Gannon On Investing

Buffett's statement sounds too simple...not to be concerned about economic moat, debt load, business risk, management quality etc just by the best bargin? Lin TV (TVL) is now priced at almost 65% of Morningstar Fair Value Estimate. Perhaps I am digging too deep on companies before buying.

Buffet: “The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”

I know Morningstar claims to use a discounted future cash flows calculation to come up with its fair value estimates, but mine rarely agree with theirs. I do find that over large numbers of stocks, I tend to agree with their star ratings more than I agree with Wall Street analysts’ buy/sell recommendations. However, I simply don’t understand some of Morningstar’s fair value estimates.

For TVL they can’t be using a discounted future cash flow estimate.

Now, sometimes it does make sense to value a company based on the value that could be realized by selling its assets. Bill of No DooDahs brought Rex Stores (RSC) to the attention of this blog’s readers. A big part of the value of RSC is in the real estate.

Evaluating it on free cash flow alone would be a mistake. However, I don’t know enough about TVL to value it on the basis of what its assets are worth to another buyer. I can tell you that if Morningstar’s estimate is based on a free cash flow calculation, it’s not like any DCF calculation I’ve ever seen.

Another example where Morningstar’s fair value estimate looks questionable is Overstock.com (OSTK). I can see how some people could disagree with me about the business. That’s fine. We can argue that point. Reasonable people can disagree on Overstock’s prospects. But, I don’t think Morningstar’s fair value estimate makes any sense. How can the business be viable and only be worth some 20% or so more than where it’s trading now. If you look at the numbers, that valuation doesn’t make any sense. Are they saying it’s probably worth a lot more, but that it’s also real risky? I don’t know. They’re supposed to account for the risk by setting a much lower “consider buying” price.

For Overstock, I can understand a $0 fair value estimate and a $75 fair value estimate, but a $30 fair value estimate doesn’t make any sense to me. If you’re assuming there’s a real bankruptcy risk, tell us not to touch the stock, don’t just cut the real DCF estimate in half (or use an absurd discount rate or whatever they might be doing).

So, while I love Morningstar’s site, I’m a little skeptical of its valuation techniques. I’m just not sure they are using genuine DCF calculations.

As for what Buffett wrote, I think a lot of people misunderstand this. I believe the discounted cash flows estimate is cumulative. All qualitative and quantitative considerations are taken into account in forming the assumptions. Risk is considered at every level. Conservative estimates are used. Like I said, an intrinsic value analysis is very different from just slapping a P/E (or P/S, P/B, or EBITDA) multiple on a stock. Sometimes you’re going to end up with a very wide band. Other times, you simply won’t be able to perform the calculation.

I agree with Buffett that you need to perform the analysis, and that the value you calculate for the stock is the value you have to stick with. You simply can not pay more than the calculated value, because that is simply speculating.

A business is worth something to its owners independent of the market price. If, tomorrow, the stock market vanishes, Procter & Gamble is still worth something as is every other publicly traded company. The whole pie has a value, not just each slice.

If you don’t rely entirely on a DCF calculation, what do you have to go on? How can you settle on a value for the business apart from what it might be worth to other market participants (either now or in the future)? Some people use private transaction values, but that just casts a wider net. You are still depending on other people’s judgment, aren’t you?

I don’t know. Maybe I’m wrong. I just don’t see any other truly independent valuation method that allows you to compare all possible investment options by measuring them against a single yardstick.

While I don't disagree with your post, I think that it is TOO far on one side. O'Niel would remind us that the P/E is really a useless metric in the first place. It is really nothing more than a sentiment indicator. Some would simply toss O'Niel out, however, and call him a momentum trader. They would be too rigid in their stance, since "Cigar Butt" investing is arguably a form of trading too. That's like the pot calling the kettle black.

P/S and P/B are similar - they are "sentiment" indicators more than they are anything else.

My favorite quote is "There are a million ways to make money in the markets. The irony is that they are all very difficult." (Schwager) I agree with Jack and this is why I believe your post is too one-sided.

