Global Value Investing

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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Value

 

Meaning of Value   |   Stock Valuation   |   DCF Valuation   |   Model Types   |   Types of Growth


Meaning of Value

"He who controls vocabulary controls thought." Ludwig Wittgenstein (1889-1951), Austrian-born philosopher.

     
  From The Annotated Alice : Alice's Adventure in Wonderland & Through the Looking Glass, by Lewis Carroll, originally illustrated by John Tenniel, with an Introduction and Notes by Martin Gardner, 1960, pages 264 and 269. New York : New American Library.
     

The term "value" refers both to a concept and to a quantity. The concept of value is an economic concept, and it can be progressively refined as follows until reaching a sufficiently unambiguous meaning:

The term "investment value" refers to the concept of pure, true, intrinsic, economic value. The phrase "expected investment value" refers to investment value adjusted for risk and uncertainty. Economic valuation is the estimation of economic value.

Even with all these qualifying adjectives to clarify the meaning, the phrase is awkward and remains ambiguous. A less ambiguous distinction is between deep value and surface value. Deep value is investment value based primarily on intrinsic economic value estimated from expected future discounted cash flows and buttressed by accounting book value, quality and other aspects of value independent of market price. Deep intrinsic value can include qualitative factors such as brand recognition, franchise, corporate governance, labor relations, government contracts and assets that are not usually marked to market. A corporate governance score such as Standard & Poor's CGS [PDF or HTML] use criteria that may be indicators of long-term value creation, including both a Corporate Governance Score for a company and a separate Country Governance Classification for its country of origin. The criteria are fairness, transparency, accountability and responsibility, as elaborated in Standard & Poor's Corporate Governance Scores: Criteria, Methodology and Definitions, July, 2002. Surface value is a misnomer -- it is not really value but rather market price, usually expressed as a ratio either with accounting items such as earnings, dividends, net worth, and sales, or with growth rate. Surface value is analogous to unit pricing of fungible commodities by number, by volume, and by weight, for comparison shopping without regard to quality.

The quantity of value is an estimate or approximation. The estimated quantity of value is based on an appraisal or a valuation. It can be expressed either as an interval estimate or a range of quantitative values, or as a single-point estimate or a single quantity of varying precision. Either way, intrinsic value can be quantified as Net Present Value (NPV) based on Discounted Cash Flow (DCF) analysis.

Price is not value, neither in concept nor in quantity. Price is a market-generated quantity. The confusing term "market value" is really market price. The confusing term "fair market value" is really fair market price. The fair market price is the price that equals the single quantity that best approximates investment value. The best point estimate of investment value is the mean of the distribution of values rather than the median of the distribution of values or the midpoint of the range of values.

The distinction between human values and economic value is discussed in Investing with Your Values: Making Money and Making a Difference by Hal Brill, Jack Brill, and Cliff Feigenbaum (see citation in General Books). Whereas, the market is an effective mechanism for translating human values into the common metric of price, a valuation model is an effective method for estimating economic value.

In addition, the phrase "intrinsic value" is not to be confused with its use in a philosophic sense where the intrinsic value of something is said to be the value that it has “in itself,” or “for its own sake,” or “as such,” or “in its own right,” and extrinsic value is value that is not intrinsic [Zimmerman, Michael J., "Intrinsic vs. Extrinsic Value", The Stanford Encyclopedia of Philosophy (Fall 2003 Edition), Edward N. Zalta (ed.), URL = <http://plato.stanford.edu/archives/fall2003/entries/value-intrinsic-extrinsic/>.]

Another term that is used to refer to economic value is "fundamental value", which derives the quantity of value from so-called fundamental economic metrics generated by a firm at the firm-level, in contrast to pricing metrics generated by a securities market at the security-level. 

Markets often fail due to externalities. An externality is either a cost (negative externality) or a benefit (positive externality) that is not explicitly included in a price. In product markets, there are both production externalities and consumption externalities. An example of a positive production externality is company basic research that leads to discoveries with spillover effects beyond its commercial interests and beyond all commercial interests. An example of a negative consumption externality is the non-recycled waste of a non-renewable natural resource. Remedies for these product market imperfections or flaws are presented in The Ecology of Commerce by Paul Hawken (see citation in General Books). The reason why Earth is facing a man-made ecological crisis is presented in Ishmael by Daniel Quinn, and the complementary reason how we got to this crisis is explained in Guns, Germs, and Steel : The Fates of Human Societies by Jared Diamond (see citations in General Books). Market externalities often are a result of open-access systems known as commons that are discussed in Managing the Commons edited by Garrett Hardin and John Baden (see citation in General Books). Some companies and industries face a larger potential adjustment between their product prices and full product costs. Pricing externalities in product markets have a direct but uncertain impact on company valuations and an indirect impact on prices in capital markets.

