cash, take a look at the financing & investing cash flow statements.

So, for cash flows, I make a very important distinction that I have never seen made before.  (This may be my first contribution to the field of investing, although it’s not terribly exciting).  Some people look at operating cash flows, others look at free cash flows.  I use both- it just depends on the specific business and their current situation.  For a company that is fully established, paying out most of their earnings in dividends or share buybacks, and is not actively growing any more (Johnson & Johnson, Proctor & Gamble, Pepsico, etc…), I would value them on a free cash flow basis.  The only value created for shareholders each year is in the free cash flows, which are then subsequently paid out in whichever way management sees fit.  Their capex is mostly used to maintain their business, and therefore has no value to the shareholder.  Contrary to this is a company who is actively reinvesting their earnings in growing the business further for years to come (Aeropostale, Buckle, Jack in the Box).  For these companies, the capital expenditures are very important and should not be subtracted out of the cash earnings.  To get a sense of the importance of these capital expenditures, the investor should take a look at the historical “return on assets” figure and how it has changed over the years.  Return on assets is the net income divided by the assets and is a measure of the returns the business gets from its overall asset position.  It is not a perfect measure of asset efficiency, but can give the investor a good sense of what returns have come in the past from investing in certain assets.  If the environment the business is investing their cash into has not changed materially, the investor can expect similar returns on reinvested earnings in the future.  I define a great business with having the ability to reinvest their earnings for at least a 12% return per year.  This 12% ROA figure, when multiplied by a modest level of debt, can lead to a 20% return on equity:

(Net Income)/(Assets)   *   (Assets)/(Equity)   =    (Net Income)/ (Equity)

Return on equity is held near and dear to all investors, however I believe much more in return on assets.  Perhaps with the passing years, I will find more importance with ROE than with ROA- for now, with my current level of thinking, I like ROA.  So, with businesses reinvesting their earnings at a 12% or greater return, you will have superior economics working in your favor if you allow this to occur over time and you don’t pay a totally silly price.  For companies earning below this 12% ROA figure (11% is okay, but in general, I don’t like single-digits), I feel as though management could be doing a better job of allocating capital, or they should be returning the capital to its shareholders.  I know I can get better than 5% or 8% return on my investments, so I don’t like seeing management investing in substantially lower-yielding investments than I myself could be making.  For companies getting less than 10% ROA, I would just value the company based on a free cash flow basis.  Capex is valuable to the investor if it is done intelligently- I don’t want to be valuing sub-par capital allocation, even if it shows up as growth.  Make sure that the company is growing before you assess the ROA figure- the company could have a high ROA figure, but if they aren’t investing in growing the company further and are deploying their capital elsewhere, the capex should not be used in your valuation.

So, as a summation of that large paragraph above:

  • For established companies not focused on growing, I value on a “free cash flow” basis
  • For companies growing through capital expenditures, it depends on ROA:
    • 12+% ROA, value based on “operating cash flows”
    • <11% ROA, value based on “free cash flows”

As an aside, I am aware that companies grow in other ways beyond capital expenditures.  Some grow purely through research & development (pharmaceuticals, technology), and some grow through hiring more employees (consulting, law firms). My discussion generally applies to companies generating earnings from hard assets.  Research & development is its own Rubik’s cube to solve and depends on factors far different from assets.  Growing through number of employees would depend on how margins on the income statement have changed; it can show you if the growth was done intelligently.  How I would define a “growth” company would be, perhaps, at least 10%+ per year in sales if the margins are consistent (you don’t want growth in sales if it doesn’t lead to increased profitability).

So, I have made my distinction between operating and free cash flows for companies that are growing vs. those that are established.  There is one group of businesses that, although they may earn high return on assets, require a lot of maintenance capex.  They are very capital-intensive businesses and eat up a lot of cash.  In these industries (auto parts, auto manufacturing, airlines, steel, offshore drilling, dry bulk shipping, etc…), it is better to value on a free cash flow basis.  The constant need for capital does not enable these companies to throw off lots of excess cash to their owners and should therefore be looked at on a “free cash flow” basis.

With these general outlines for you, I’ll now lead you into actually applying it to the real world.  Rarely will you read about a valuation technique that applies in many situations, however I feel that mine works in most situations.

I view businesses the way an investor would view bonds; with yields.  If you pay $100 for a bond that pays you $10 every year, you end up with a 10% return each year.  Any 4th grader can explain this concept and it makes perfect sense.  However, very few investors apply this yield concept to businesses.  Before, I defined the “value created” for shareholders as either operating or free cash flow, depending on the environment in which a business operates.  Here is a question every investor should ask himself- what return are you willing to accept from a business in return for investing in a security that is historically much more volatile than bonds?  I am looking for a return of 20% for free cash flow businesses that aren’t growing, and a return of 15% today if that business is growing.   That 15% in the first year ($15 from a $100 investment) will grow each year near the rate of return on assets ($15 payout becomes $16.50, becomes $18.00, etc… over time).  A 20% annual return doubles my money roughly every three and a half years.  This is my minimum requirement for a company.  To reach this 20% figure, you must pay 5X the company’s appropriate cash flow valuation (operating or free).  5X an interest payment on a bond would have you pay $100 for a $20 interest payment, giving you a return on it every year of 1/5, or 20%.  So, in my screening of most investments, I will do a quick overview of every business to see if I understand them.  After meeting this first requirement, I then see if it is trading close to the appropriate cash flow measure.  You then want to make sure that management of the business is sufficiently skilled & honest to reinvest those earnings for you.  Management skill in the cash flow valuation method is key- without it, you will get terrible returns on the invested cash.

I will sometimes “stretch” this method to encompass a 6X or even 7X (about 16% or 13% return) if I truly believe in the company & its management.  Warren Buffett has run into trouble in the past with lowering his standards, and it is something to keep in mind, but if no screaming discounts are available and I love the business, I may pay 6x or 7x if I like the businesses being offered to me at those prices.

Many of you may be saying, “Hey, that is similar to P/E ratios or P/cash flow ratios!”  You are right. My method is very similar.  The main differences are:

  • I am focusing on yield, whereas most P/E users assign arbitrary P/E multiples that are taken seemingly from nowhere
  • I seek to identify the true shareholder value creation in each company’s financial statements to determine which metric to add a multiple to (operating, free cash flows)
  • I do not focus on what investors used to pay on a multiple basis.  I am looking at the returns that can be expected from paying a certain price and allowing managers to reinvest my earnings for me.

On the valuation for selling a company, I will write a separate article.  There are many reasons to sell a company and it would make this discussion of valuing a company far too long.

Even if my valuation method doesn’t change your mindset from where you are currently, I hope it has at least given you something to think about.  I appreciate all and any commentary on my work.  It is my pleasure to share what I can and I would like to generate discussion.

Here’s a pdf of this article: Valuation

Please comment on my work, I appreciate and encourage discussion.  Enjoy.

Advertisements

About Andrew Schneck

I am a value investor focused on misunderstood securities and industries, with an eye for long-term stock ownership.
This entry was posted in Investment Principles and tagged . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s