Part 4 in a series of tutorials on value investing: When it comes to valuing stocks, one size does not fit all.
Part 4: Building a Valuation Framework:
Comparing Apples to Oranges
With our investor’s toolkit in hand we can now begin to examine the companies in the stock market in more detail and develop a more nuanced approach to calculating fair value.
When we looked at the General Store in part 2 of this series we came up with the rough rule of thumb that the average small cap company should trade at a p:e of around 12. This, of course, will change if the market as a whole becomes overly exuberant or unreasonably despondent. I’ll cover this in more detail towards the end of this section. For now, though, let’s assume that market conditions are comfortably in the middle, between these two extremes.
You could get a long way in the market if this was the only criteria you used to evaluate new investments. You could simply search for average looking companies and then buy any whose p:e ratio was trading significantly below 12.
However, while there seem to be an overwhelming number of stocks to choose from (well over 2000 in the Canadian markets), once you weed out all the chaff, you’re really only left with a few hundred that are worthy of more careful consideration. And most of these will be fairly priced. It would be hard to fill an entire portfolio solely with deeply undervalued, average-looking companies. If you’re limiting yourself to only looking at these middle-of-the-road sorts of companies, you’ll miss out on a lot of exciting opportunities in other sectors of the market.
But how do we compare the value of a run-of-the-mill retailer with a high-flying technology company or a beaten-down oil drilling company? In other words, how do we compare stock market apples to stock market oranges? Our general store type of model won’t necessarily fit these other companies very well. To handle this, I’ve developed 6 separate categories that I use to characterize different types of stocks. Between them, these 6 categories cover a broad enough cross section of the marketplace that I can usually find enough deep value opportunities to fill my portfolio. Once I’ve properly categorized a stock and calculated its fair value, I can use this information to more accurately compare it to sometimes quite dissimilar companies in other categories. I simply buy whichever stock is trading at the biggest discount to its fair value.
Here, then, are the 6 different categories that I’ve used to develop a more complete valuation framework.
Most of the time I focus on small and mid cap companies. Here’s where I often find the greatest value opportunities. The numbers that I bandy about in the following descriptions relate to these smaller sized stocks. However, once in a while a large cap company will cross my radar and this type of company merits its own category.
The average large cap stock will typically trade at a p:e of around 16 which has been the long term average for large cap stocks over the past 50 years. If I find a large cap company that catches my eye, I’ll use this as my yardstick for fair value instead of the 12 times earnings that I use for the typical small cap company.
The valuation disparity makes sense if you consider the more volatile nature of smaller companies. A smaller company is more likely to see its earnings plunge during the periodic business downturns that affect the economy. Out of a 10 year business cycle, earnings might drop to zero in 2 or 3 of those years. When we calculate our p:e ratio we are using the earnings from a robust, non-recessionary year. The average earnings over a full business cycle will tend to be lower than this number for the typical small cap stock, whereas for a large cap stock, earnings are more representative of the long-term average. Being more reliably consistent, the large cap earnings are worth more to investors than the more variable earnings of the small cap stocks.
By slotting large cap companies (in Canada, that means a market cap of over $1 billion) into their own unique category, we can more properly value them and compare investment opportunities in this space to those in the smaller, more volatile end of the market.
Turning our attention now to the small cap arena, the next distinguishing characteristic I look at when determining which category to slot a company in to is its growth rate. Given that a company’s value is primarily tied to its future earnings, it stands to reason that a company that is expected to double its earnings over the next few years is worth considerably more than a company that appears to be stuck in a rut.
As I said in the last section, you can’t be too precise when estimating a company’s future growth. There are a lot of factors that are going to determine that rate of growth and many of them are simply unforeseeable. When categorizing companies in terms of their growth profile, I typically only use three broad categories: high growth, average growth and no growth. This gives me enough wiggle room so that I don’t have to get too obsessive about trying to estimate growth rates to the nearest percentage point.
Over the past 50 years or so, small cap stock prices have risen by about 7% per year. If we’re careful with our start and end points, this also means that earnings have grown at about the same rate. And this is the rate that I use when I refer to “average” growth. To qualify as average, I am looking for companies that are growing at somewhere between 5 and 10% a year. Over a 10 year period, this means that they will have roughly doubled in size. If you were to look back at the company’s results from 10 years previously, you should see that sales, earnings and book value were all roughly half of what they are today. Again, we don’t have to be too precise. If sales have climbed by 13% a year while earnings have risen by 8% and book value has climbed by 7%, that’s close enough. I’m just trying to ballpark things here.
An important exception occurs if the company has been issuing a high dividend. If the company is dividending out most of its earnings to shareholders, it is unreasonable to expect it to also be able to reinvest in its own growth. So a high payout ratio (which measures the percent of earnings that are paid out as dividends every year) can get a company into the average growth category even if earnings haven’t been growing.
