Part 2 in a series of tutorials on value investing: Putting theory into practice. How we might begin to value an old time general store.

Part 1: My Investment Philosophy

Part 2: The General Store:

Assessing Fair Value

In part 1 of this series, I explained my basic value investing philosophy. When I buy a stock, I like to think of myself as buying the whole company, not just a small piece of it. I like to buy with a long-term outlook, mentally prepared to hold on to this investment through thick and thin. Finally, and most importantly, I only buy companies that are trading at a big discount to their fair value.

This is where things get slippery. Fair value is an opinion, not a fact. Ask 10 different value investors what the fair value of a company is and you will get 10 different answers. Having said that, the approach I have developed has led me to outperform the market by a very wide margin over a long period of time. After owning hundreds of different stocks over the years, I can report that my estimate of a company’s fair value often seems to be pretty close to where the share price eventually winds up. Here then, is how I think about and calculate fair value…

Case Study: The Local General Store

In the small town where I live, there is a wonderful general store. The main floor is taken up by a well-stocked grocery section with lots of fresh, local produce and all the basic staples you might need. Upstairs is a gift store with an interesting collection of knick-knacks and next to this is a restaurant with a stunning view looking out over the water. I have spent many mornings here over the years with a stack of pancakes doused in maple syrup, a bottomless cup of coffee and the business section of the Globe and Mail spread out in front of me.

If I wanted to buy this business, how would I determine what a fair price would be to pay for it? For this thought experiment, let’s say that the business has a very competent manager who has been running the day to day operations for many years and has every intention of staying on in this role. As the new owner of the business, we are simply going to sit back, let this manager do their job and collect our payout. As amazing as it seems, this sort of free ride is exactly what you get in the stock market, so let’s pretend that this is how our private investment will work as well.

In this scenario, how would we determine what a fair asking price for this fine establishment might be? In other words, how would we assess the fair value of this business? The first place I would start, as I do with any new stock that I look at, is with the business’s financial statements. These are a treasure trove of information and include all sorts of interesting financial details about the company; its total sales, its profit or loss, the value of its real estate, its inventory, the way that money flows in to and out of the company, the value of any dividends it might pay, its tax rate, etc. Out of all of these numbers, however, there is one that stands head and shoulders above the rest in helping me put a fair price on the business. For our general store, what do you think that one piece of information might be?

Book Value

The store sits in its own building in a beautiful location, right off of main street, next to a park and overlooking the water. This building is a valuable piece of real estate. We could perhaps ask for the appraised value of the building and base our offering price on that. But we’d have to know if the building was owned outright or if it was rented. If it was owned we’d want to know if there was a large mortgage outstanding on it. And this ignores any other assets or liabilities the business might have. There’s the value of all that inventory, for instance. On the other side of the equation, the owner might have taken out a large loan from the bank to do some major renovations a few years back and we’d have to factor this into our calculations as well. If we added up all the things the company owned (its assets) and subtracted out all of the money it owed (its liabilities) we’d come up with a final number that is commonly referred to as tangible book value. One possibility might be to use this book value figure as our estimate of fair value and base our offering price on that.

But this ignores a lot of intangible value that the company might have. The owner has spent years building this business, establishing a brand and a reputation and perfecting its day to day operations. There is a good chance that the business is worth significantly more than just the value of its hard, physical assets. We could certainly offer the owner a price equal to the book value of his business. We could even try to lowball him to see if we could get the business at a discount to its book value. If he agreed to our offer, though, we’d have to pause and ask ourselves why he was willing to sell us the business for only the value of its assets, giving no additional consideration to the business he has built on top of those assets. Perhaps we have just bought ourselves a lemon!

Sales

So what else could we use to value this business? We could look at its total sales (also called revenues). All of the bunches of organic kale, the loaves of fresh baked bread, the boxes of macaroni and cheese and the plates of hungry man breakfasts that it serves, all added up over the course of a year will give us a number for the general store’s total revenues. Could we base our offering price on this number? Not really. Grocery stores are a low margin business. The store might sell a lot of stuff, but if its expenses are too high it might actually be losing money. Buying a business that could be losing money isn’t really what we had in mind.

