- The Little Book of Valuation outlines how to identify and value various types of companies. In short, you learn to assess the worth of seven types of businesses on an intrinsic (given this company’s cash flows and risk, is it under- or overvalued?) and relative (is this company cheap or expensive, given how the market is pricing other companies just like this one?) basis.
- The author presents some multiples and associated companion variables that might prove profitable to combine when screening for bargaining stocks.
- You’ll learn “what to look for” for two of the seven types, namely growth and mature companies.
I’ve enjoyed listening to quite a few of Aswath Damodaran’s YouTube-videos on valuation, so I deemed it worthwhile to read this condensed book on valuation. A great, easily-read book that outlines how to identify and value various types of companies: young growth, growth, mature and declining as well as financial, cyclical and ‘intangible-rich’ businesses. As the actual valuation models used to assess the worth of each type are neatly outlined on Aswath’s own website, I will dedicate this write-up to the more general lessons of The Little Book of Valuation.
Technicians and Cynics
Aswath starts off chapter 1 by stating that in order to “not pay more for an asset than it is worth” (p. 3), you need to value whatever you are buying before buying it. The approach of buying a stock because “others will pay a higher price in the future”, which many ‘investors’ resort to, is absurd. Buying a stock solely based on its price movements are cynical: “Oscar Wilde defined a cynic as one who ‘knows the price of everything and the value of nothing.'” (p. 3)
So, as so often proclaimed here on the blog, an investment decision revolves around an estimate of the underlying business’ worth. There are two ways to assess such.
Intrinsic vs. relative value
The two overarching valuation methodologies are intrinsic value and relative value:
A business’ intrinsic value offsprings from an assessment of the amount of free cash flow you can expect to receive from the given assets during its lifetime, and how uncertain you feel about said cash flows. In other words, the intrinsic value is calculated via a discounted cash flow (DCF) analysis.
A business relative value is determined by comparing how the market values the asset in question with similar assets, i.e. one oil company compared to another based on its P/E, P/BV, ROE, margins etc. Note, however, that other authors such as Stephen Penman calls this approach a no-no. In his book, Accounting for Value, he says that price should be determined by reference to fundamentals; determining that A is worth X because B is worth Y is not a viable way to go about valuing a business (according to Stephen).
Yet, Aswath promotes relative valuation, but too says it should be used in conjunction with an intrinsic value assessment. In length, he states that each method answers a different question: “With intrinsic valuation, the question we are answering is: Given this company’s cash flows and risk, is it under- or overvalued? With relative valuation, the question being answered is: Is this company cheap or expensive, given how the market is pricing other companies just like this one?” (p. 226)
Regardless of how you go about calculating a business’ worth, it’s conventional wisdom that a value estimate is just that: an estimate. There is no finite result, but having an idea of whether the asset is undervalued is the inevitable starting point to being more right than wrong: “Success in investing comes not from being right but from wrong less often than everyone else.” (p. 12)
Finding Bargain Candidates
In the post The Hunt and in the book summary of The Manual of Ideas, I have gone over a few ways to screen for bargain stocks. Aswath presents some multiples and associated companion variables that might prove profitable to combine. For instance, one could screen for businesses with low P/E multiples, but a high PEG variable as a way to find cheap growth stocks. The table below outlines these multiples and variables:
|Multiple||Companion Variable||Mismatch Indicator|
|P/E||Expected Growth||A low P/E with high expected growth in EPS.|
|P/BV||ROE||A low P/BV with a high ROE.|
|P/S||Net Margin||A low P/S with high net profit margin.|
|EV/EBITDA||Reinvestment Rate||A low EV/EBITDA with low reinvestment needs.|
|EV/Capital||Return on Capital||A low EV/Capital ratio with high return on capital.|
|EV/Sales||Operating Margin||A low EV/Sales with high after-tax operating margin.|
Company Types: What Should You Look For?
As mentioned above, The Little Book of Valuation teaches you to identify and value no less than seven types of companies. There are three common characteristics for all – its capacity to generate cash flows, its expected growth of these cash flows and the uncertainty/risk associated with them – but the models applied to each are slightly different in terms of mechanics and assumptions. Hence, I’ll again refer the reader to Aswath’s website. However, I would like to highlight the “things to look for” in the two types of companies I find myself analyzing most frequently, growth companies (i.e. Playtech PLC (PTEC)) and mature companies (i.e. McKesson Corp. (MCK))
Growth companies need to scale-up growth while preserving profit margins in order to succeed. In trying to find such businesses, you should keep an eye out for..
- Scalable Growth: Can the business’ product offerings be diversified, and thus cater to a wider customer base as it grows?
- Sustainable Margins: Success attracts competition, so you need to ask yourself: Can the business in question preserve its profit margins and returns as it grows?
- The Right Price: Make sure you don’t overpay for rosy growth prospects.
Mature companies are characterized by i.e. revenue growth that tracks or hovers around the economy’s overall growth rate, established margins, a tendency to build-up cash as reinvestment needs drop off and acquisition-driven growth. These companies succeed/improve by operating more efficiently (i.e. cutting costs, improve productivity or redeploying assets to better use), reinvest more or better, and augmenting existing barriers to entry to strengthen its competitive advantage. In trying to find such businesses, you should keep an eye out for..
- Performance Indicators: The worse a company is run, the greater the potential for increasing value. Look for low operating margins, returns on capital and D/E ratios relative to the sector.
- Potential for Management Change: Management has to change in order to ‘unlock’/increase value. Avoid companies where a change of management is impossible.
- Early Warning System: In length of point 2, focus on firms with a catalyst for management change, i.e. an aging CEO or an activist investor on the board.
In short, you’ll learn tons about valuation of businesses! Each company type is demonstrated with a case study, which delves into both the intrinsic and relative value of the business in question. Furthermore, you’ll be presented with a “things to look for” checklist as the ones presented above. Now, I need to find something to value!