Price is not value, pricing is not valuation, and pricing models are not valuation models. The conventional academic capital asset pricing model has one factor, the beta coefficient. Models that include beta are pricing models, not valuation models. This is not merely a matter of semantics. The difference between price and value, referred to as the margin of safety, is the raison d'etre of investment valuation independent of market pricing.

Stock Valuation

Economic value can refer to either value in use or value in exchange as understood by David Ricardo. For example, water has high value in use but due to an excess supply may have a low price or be free for the taking. Diamonds, in contrast, have high value in exchange due to their real or artificially-managed low supply relative to demand. Michel Foucault in The Order of Things : An Archaeology of the Human Sciences, page 167, writes: "A beginning is thought to have been made, too -- in the work of Cantillon -- on the task of disentangling the theory of intrinsic value from from that of market value; and the great 'paradox of value' was dealt with, by opposing the useless dearness of the diamond to the cheapness of the water without which we cannot live (it is possible, in fact, to find this problem rigorously formulated in Galiani); a start is supposed to have been made, thus prefiguring the work of Jevons and Menger, at connecting value to a general theory of utility." The apparent paradox between the value of water and diamonds is resolved by the difference between total utility and marginal utility.

Value in exchange for common stocks may be expressed in either absolute terms or relative to other stocks. Absolute value determined independent of market prices is sometimes called intrinsic value and is what the company would be worth to private owners. Intrinsic economic value is the ultimate, long-term value of an investment; i.e., the present value of the expected dividends and future selling price; i.e., what you can expect to get out of the investment.

The term value can refer to either accounting value, market value, or economic value. Measures of accounting value include book value per share, net worth per share, net asset value per share, and net tangible asset value per share. Market value refers to common stock equity capitalization or financial "size", and is equal to the share price times the number of shares outstanding. Publicly-traded market value includes only those shares that are not held in private accounts. Measures of accounting value and market value can be used for quick mechanical screening criteria for filtering out common stocks for further investigation. In contrast, economic value refers to intrinsic, long-term, ultimate value of an operating enterprise as determined by net cash flow analysis using spreadsheets and formulas. Intrinsic value is independent of quoted market prices. Accounting value is commonly confused with economic value. For elaboration on the crucial distinction between accounting and economic value, see the philosophy,
styles and screening discussion. Also see the comparison between 1st & 4th editions of Graham & Dodd's Security Analysis for explanation of intrinsic value concept and its shifting emphasis on growth.

There is no intrinsic value of gold or other commodities. They are inert, non-earning assets. As an investment, gold is a pure speculation because there is no internal creation of value. Industrial metals, such as copper, are less speculative than precious metals because their prices more generally reflect demand and supply. Nevertheless, extrinsic factors operating through buyers and sellers determine the price of every commodity. In contrast, for equities and other claims on assets, their value is intrinsic because it is generated by the underlying operating enterprise in the form of earnings, dividends, and cash flows. There are no intrinsic prices, only intrinsic values.

The method of valuation contrasts with both the method of forecasting growth for the sake of growth and the method of technical analysis. The valuation method considers no daily quotes, no charts, no breaking headlines, and no hot tips. Also, it does not take at face value any broker opinions or brokerage house research: neither fresh, bullish-sales biased, investment-banking compromised, buy/sell/hold recommendations with occasional self-contradictions and internal inconsistency for presentation to the larger institutional customers, nor stale versions of these same recommendations repackaged for smaller individual customers. Most importantly, no forecasts: neither those for official public consumption, nor the private "whispered" versions shared among colleagues (The Wall Street Journal, 16 January 1997, C1, C20). See citation in General Books. In short, no distractions, just the relevant facts. This, of course, does not greatly increase the demand for such information services.

There are three main types of estimates of the future. In order of increasing sophistication, they can be referred to as the naive, the gullible, and the expert. The naive forecast is based on linear trend extrapolations. The gullible forecast is based on analysts' estimates, such as provided by S&P Compustat's Analysts' Consensus Estimates, ACE, or by Institutional Brokers Estimate System, I/B/E/S. The expert prediction is based on rigorous systematic study of a company, its industry, and the economy.