Profit

Sales and book value are valuable pieces of information to have but at the end of the day what we really want to know is how much money the company makes. Once the store has paid all of it’s myriad expenses, once it’s paid the farmers for their pints of fresh picked blueberries, once it’s paid my son (who worked there one summer) to wash the breakfast dishes, once it’s paid the electric company to keep the lights on, once it’s paid the bank the mortgage interest on the building and paid the tax man his share, how much is left over? The amount that’s left over is the store’s profit. (This is also frequently referred to as earnings, income or net earnings or net income.) If I could have only one piece of information about a company, this would be it: the company’s annual profit.

As a new owner of the business, this profit is the money that is left over for me, free and clear, after everyone else gets their piece of the pie. It is not earmarked for anything. If the accounting has been done properly, I can take this money out of the business (by way of a dividend) and the store would not suffer in any way. I can use this money to pay for my son’s university education or buy a new car. Or, I could simply sock it away in my bank account.
This profit is the return that I am hoping to get from my investment in the general store and so plays a big role in determining what price I am willing to pay for that investment. Let’s say that after paying the general manager his salary and paying all the other expenses that come with running a business, the store is clearing $100 000 in profit a year. (probably a lowball estimate but it makes the math easy.) What then would be a fair price to pay for the business?

It’s Just Not Fair

It might help to start by identifying what wouldn’t be fair. If the current owner was asking $3 million for his business, I would say, “thanks, but no thanks.” It might be a wonderful establishment to frequent as a customer but as a potential new owner, the payoff at this price is just not there. If the annual net earnings of this business were $100 000, that’s how much I could take out of the business every year. At a $3 million asking price, it would take me 30 years just to make back my initial investment. 30 years is a long time. A lot can go wrong in 30 years. Perhaps a hyperspace bypass will be built through the middle of town.

Looked at another way, the $100 000 in annual earnings that this store is generating would represent a return of 3% on our initial investment of $3 million. We would say that the earnings yield of this investment was 3%. Again, considering the fairly substantial risks inherent in owning a small business, this is just not enough of a potential return to make it worth our while. The price is going to have to be lower to entice us to buy.

What if we offered $500 000? Now the math is looking much more favourable. At this price, the return on our investment would be 20% ($100 000 being 20% of $500 000). If we took all of this money out of the business, we’d have made back our initial grubstake in only 5 years. After that, the intergalactic civil planners can do as they want. Of course, the current owner is no dummy and is unlikely to sell off his baby at such a low price.

The Mighty P:E Ratio

The ratio of the purchase price of a business to its underlying earnings is known as the p:e ratio. Price divided by earnings. In our general store example, to calculate the p:e ratio of this investment we simply take the price that we would have to pay to buy the entire business and divide it by the earnings or profit that that business is generating every year. At a purchase price of $3 million, we’d be paying a p:e of 30 for this investment and at a price of $500 000, we’d be looking at a p:e of 5.

We can apply the same math to investments we might make in the stock market. Here, you’re not buying an entire company, you’re just buying small pieces of a company (known as shares). Each share is entitled to a tiny piece of the overall company profits. If a company had earnings of $10 million a year and there were 10 million shares outstanding in the company, then each share would represent an ownership stake in $1 of those total profits. ($10 million profit / 10 million shares = $1 per share) This company would then be said to have earnings per share (EPS) of $1. If the share price was $10 then the p:e ratio of this stock would simply be the purchase price of a single share ($10) divided by that share’s small piece of the total earnings ($1). $10/$1 = 10. So this company would have a p:e of 10.

You can do the same sort of calculation using a company’s market cap. Market cap is short for market capitalization and is how much it would cost you to buy up the entire business by buying up all of its shares at the current share price. If you took the market cap of the company in our example above (10 million shares x $10 share price = $100 million) and divided that by the annual net earnings of $10 million, you’d get the same p:e ratio of 10.