Assuming that debt levels are reasonable and that there are no other mitigating factors (the impending loss of a patent, say), a company with this sort of average growth profile should have a fair value of around 12 times earnings.
Even though their growth may be wholly unremarkable, these kinds of stocks can still make wonderful investments if you can buy them at a big enough discount. In fact, this category of stock has probably made up the majority of my investments over the years. I’ll often try to tilt the odds in my favour by searching out those companies which may have exhibited average growth in the past but have some tricks up their sleeve which might end up surprising investors with higher growth in the future. Maybe they have a pile of cash on their balance sheet or a new product about to be introduced into the marketplace. Because the market is not expecting too much out of them, they are less likely to disappoint and may pleasantly surprise you instead.
Because of this potential, and because of the values you can often find here, I’ve labelled this category “perfectly average”.
Moving down the growth spectrum, I have my “wallflower” companies. These are companies that are just treading water. They don’t pay out much of a dividend so we can’t give them a pass for that. Despite their best efforts, profits have been stagnating or declining for the past number of years. Maybe they are in a dying industry or are struggling with a legacy product that no one wants anymore. Maybe the company is just very badly run. For whatever reason, they are going nowhere fast. But every dog has its day. Sometimes they can get their act together and turn things around. Pivot into new lines of business, develop new products, hire more competent managers. If they do, the stock price can soar. I need to be able to buy this at a steep discount to make the gamble worth it, but even a dog like this has its price. I put a fair value p:e of 8 on this sort of stock.
The High Flyer
Some companies will have a line on something more exciting. Maybe a new technology, process, brand or service that lets them grow at a significantly higher rate. I call these companies “high flyers” and they can make great investments if you can find them at the right price. To qualify as a high flyer I am looking for growth in earnings (ideally confirmed by a similar level of sales growth) of 20% or more per year and I want to be able to see ways in which this growth could continue for another few years at least. Through trial and error and observation (backed up by a little mathematical modelling after the fact) I have established a p:e of around 20 as a fair value estimate for these sorts of companies. If I can find a stock with these kind of growth characteristics at a big enough discount to this fair value then I will gladly jump onboard. Not only do I get a nice ride from the p:e ratio rising to meet my fair value target, but if I’m right about the growth trajectory, I’ll enjoy an added tailwind along the way from an increase in the underlying earnings.
If you try to look too far out into the future, your crystal ball can get pretty cloudy. To qualify as high growth, I expect to see growth rates of at least 20% a year (which means that I’m expecting earnings to double over the next 3 to 4 years) but I don’t try to look beyond that. In fact, I generally expect growth to slow back down to an average rate at some point in the not too distant future. Which is why I don’t assign higher fair value p:e ratios to these sorts of companies. Some companies will go on to produce stellar growth year after year, but they are the exception, not the rule. Especially in the small cap arena, spurts of rapid growth often have a limited lifespan.
In these situations, growth doesn’t really enter into the equation. In fact, quite the opposite: earnings have taken a trip into the cellar. These are companies that have fallen on hard times. Often the company will be losing money or just scraping by. However, there is good reason to expect that the downturn is temporary. It may be due to external factors that are cyclical in nature. A recession may have dampened sales at a clothing retailer or a drilling rig operator may have got caught up in the periodic boom and bust cycle of the oil patch. The decline could also be due to company specific factors that you think can be rectified. Maybe the company launched a new advertising campaign that was a huge flop and this has temporarily hurt their results.
You can’t use a regular p:e ratio to value these companies because they often don’t have any earnings at the moment or if they do, they are severely depressed and not indicative of what the company might make going forward. In these turnaround situations, I still use a p:e ratio to evaluate their fair value but I go back and use an earnings number from before the downturn that I feel is representative of what they might earn once they get back on their feet. As well, I use a lower p:e ratio of 8 to these “peak earnings” as my fair value estimate to compensate for the added risk that things may not, in fact, turn around as quickly or as completely as I expect.
Other factors besides earnings become more important in these situations. The company has to be financially solid, with no or low debt levels so that it can last a year or two without any profits coming in. Cash in the bank is even better. I also like to see positive cash flow even if earnings are negative from an accounting perspective. (Earnings often include non-cash expenses like depreciation. Cash flow backs out these non-cash items and gives you a sense of how much cold, hard cash is actually flowing into or out of the company.)
The risks are definitely elevated with this sort of investment, but the rewards can be worth it.
The Asset Play
In the normal course of events, a company’s book value doesn’t figure heavily in to my calculations. It’s nice to see a relatively low price to book value ratio to give you some reassurance that there is something tangible there to support the stock price if things really go off the rails but I will gladly buy a high flyer for 5 or 6 times book value if the earnings and growth rate are there to support the decision. You can’t always have it all. It’s often the companies with relatively little in the way of hard, physical assets that can grow the most quickly.
