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Tuesday, June 21, 2016

(VGI) Simple valuation methods are often right

(VGI) Simple valuation methods are often right

Author: ValueGrowthInvestor   |   Publish date: Thu, 9 Jun 2016, 09:16 AM 

Most might not know this but commonly, the most complicated valuation methods are the most easily manipulated. Take the DCF method for instance, It might look very sophisticated but many might not know that the many assumptions need to be made such as growth rates, discount rates and free cash flow. It is mostly used by financial experts and analysts who have a multitude of rationale to back up each claim. Some use average ROIC as measure to forecast price-to-book ratio.
Often, people ignore simple valuation methods such as the PE ratio. It is easy to understand and easily calculated. The common school of thought is that lower the better. The counter argument to that is that the low PE companies are expected to have low profit growth rates. But what if a company has a low PE at only 5-6x while displaying over 300% growth in net profits? Identifying such companies was the reason I started writing.
The only question is, what would you do if you found such a company? Wait for the herd to enter first?

Ricky Yeo you're right complicated valuation method can be easily manipulated but simple valuation like PE is just as easily manipulated as well.

The E in the PE has already been manipulated by interest income & currency, therefore you get a PE of 6.

The correct question is not about "Is simple valuation better or complicated valuation better?". But "what kind of valuation is the closest to making sense of real world?"

One can ignore cost of capital using simple valuation but cost of capital is real and alive. When a company cannot generate return higher than the cost of capital, it is destroying value no matter how low the PE is. The opposite is just as true
09/06/2016 14:13
yktay1 Ricky I think you shouldn't get too caught up with accounting/finance theories. Cost of capital this and that, you forget that the company is paying dividends and quite generously. Would a company with value being destroyed return capital to shareholders?

Also, currency and interest still equates to cash at the end of the day. I would be worried if it is fair value gain though.
09/06/2016 15:43
Ricky Yeo Cost of capital is not a gimmick, it is opportunity cost. If you invest $100 in a business and it earns $5 every year. It doesnt matter if the business keep that $5 or pay you all of it, you still earns $5, a return of 5%, it's just a matter of whether it is in your hand or in the business.

Now if you realise you can put your $100 in FD and get 3%, in ASB 6%, Rental yield 5% and on and on. The fact that the business cannot match the return of other equivalent or safer investment means it is destroying value. You did not put your $100 in other investment but in the business, that's opportunity cost, and it is not a finance theories.
09/06/2016 17:47
fung9815 Totally agree that valuation should be made simple, but I think many people misunderstood DCF.

Most DCF users out there (including the finance professionals) don't understand the gist of DCF, they just get the theory from business schools/CFA, then create the spreadsheets and fill in the blanks, ta da... the valuation is $xxx.xx million! So powerful!

Anyone realise that the terminal value calculation in DCF is effectively P/FCF or P/E? Ya I know formula wise it is {FCF(1+g)/(r-g)/(1+r)^t}, but it is actually the fxcking P/FCF!

To simplify it, terminal value is normally FCF/(r-g). So 1/(r-g) is how we all get our multiple on P/E or P/FCF. Say r=10% & g=2%, you get 12.5 times multiple; say r=10% & g=4%, you get 16.7 times multiple. It's actually a very simplistic thinking.

The essence is to actually understand r & g (not the biz school/CFA way, but the logical way).

As Ricky Yeo rightfully pointed out, r is opportunity cost. We should value the next idea based on the r of our best idea, it's not rocket science (as Charlie Munger put it).

g is "long-term" growth rate, so don't jump the gun and impose a 8% LT growth rate because no company in this world can grow 8% "perpetually". 5% is the max I give, and I only give it to Coca-Cola.

When you understand (r-g) deeply, the world will become so simple.
10/06/2016 09:44
kcchongnz Often, people ignore simple valuation methods such as the PE ratio. It is easy to understand and easily calculated.

"If something is easy to compute and understand, it is extremely unlikely that the market will misinterpret it. Therefore, such information will not, by itself, provide evidence of mis-pricing."
10/06/2016 10:29

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