Show Me The Money

The p:e ratio is a very common way to look at stock investments. It highlights the notion that when you buy a stock, you are buying an actual piece of a company and with that piece comes an ownership claim on a proportionate share of that company’s annual profit. With our general store example, there was a straight and direct line between the profit the company was generating and our own personal bank account, as a proud, new owner of the company. With public stock market investments, that line is a little more hazy. One way or another, though, those profits still find their eventual way into our pocket. For example, companies can choose to dividend out all of their earnings to shareholders. In this situation, we would quite literally get our share of the profits deposited directly into our brokerage account on a regular basis. But often the company will choose to retain some or all of these profits to reinvest in the growth and expansion of the business. While it might take longer, this money is still ultimately destined for our wallets. The company might use this money to make an acquisition, buying up another company. The added profits from this new acquisition will boost overall profits and thereby raise the value of the company and the price of our shares. Or it might invest more directly in its own growth by building a new factory or hiring more salespeople. Again, this should hopefully lead to higher profits and a higher share price. The company could also use the earnings it is generating to buy back shares, reducing the total number of shares and thereby increasing the proportion of the total earnings attributable to each of the remaining shares.
One way or another, those earnings should find their way back into our pocket as a shareholder in the company. While a little more abstract, this is directly comparable to our example of the general store and it is how I look at all the investments I make.
The p:e ratio (or derivations thereof) is where I and most value investors, hang their hat. There are many other factors to consider when making an investment. How much debt is the company carrying? How does it perform during recessions? What are its plans for future growth? But after taking all of these other things into account, the p:e ratio still usually forms the core of our fair value assessment.

For our general store example, we determined that paying 30 times the annual earnings was too much, while being able to buy the business for 5 times earnings seemed like a steal. Likewise, in the stock market, a stock with a p:e of 30 is looking very pricey while one with a p:e of 5 (assuming everything else checks out) could represent a real bargain.

It’s All About The Earnings

To my way of value investing, it’s all about the earnings. I look at stock market investments the same way I’d look at buying the general store. As the new owner of these businesses, my chief consideration is how much money my new company will be generating for me (ie how profitable it will be). Whether these profits get dividended out to me or whether they are re-invested in the future growth and expansion of the business, this money should eventually find its way into my pocket. And by extension, it’s the price I pay for every dollar of those earnings that determines whether I am making a good investment or a bad one.

In somewhat simplistic terms, the lower the p:e ratio, the higher the return you should expect to get on your investment. To a certain degree, my investment approach over the past 20+ years has simply been to search out the companies with the lowest p:e ratios.

Of course, there’s a lot more that goes in to it than that. You need to look at a company’s financial health. Are they loaded down with debt or do they have a big wad of cash stashed away in their bank account? Are the earnings you’re basing your p:e calculation on accurate? Have they been distorted by one-off events like a big legal settlement or the sale of a business division? Does the company operate in a highly cyclical industry and if so, do current earnings represent the top of the cycle or the bottom? Is the company dependent on a single, large customer for the bulk of its business? Does it have a strong track record of growth or have earnings been spotty and unreliable? All these considerations and more enter into the equation.

Cheap For A Reason

The market is not made up of idiots (although there are times when one might question that statement). Most stocks out there with low p:e ratios are cheap for good reason. Value investing is about sifting through a large pile of low priced stocks (as measured by the p:e ratio or perhaps some other test of value like the price to book ratio) and identifying the reason that the stock is cheap. 9 times out of 10 there will be a very good one. In these cases, investors are essentially saying that they do not believe the earnings of the business are sustainable. They believe that earnings will drop in the future, bringing the p:e ratio (as calculated using the new, lowered earnings) more in line with the rest of the market. (If the share price stays the same but earnings drop then the p:e ratio will rise to a more normal level.) And usually, they are right. But every so often, you’ll do your full due diligence on a low-priced stock and you won’t find anything wrong with it. After unpacking your entire bag of tricks and combing through the company’s financial statements, annual reports and news releases you still won’t have found a good reason for the bargain basement price. That’s when you back the truck up and hit “buy”!

Setting The Scene

The p:e ratio is a very useful tool. But how exactly do we use it to help us estimate the fair value of a company? In my general store example, I made a few assumptions. I assumed that the company was profitable and that the profit figure I was basing my fair value estimate on was representative of what the business was going to continue to make going forward. I assumed that the company was not in hawk up to its eyeballs and that there were no nasty skeletons (a pending lawsuit related to a slip and fall on the ice outside the store, for instance) in its closet. Let’s also assume that we take some of the profit every year and use that to pay ourselves a dividend. What’s left over we’ll use to gradually expand and grow the business, maybe adding a take-out pizza counter downstairs or maybe buying the next door lot to use as an outdoor farmer’s market in the summer.

Most businesses, especially smaller ones, are cyclical. That is, their fortunes rise and fall with the business cycle. During good years, business is brisk and profits are fat. During recessions, people tighten their belts and buy less organic produce and specialty soaps. Profits recede for a while before coming back in the next up cycle. Let’s assume this applies to our general store as well and that we’re currently in the expansion part of the business cycle so that current earnings are indicative of what the company might earn in one of the good years (which fortunately outnumber the bad years).