Forecasts, predictions, prophesies, expectations, and anticipations concern the future. Man has always had an inordinate desire to know the future, and this is exploited just as fully as any other human passion. Aristotle in his Rhetoric (1358b1-1359a26, pages 32-34) made a distinction between hortatory statements about the future and expository statements about the present time. See the citation in General Books.

Following this lead, John Neville Keynes in his Scope and Method originated the use of the term "positive" to refer to "what is" and the term "normative" to refer to "what should be." See the citation in General Books. These terms make the distinction between facts about the present, on one hand, and opinions about either the speculative future or an ideal state on the other hand, respectively. In philosophy, Hume's law is the insistence that the naturalistic fallacy is indeed a fallacy, and therefore conclusions about what ought to be cannot be deduced from premises stating only what is, and vice versa.

The important point here is that statements about future earnings growth rates are normative, not positive. They are opinions, not facts. No one's crystal ball is any more reliable than any one else's. Therefore, if not self-reliant, then one must rely on the expert opinion of others who have different agendas and conflicting interests. Similarly, statements about efficient and rational markets where all prices instantly converge to intrinsic value are normative, not positive. They are not reality, but rather utopian ideals approached by stock markets as complex aggregates but not by individual stocks. Perfectly efficient markets are necessary as a fixed standard for comparison, and thus serve a useful methodological function.

Reliance on the earnings estimates of experts can range from blind faith at one end of the spectrum to reasoned faith at the other end.. Even if an investor knows the difference between either cash flow or "free" cash flow, however defined, and true long-term economic earnings, and even if an investor accepts the operating definition of earnings used by experts, the acceptance of their estimates of earnings and growth in earnings constitutes an act of faith. Ambrose Bierce had some insightful comments about "faith, hope, and charity (love)" and about "education". See the citation in General Books. Is faith in speculation about future earnings more, or less, reasonable than faith in appraisal of today's value?

Not without reason does the U.S. Securities and Exchange Commission (SEC) censor forward-looking statements about a company's future prospects by following the Financial Accounting Standards Board (FASB) in their prohibition of making statements about future earnings in the documents filed with the SEC. Forward-looking statements about capital spending plans, R&D projects, share (re)purchase programs, and other uncommitted contingent activities find their public forum in press releases that are carefully worded to avoid class action lawsuits by disgruntled shareholders.

The important point is that growth per se does not always create value for the common stock owners. As John Burr Williams wrote (1938: 419): "That a non-growing industry can be profitable is shown ... , and that a fast-growing industry can be unprofitable is shown ... "

An important distinction is the difference between reported accounting value (book value or net worth per share) and intrinsic economic value (discounted future dividends per share). Book value does not reflect inflation and obsolescence, nor does it include intangible assets such as "franchises" and technological prowess resulting from R&D expenditures. In addition, book value per share is merely a mechanical screening ratio set at an arbitrary cutoff point which does not reflect judgment and does not reliably distinguish between underpriced bargain stocks and fairly-priced junk stocks.

Intrinsic economic value of an operating enterprise is appraised by use of discounted cash flow techniques in the so-called dividend discount model originated by John Burr Williams. He made allowance for both dividends and future selling price. He also explains how the transposed dividend discount model can be used to determine what the market as a whole is expecting, and this can be compared with the investor's expectation.

As John Burr Williams (1938: page 466) wrote: "in other words, Investment Analysis usually measures the relative rather than the absolute value of any stock, and leaves to the economist the broad question of whether stocks in general are selling too high or too low. ... From the point of view of this book, which is concerned with absolute rather than relative value, ... "

According to Williams (1938), the four basic factors needed to appraise the intrinsic value of an operating enterprise and thus its common stock equity, two economy-wide factors and two company-specific factors. The economy-wide factors are general price level inflation and the real interest rate. The company-specific factors are the estimated future net cash distributions to the stockholders and the discount rate or rates applied to those cash receipts. For foreign companies, a fifth factor may be required: the currency exchange rate, which is discussed at length by Williams (1954). This is important enough to justify a table to repeat it for emphasis.

Factors of Intrinsic Economic Value

Number

Description

1

general price level inflation rate

2

real interest rate

3

dividends or free cash flows to equity

4

discount rate or rates

5

currency exchange rate, where applicable

The investment value of a stock is conceptually a single point value, the mean of the distribution of investment value. Operationally, investment value is estimated as a range of values. For practical purposes, it is sometimes sufficient to estimate either the upper bound of the investment value range to deselect a stock or the lower bound of the investment value range to select a stock. As an example, if the upper bound of investment value of a given stock is confidently estimated to be no higher than $50 per share and the current quoted market price for this stock is $75 per share, then this particular stock can be deselected. Similarly, if the lower bound of investment value of another stock is confidently estimated to be at least $50 per share and the current quoted market price for this stock is $25 per share, then this particular stock can be selected.

