Value investors focus on valuation. Nothing surprising there. We want to find companies whose share prices are at meaningful discounts to their underlying value. Warren Buffett best captured this concept with his timeless quote, “Price is what you pay, value is what you get.” The idea behind this quote is that price does not necessarily equal value, an important proposition for avoiding a common investing mistake.
Determining “price” is easy for investors in publicly traded shares – it is, of course, the current market quote. For major institutional investors, who might need to move large positions measured in 100,000 share increments, “price” is a bit murkier as their volumes will influence the price, but generally, their realized price will be close to the quoted price. For private companies, “price” is murky as there is no market quote at all.
The biggest challenge for value investors is determining “value.” There is no single correct value for a company, given the vast number of internal and external traits including management quality, product/service relevance, competitive edge, financial condition and business environment. A key ingredient in any valuation is a measure of risk, yet risk is unobservable. And, as the future is unknowable, investors must build some assumption about a company’s prospects into their valuations, making valuation subject to this potentially random variable.
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A company might be worth more to some investors than others. To activist investor Jana Partners and private equity firm Ares Capital, Frontier Communications (FYBR) is worth a lot more than what the typical public equity investor believes, given the two firms’ combined 16+% ownership and their pressure for Frontier to sell itself.
And, the apparent value of companies may change quickly. The recent earnings report from Tesla (TSLA) suggests that its underlying businesses aren’t quite worth what investors previously believed.
How can a value investor determine “value?” One readily available approach uses valuation multiples1. The price/earnings multiple is the most common metric. Other metrics, including EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization), provide a deeper understanding. This ratio compares a company’s business value to its cash operating earnings. Price/book value is helpful for financials and homebuilders. Mining companies might be valued on price/net asset value.
Once the right metric is selected, how does an investor avoid a common investing mistake and select the right multiple of earnings (or other base)? While frustrating to hear, this is an art, not a science. But, this is also an opportunity, as many investors and popular media use flawed reasoning.
One common investing mistake we see (amazingly often) is in comparing a company’s current multiple to its average over the past five years. One example: Deere & Co (DE) trades at 12.7x estimated 2024 earnings, a sizeable 20% discount to its five-year average multiple of 15x. But few could argue that Deere shares are cheap. Per-share earnings have more than tripled over this time, with investors driving the multiple higher in anticipation of this impressive growth. In 2020, the price/earnings multiple reached 25x forward estimated earnings – a multiple that is highly unlikely to be reached again in the foreseeable future. Earnings growth will almost certainly be much lower over the next several years and could readily turn into earnings declines.
And, critically, interest rates today are much higher, with the 10-year Treasury yield at nearly 5%, so the value of future earnings is lower than when interest rates were approaching zero. These two basic fundamentals render a quick comparison to the five-year average multiple nearly meaningless and likely dangerous to investor profits.
For value investors who avoid this common investing mistake – the flawed use of an otherwise worthy metric – their skills will readily set them ahead of many others.
[1] Investment firms may use a discounted cash flow analysis. This approach may be more robust in theory than a valuation multiple approach, it suffers from significant flaws ranging from selecting an appropriate discount rate to a heavy reliance on years-away cash flow assumptions. The DCF approach is best used as a comparison within a modeling system that includes the investors’ entire relevant universe of stocks – an approach available generally only to those with enough resources to employ a team of analysts.
As specialists in value investing, we focus on companies that trade at sizeable discounts to their underlying value. We do all the extensive analysis and valuation work to help you benefit from truly undervalued stocks. Our capabilities save you time while boosting your chances of profitable investing. Over the past three years, the portfolio of Buy-rated recommendations for the Cabot Turnaround Letter has generated a 19.9% annualized return compared to the 10.2% annualized return of the S&P 500, as compiled by the independent ratings organization Hulbert Ratings.
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