Some investors do very, very well by paying fair prices for businesses because they understand that the markets can still reward them. However, a buy-and-hold-til-I-die investor cannot do this. The reality is nobody knows the future and what the value of a business can be. If you do, you probably should go to jail. :-)

As for your valuation measure, DCF is the status quo, but EVA and APV - although similar aren't considered "DCF" as in the classic definition. APV is really just a bunch of more complicated DCF's, but EVA is a different method of valuing a company and it is a popular one.

I have to disagree with the idea that price - to - earnings, price - to - sales, and price - to - book ratios are sentiment indicators more than anything.

I think each metric has important uses. The price - to - sales ratio is very useful in valuing companies. My analysis of Overstock was largely based on the existence of a very low price - to - sales ratio for a company that was growing sales so rapidly.

The price - to - sales ratio lets you analyze a business based on an estimate of the future free cash flow margin. It can be used to value unprofitable businesses as well as profitable businesses; as long as you believe you can estimate a free cash flow margin.

While I concede that it’s possible for people to make money using other approaches, the primary use of the P/E, P/S, and P/B ratios is fundamental analysis. After all, if a business' value is not determined by its earnings, sales, and assets, what is its value determined by?

Of course, the P/E, P/S, and P/B ratio aren't the best way to measure these things. Qualitative assessments need to be made. Debt levels and taxes need to be considered. So, these aren't perfect measures by any means. But, they do get at the heart of the issue. What is this business worth?

Others may be able to make money by asking different questions. I can't. I can only do my best to answer one simple question: What is this business worth?

I wouldn't know how to tackle any of the other questions an investor might want to know the answer to. I don't know how to analyze markets; I know how to analyze businesses.

Without a DCF, I might be able to list the pros and cons of buying a particular stock, but how would I weigh these against each other?

They need to be converted into a common currency: cash flows. Without first performing that conversion, how can you evaluate the Babel of data before you?

At one point, I considered that PS and PB were pure sentiment measures, because the revenue and book values were static and did nothing to indicate the health of the company - and I even posted that. Looking back, I would have to lump PS and PB with PE as "fundatechnical" in that at least you have to look at the balance sheet or income statement, i.e. they're not pure sentiment numbers. But they are more about sentiment than they are about the company, however. Probably 75% sentiment for PE and 90% sentiment for PB and PS, as these vary by industry as to what the norm is.

Of interest may be the function of price. Every transaction where money is exchanged creates a price, but price is agreed upon, but VALUE IS NOT AGREED UPON. I buy the mcburger because I value it more than I value the $3 it costs me, and they sell it because they have plenty of mcburgers and would rather have the $3, thank you very much. Similarly, every stock transaction is the nexus of a DISAGREEMENT about value.

IMO the pure value guys are so rational in their approach, that they lose sight of the irrationality of others. To wit: "After all, if a business' value is not determined by its earnings, sales, and assets, what is its value determined by?"

Hey, I can't talk about how my specialty chemical company investment made 110% since the end of April 2005 at a party, but it would be easy to hype BCRX or GOOG at a party, or talk about the excitement of a biochem research or alternative energy company at the barber shop. No one would have wanted to hear NEU as a "hot tip." So the retail investor (at least some of them) have very irrational motives for buying what they buy.

Reading a little "One Up On Wall Street" will clue you in on what mutual fund managers value. Hint: it's different than an objective measure of fundamental analysis.

Even paying a discount to the "intrinsic value" is a speculation. You are speculating that "Mr. Market" will someday see that company as being worth what you think it is. It is all "speculation" you are just using a certain structure and method, that is all, but you are still speculating per se.

"You are still depending on other people’s judgment, aren’t you?" And so is the value investor. You're looking for a mismatch between your rational approach and the "other people's judgment" price, therefore you are dependent upon their judgement to some degree. Don't you think so?

"Cigar Butt" investing is a form of trading, it's a mean reverting sentiment trade. If you were to trade stocks that were short-term oversold, but limit your purchases to those that were debt-free and had a history of profits, that would be identical to "cigar butting" in every respect except timeframe.

Bill - I agree with what you've written.

Geoff - Thank you for explaining to me what I have not yet been able to put in words. I guess I DO study markets first, and companies second. I am in school to find the right balance.

As usual, I'm probably learning MORE via my daily blog interactions than I am in class :-)