Concerning the range of estimated appraisal values, Williams (1954:32-33) explained: "Scholar: Yes, economics supplies the answer to many questions of great practical importance. Skeptic: How can it possibly do so if it lacks the mathematical precision of astronomy? Scholar: Economics is more like chemistry than it is like astronomy. Or rather, it is like that branch of chemistry known as qualitative analysis, in contrast to quantitative analysis. In economics, just as in qualitative analysis, you don't always have to have an exact answer to have a useful one. For instance, if a chemist testifies in court that a dead man was found to have enough arsenic in his system to kill an ox, let alone a human being, then it really doesn't matter whether the amount of arsenic involved is two grams or ten, so long as the chemist is absolutely sure that what he found was really arsenic and not a related substance like tin or antimony. Precise measurement is unnecessary. The same is true in economics.

A rapidly growing company presents special problems in valuation. John Burr Williams (1938:560) succinctly writes "They had high hopes for their business, but no logical evaluation of these hopes in terms of stock prices. The very fact that [the company] was one of the hardest of all stocks to appraise rationally was the reason why it sold at the most extravagant prices, for speculation ever feeds on mystery, as we have seen before."

The problem with estimating an approximate appraisal value for rapidly growing companies is presented most clearly in the St. Petersburg Paradox. As David Durand wrote (see the citation in General Books) on page 362: "With growth stocks, the uncritical use of conventional discount formulas is particularly likely to be hazardous; for, as we have seen, growth stocks represent the ultimate in investments of long duration. Likewise, they seem to represent the ultimate in difficulty of evaluation." Maurice Allais resolves the St. Petersburg Paradox with his general theory of random choice and a related paradox (see the citation in General Books). These paradoxes are discussed along with risk as defined and measured mathematically for pricing models as opposed to valuation models.

Some investment strategies seek growth for its own sake or growth for the sake of growth rather than growth for the sake of value. Wall Street wisdom (pardon the oxymoron) adheres to the KISS principle as its highest virtue: Keep It Short and Simple. Most highly prized by brokers are slogans that fit easily on t-shirts and bumper stickers. As an example, one popular investment rule of thumb is that for a fully and fairly valued growth stock, the stock's price-to-earnings ratio should be equal to the percentage of the growth rate of the earnings per share of the associated company, i.e. PE = G. As with any such rule of thumb, this is not only superficial but also arbitrary and capricious. A common screen based on this heuristic is the ratio of the PE ratio to the EPS growth rate, or the PE/G. In an effort to better fit the historical performance of cyclical stocks and large-cap stocks, ad hoc variations on the PE/G ratio include (1) using an estimated future growth rate instead of an historical growth rate or PE/FG, (2) adding the dividend yield percentage to the EPS growth rate percentage or PE/DG, and (3) adding two time the dividend yield percentage to the EPS growth rate percentage or PE/2DG.

When discussing intrinsic value, we use the term appraise to emphasize analysis over the use of mere price multiples and mechanical screening based on price ratios. Whereas appraisal denotes an informed estimate of worth, valuation and pricing are highly synonymous and thus ambiguous in common usage. Nevertheless, appraisal itself can have a pejorative connotation in that strict appraisal includes an opinion based on subjective comparables.

That having been said, we mention appraisal practices and the specialty of business valuation, especially for small closely-held private businesses. There are three major professional valuation organizations: the American Society of Appraisers (ASA) with multiple specialties, the Institute of Business Appraisers (IBA) focusing on small, closely-held businesses, and the National Association of Certified Valuation Analysis (NACVA) composed of CPAs only. The American Institute of Certified Public Accountants (AICPA) is establishing their own designation for Accredited in Business Valuation (ABV) among other accreditations or practices. In addition, there is the Appraisal Standards Foundation that has published standards for valuation (real property, personal property, and business valuation) called the Uniform Standards of Professional Appraisal Practice (USPAP).

