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Value investing and valuing a business

Originating from the economist and investor Benjamin Graham, the philosophy of value investing has been a strategy employed by some of the most successful investors in history including Warren Buffet and David Dodd. This approach revolves around investing in stocks trading at a discount to their intrinsic value but there is always one critical question inherent in this investment philosophy; what valuation multiples do you use to identify the intrinsic value of a company?

Selecting valuation multiples

Unfortunately there is no single method of valuation and it is subjective whether an investor places more importance on current assets and earnings or on future cash flows and growth prospects. Over the years there have been opposing thoughts. Modern Portfolio Theory argues that due to the Efficient Market Hypothesis, all stocks trade at their fair value and it is impossible to identify undervalued shares. Yet it is widely agreed that value stocks have consistently outperformed growth stocks in the long term and some of the most successful investors have continued to outperform the market by identifying companies that are trading at a significant discount to their intrinsic value.

Keeping in mind that there are a range of multiples and valuation models that can be employed in value investing, there are some key factors that are often considered in valuing a business.

When we qualitatively analyse the quality of a business, the fundamental drivers of value include the company’s management team and their experience in the respective sector, the company’s strategy and plans in place for the company’s expansion. Translating this to quantitative drivers, return on equity and capital, debt to equity ratios and cost of capital come into play. A value investor should also take into consideration accounting policy differences which can skew profit multiples, and can lead to misleading valuations of companies in comparison to its sector. Depreciation, goodwill, provisions and deferred tax should be considered. As a result, a company’s cash flow is a good metric for valuation as it is free from accounting distortions and its EBITDA is a suitable measure to assess profitability.

The Price to Earnings (PE) Ratio is one of the most common multiples used by the retail investor to indicate if a share is over or undervalued but this can be misleading for a few reasons:

  • earnings are subject to different accounting policies
  • different capital structures will lead to a gearing effect on the earnings which will skew results for different companies
  • a low PE could be a sign of negative market sentiment towards the stock rather than a reflection of the stock being undervalued.

The Price to Book Value, which represents a company’s share price over its book value, is often used to value a business where value is generated through its tangible assets. This is where Return on Equity comes into play. Financial stocks, especially banks, are often valued using the Return on Equity ratio due to their high levels of leverage from deposits coupled with significant assets through loans. Return on Equity can reflect how efficiently a company utilises shareholders’ equity to produce profit, as well as how effective the company manages its debt and asset turnover. A company with a consistently increasing Return on Equity and a decreasing debt level is often a sign of an effectively-managed business.

After analysing these key valuation multiples, investors should gain an in-depth understanding of the company’s business model and its sector to make a more informed investment decision.

What to look for in listed companies

My golden rules for investing are:

  1. Make informed and educated investment decisions
  2. Know why you are buying shares in the company
  3. Do not speculate
  4. Invest only when there is an opportunity
  5. Invest in quality companies with great future prospects
  6. Understand the business before investing
  7. Have an exit strategy
  8. Have patience and discipline.

Value investing is a strategy used by some of the most renowned investors in history and is a proven approach that can help the medium to long term investor identify undervalued businesses. The market is dynamic and volatile and investors should have a clear strategy and direction before making any investment decision. An individual should invest in quality stocks that are trading below their intrinsic value with a target in mind.

Michael Kodari is Managing Director of Kodari Securities (KOSEC).

 

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