It’s Okay To Be Average

I’ve just described what I use as my model for an “average” company. I would actually classify most of the companies in the stock market as average. They might have the occasional run of good fortune or might hit a rough patch every now and then but there is a strong tendency for reversion to the mean. If a company is making inordinately large profits, other companies will take notice and muscle in on the same sector, bringing down profits for everyone. Likewise, if a company has fallen on hard times, there is a strong incentive to cut costs, lay off staff or pivot into more promising areas to bring profits back in to line. It is unusual to see companies that can earn unusually high rates of return and grow significantly faster than normal for extended periods of time. These companies do exist and if you can find one that is cheap enough they make great investments. But the exceptional companies rarely come cheap.

Investors tend to be drawn to the expensive, high growth, glamour stocks like moths to a flame but they are missing out on the real opportunities in the broad middle of the market. Here is where you are more likely to find those overlooked, undervalued stocks. If you can find them at a low enough price, these un-sexy stocks can go on to give you very sexy returns.

My Valuation Framework

Over the past 20 years, I have developed a series of rough rules of thumb that I use to value companies. I start off by slotting companies into one of a handful of broad categories. I’ll use a somewhat different approach and set of valuation guidelines for each category. Most of the companies I buy fall into the “average” category. Let’s call them “average joe’s”. For smaller companies (those with market caps of less than $1 billion) that fall into this category, I generally consider them to be fairly valued if they are selling for around 12 times their annual earnings, with those earnings being representative of what the company might make in a normal, non-recessionary year. I want them to be financially healthy, without too much debt and not have any black clouds on the horizon. I’m not setting the bar very high here. (although quite a few companies will fail to pass even this low hurdle.)

So for our general store, I would put a fair value on this company, assuming all my conditions and assumptions are met, of roughly 12 times annual earnings. If the company was making $100 000 a year, I would put a fair price of $1.2 million on it.

I mentioned previously that if I look hard enough I can usually find a few companies that are trading at a 40% discount to their fair value. If I’m saying that the value of the typical, smaller sized company is roughly 12 times its annual earnings, then that means I’m looking for companies that fit this description that I can buy for a p:e of 7 or less. If I find a gem like this, I’ll buy it.

Over the past two decades, this broad rule of thumb has served me quite well. I have stuck to these numbers most of the time. There have been periods of excessive investor euphoria when stock prices rose significantly above this level and I was forced to relax my criteria to find anything at all to buy. And there were a few months after the market meltdown in 2008 when stocks went on sale and I was able to tighten up my standards and buy companies at p:e ratios well down in to the lower single digits. But for the most part, I have used this p:e of 12 rule as a reasonable approximation of the fair value of the typical, smaller sized company.

Fair Value Is An Opinion

As I said at the beginning, fair value is an opinion, not a fact. You can’t directly measure fair value. What looks fair to one investor will look overpriced to another. Professional stock market analysts can put together incredibly complex valuation models. They can make detailed earnings estimates stretching 5 or 10 years in to the future and then extrapolate back to the present to come up with a target price to the nearest penny. Their reports can stretch to 25 pages or more with fancy graphs and charts that attempt to look at the business from every possible angle. While there is sure to be valuable information and insights in these reports and I, myself often spend hours researching a company before pulling the trigger, the detailed estimates they come up with are misleadingly precise. And, judging by the overall track record of most analysts, may not be worth the price of the paper they are printed on.

The business world is a chaotic place. Companies rise and fall and fortunes can turn on a dime. While thorough research and understanding are key, you can’t let yourself get too enamoured of your own analysis. I have found a few general valuation rules of thumb to be far more useful than trying to predict future earnings to the nearest penny. There is no way of knowing if a company should rightly be worth a p:e of 12 or 14 or 10 or if earnings will come in next year at $1.00 or $1.10 or 90 c. And that’s okay. All you need to do is get in the right ballpark. Because you’re always buying companies at a huge discount to what admittedly can only ever be a rough estimate of their true worth, if you’re ultimately off by 10% or 20%, you’ll still come out ahead in the long run. And for every company that disappoints and ends up being worth less than you thought it might, there is one that pleasantly surprises you and ends up being worth considerably more than what you had expected.

In Part 3 (The Investor’s Toolkit), I’ll explore in more detail some of the basic accounting  measures I use to evaluate a new stock.

Part 1: My Investment Philosophy