Another source of potential confusion concerns the management fad of economic value added (EVA). This edifice is built on the weak foundation of the theoretical Capital Asset Pricing Model (CAPM) which is univariate (monocausal) as opposed to multivariate, statistical as opposed to idiosyncratic (company-specific), potentially logically circular depending on the inclusion of additional so-called risk factors and thus not valid, and based on price as opposed to value. A more accurate name for this fad might be economic price added (EPA) to clarify the primary concern of increasing the quoted stock market price of the company's common stock which may or may not coincide with creating long-term economic value for the stockowners.

The sources of value of a company include the intrinsic value of the company as a strictly going concern and any potential resource conversions.


DCF Valuation

The valuation model for estimating the investment value of an operating enterprise in the private market, independent of the stock market price quotations, is based on the discounted cash flow (DCF) method using the time value of money. The classic work of John Burr Williams (see the models section at theory ) is the basis for the development of most equity valuation models, and his work is here referred to as the DCF Model rather than the narrower misleading name of Dividend Discont Model or DDM. For academic models of equity valuation, see Investments by Brodie, Kane and Marcus in General Books, or go to textbook models. For less academic approaches to firm valuation, see Damodaran on Valuation in Special Books, or go to his practical models of equity valuation. For a practical firm valuation model, see the McKinsey model tutorial with an example company valuation and downloads in a working paper at the Stockholm School of Economics. The McKinsey approach is the subject of the book titled Valuation by Tom Copeland et al in General Books.

The general model can be expressed verbally, mathematically, and graphically. Thus, in words:

1. If you commit your cash to a particular investment opportunity, then what cash can you expect to get out of it in return? What is your reward for abstinence and risk-taking?

2. What are the estimated net cash flows attributable to this proposed investment; i.e., what are the expected dividend distributions and the future terminal selling price?

3. What is the present value of these net cash flows, discounted at an appropriate rate of interest? This is the intrinsic economic value of the equity investment.

4. What is the margin of safety, both in dollars and in percentage? Is the intrinsic value per share of common stock greater than the stock market asking-price quotation by an amount sufficiently compelling to justify a long-term commitment to this particular investment?

Mathematically, the DCF model can be expressed both in an abstract standard form for the general case and in many concrete forms for simplifying special cases. Conceptually, the DCF Model is like an ideal of Plato which manifests itself in different empirical forms. We refer to these empirical forms types of the DCF Model. In all forms, the net present value of the investment, i.e., its intrinsic economic value, is equated with the sum of the products of each net cash flow and its discount rate. After intrinsic value has been estimated from fundamental data, it can be expressed in terms of earnings, book value, dividends, sales, cash flow, or other accounting measures, but this is not necessary. For computing assistance, see the financial calculators and spreadsheets in Selected Links.

Graphically, the model can be expressed in two dimensions as a horizontal time line with vertical bars showing positive and negative net cash flows, above and below the line respectively, from the date of your investment at time zero to the date of your future sale at the end of your horizon for this investment.


Model Types

Instead of estimating each cash flow for each time period using a general-purpose DCF model that can be used for any investment asset, we can make reasonable simplifying assumptions for different kinds of specific investments in order to develop formulas by which these estimates can be made. These formulas provide shortcuts to operationalize the theory, and represent different types of the dividend discount model (DDM). In each model type, dividends or free-cash-flow continue forever, but a terminal price may be assumed to simplify the analysis. These model types can be given names so as to emphasize their specific simplifying assumptions.

Some of the most common types of intrinsic economic valuation model are

Following the example of John Burr Williams (1938), four types of models of investment valuation and four types of dividend forecasts are illustrated below. The vertical axis is cash flow, and the scale is log-linear except for FCF forecasts which is linear. The horizontal axis is time in years, and it continues to infinity. A company lives forever, but its estimate of dividends or cash flow can have a finite life with a capital gain at the end of the forecast period.

Types of Growth
 
Models of Investment Valuation
Declining DDM Constant DDM Slow Growth DDM Fast Growth DDM
 
Forecasts of Dividends or Free Cash Flow
Logit Growth DDM 2-Stage Growth DDM FCF Constant D/E FCF Rising D/E

Slow and fast growth are relative to current average growth rates, historical precedents and the discount rate used in the model. Fast growth includes speculative growth. LOGIT growth is a special case of S-curve growth for rapid followed by slower growth phases. These growth patterns may be used in multi-stage models with different patterns for different stages of growth. See theory for the mathematics behind these models.

These models have been implemented in DCF Valuator, a free online web-based application that estimates intrinsic value per share, goal implied value, range of value with Monte Carlo simulation scenarios, and rate of return on investment for any common stock in any currency. For a walk-through tour of the DCF Valuator, click here and invoke any of the model types in the table.


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