Be wary of shortcuts that pretend to assess a stock’s value4 min read . Updated: 27 Feb 2016, 01:51 AM IST
Extending working capital cycle can help show high Ebitda margins but may deteriorate cash flows
If there is an art in successful equity investing, then surely it is in the process of valuing the business. When one looks at the landscape of financial measures that claim to value the business, one is reminded of a circus artist twisting and twirling to enthrall the audience. Many of these valuation techniques are at best entertaining, at worst, ensnaring the innocent investor.
Valuing any asset essentially involves three steps. First, how much does it cost to invest? Second, how much cash will the asset or investment produce in future? Finally, when exactly will the cash be produced in future?
In the case of a bank deposit, all three questions are easily answered. With an equity investment, the first question is answered by looking at the price of the stock. To answer the second and third questions one needs to make certain assumptions. The eventual difference between the assumptions made and the reality which enfolds determines the success of the investment.
This is the only way to assess the value of the stock or company (or a piece of land or even a college education). Every other method touted around is a shortcut and they only work under certain conditions specific to each one of them. In order to assess the quantum and time frame of receiving future cash flows, it is important to understand the nature of the business, its management and its competitive positioning. Just like all predictions, it is reasonable to believe that there are no guarantees: no prediction will necessarily be entirely correct. How does one then value companies? This involves two steps. One, as stated above, a thorough knowledge of the business is imperative. Second, a buffer has to be built in for unforeseen events that may occur. These steps are not easy to take and are also not completely analytical. Therefore valuing business is a bit of an art. But one can become a maestro in it by practice.
If one finds it difficult to make a prediction of future cash flows, one can easily calculate the expected cash flows embedded in the price of the stock. Once the expected stream of cash flows is calculated, which can arithmetically justify the stock price, one would have to look at it realistically and make an assessment if such cash flows are indeed possible. As an illustration, if an investor desires a 15% return per annum from an investment and the stock is trading at 20 times price-to-earnings (P-E), then the company will have to compound its cash flows at the rate of 10% until the end of time. If the stock is trading at 10 times P-E, then the ask rate of growth of cash flows will drop to 5%, and at 30 times P-E, it goes up to 11.7%. This way one can make a reasoned judgement whether the business can actually deliver these growth rates.
This illustration makes an important assumption: earnings are similar to cash flows. If that is true then P-E is a good shortcut; else not. Many times, reported earnings are much higher than cash flows. Assuming cash flows are 75% of the earnings, the stock which is trading at 20 times P-E will need to grow its earnings at 11.25% as compared to 10% in the illustration above. If cash flows are 50% of earnings, then the ask rate goes up to 12.5%. Therefore, it is better to buy a company at 30 times P-E than 20 times P-E, if the cash flow conversion from earnings is higher in the former than the latter as shown above.
As we discussed earlier, there is a tendency to “saw off" the profit and loss statement and use those financial numbers as proxies for cash flows, which can be dangerous. Replacing a man with a machine can increase earnings before interest, taxes, depreciation and amortisation (Ebitda) but may not make any difference to cash flows. Extending working capital cycle can help show high Ebitda margins but may deteriorate cash flows. Instead of using such truncated ratios to value business, investors should go through the trouble of doing it the right way, which is also the hard way.
The moment a new shortcut is invented to value a business, it becomes vulnerable to manipulation. One has seen such sawed off ratios where the denominator is replaced not just by operating earnings, but sometimes by sales, and many a time amazingly by physical attributes such as “eyeballs" or “acres of land". Investments made using such shortcuts rarely have a happy ending.
There is one shortcut ratio that is reasonable and can be looked at. This is the dividend yield ratio. Of course, as with all shortcuts, one should remember that this one, too, can give a flawed signal. This would happen when the sustainability of future dividends is in doubt. As sustainability comes into question, the price will keep coming down and hypothetically the price will be equal to the dividend (100% dividend yield) if there is just one more dividend which the company is expected to pay.
To conclude, successful investing starts by learning the language of business—accounting. It then requires developing a deep understanding of the economics of the business. Finally, it requires cultivating imaginative powers to make reasonable assumptions of the future to determine the value the business.
Huzaifa Husain is head equities, PineBridge Investments India.