However, for the more beaten up names in my portfolio, a bit of meat on the bones is a reassuring thing to have. In the wallflower and turnaround situations, a large tangible asset base is something the company can fall back on to secure additional bank funding and to help support the stock price, so I will pay more attention to the book value in these cases.
As well, there is a separate category of investment that I stumble across every now and then called the “asset play”. These are companies with a large asset that may be underappreciated by the market. Maybe it is a large hoard of cash or a valuable piece of real estate. Or maybe it is a fleet of unused drilling rigs that were mothballed in the last oil industry downturn. Whatever the source, the stock price is trading at a big discount to the value of this asset. The way in which the company will eventually manage to monetize this asset is often unclear, so this sort of investment requires patience and a bit of a leap of faith. But it helps to add a bit of variety to the portfolio.
For this category of stock, I use the price to book value ratio to assign it a fair value instead of the p:e. As a rough guideline, and a fairly conservative one at that, I’ll usually use a price to book value of 1 as my estimate of fair value. If the company has significant assets and I can buy those assets at significantly less than their current dollar value then I feel I am getting a good deal.
The Market Environment
This overview of the valuation framework I use to value stocks wouldn’t be complete without mentioning the role that investor sentiment has on overall market prices. The market fluctuates between periods of over exuberance and irrational pessimism. I’ve had the privilege of getting a taste of both extremes on more than one occasion over the past 21 years. When the champagne is flowing on Wall Street, stock prices and average p:e ratios can get considerably higher than what you’d usually expect to see and when the tide turns the other way, p:e ratios and other valuation metrics can get driven down to unreasonably low levels.
My anchor has always been the typical small cap company with a reasonable amount of debt, growing at a decent rate of 5-10% per year (the “perfectly average” companies). This sort of company usually trades at a p:e of 12. But when stock prices have been bid up, it is not unusual to see it trading hands at 16 times earnings. At the same time, the prices of all the other kinds of companies out there tend to rise as well. A large cap, “whale” might be expected to fetch a p:e of 20 in this environment instead of its long term average of 16 while even “wallflowers” and “turnarounds” can sell at a reasonably pricey 12 times earnings.
Conversely when prices drop, as they did during the Great Financial Crisis of 2008, there were many “perfectly average” companies to be had for only 8 times earnings. So my fair value calculations always have to take into account the kind of market environment I am in. When prices are high, I need to raise my fair value estimates and when times are tough, I need to dial them back again.
Unfortunately, there is no easy way to tell exactly how much you should be adjusting your numbers by. The best method is through simple brute force. Take a look at a bunch of average, small cap companies and see what their p:e ratios are. If they are clustering around the 16 mark then you’ll know that you need to raise all your fair value estimates by a similar amount to compensate for the market’s over exuberance. Either that, or refuse to play along and park your money in cash. Likewise, when the market is in a funk, you may be able to tighten up your standards considerably and lower your fair value estimates accordingly.
The Valuation Framework
By using my 6 basic investment categories (perfectly average, high flyer, wallflower, turnaround, asset play and whale) I can cover a good cross section of the investment universe. Not everything qualifies. There is no category for “money losing internet stock or prospective mineral exploration property” for example. But if the company is making, has made or is likely to make a profit then I can usually find some category to shoehorn it into. It may not be an exact fit, but it gets me into the rough ballpark and if I’m always buying at a big discount to whatever fair value this leads me to, that’s been more than enough to produce impressive long-term returns.
I can also use these basic categories as building blocks to cover more unique situations. Most of the time, for instance, if a company does not have a high enough growth rate to make it into the high flyer category it will get lumped in with all the other “perfectly average” companies out there. Sometimes, however, the company has displayed consistent, long term growth in the more middling range, say 15% per year. If I am fairly confidant that this will continue then I might assign it a fair value in between the average and high growth categories, using a p:e of 16, say. Or perhaps a company is a turnaround candidate which normally gets assigned a fair value of 8 times peak earnings but they were growing quite rapidly before a recession brought things to a screeching halt. If I think growth will resume once the recession fades then I might bump up the fair value I assign to this turnaround candidate.
The categories I’ve described here give me a framework I can use to compare different companies. The numbers I’ve given for p:e ratios are rough guidelines and aren’t meant to be slavishly adhered to although I do stick pretty close to them most of the time.
To recap, here are the fair value rules of thumb I apply to the different stock categories (adjusted up or down depending on market conditions):
Perfectly Average – p:e 12
High Flyer – p:e 20
Wallflower – p:e 8
Turnaround – p:e 8
Asset Play – p:b 1
Whale – p:e 16
With this valuation framework in place, I can now move on to the real nitty gritty of stock analysis. In part 5, I dissect in detail the step by step process I use to evaluate every potential new stock investment.