Someone who reads the blog sent me this email:
I'm a college student just learning that I have a desire to learn how to invest. I've come across many blogs and found yours to be very helpful. Yet, I still can't seem to figure out how to value a stock. Do you know of any websites that you can link me to about stock valuation? Anything would help, Thank you!
Lots of websites will show you how to value a stock. I don’t think most of them are helpful. They will tend to use some sort of discounted cash flow (DCF) calculation. Or some approximation of earnings and growth. Many will focus on free cash flow.
Problems With Automated Approaches to Appraising a Stock’s Value
Some stocks have no free cash flow. Others have no tangible book value. A DCF needs to have a point where the discount rate is higher than the growth rate. Often this is done by slicing growth expectations into stages. For example, how fast will the company grow sales over the next 10 years, the next 10 to 30 years, and then all years beyond that?
There are serious problems with these approaches. The very best, most durable businesses actually may not have expected growth rates below the discount rate you should be using. For example, Moody’s 30-Year BAA corporate bonds – investment grade, but not the safest bonds out there – yield 5% right now. Over the last 10 years, Coca-Cola (KO) grew earnings per share by almost 9% a year.
That’s a problem. Should you arbitrarily assume Coca-Cola will grow at 4% a year at some point? Or should you use a rate different from the BAA yield? What’s the justification for doing that? Yes, a bond has legal protection for you. But Coke’s earnings power has some really strong customer behavior protection.
I would argue it makes much more sense to look at Coca-Cola without doing a discounted cash flow analysis.
The two approaches that make the most sense are finding similar merchandise available at the present time, in the recent past, in other countries, etc. And calculating your likely return if you bought and held Coca-Cola stock forever.
How I Look at Stocks – More Angles, Less Precision, But More Confidence
Those are my two go to approaches. I look at what peers – or companies that are comparable in some way – trade for. And I look at how fast I can expect my investment in this stock to compound if I hold it forever.
You can look at these as a kind of short-run limit and a long-run limit. The short-run limit is the stock price adjusting to match the valuation given to its peers. This is a “reversion to the mean” type of approach. Very standard value investing stuff.
The long-run limit is pretty much the company’s own capacity to reinvest and earn high returns on reinvestment. This is Phil Fisher type stuff.
Reality tends to fall somewhere in between. If two companies both have the same estimated buy and hold forever return and one has a much lower valuation relative to peers, past ratios its traded at, etc. – I’ll prefer that stock. Because I might get a nice price increase in that stock within just the next 1 to 3 years.
For a pricey stock with a decent looking buy and hold forever return – like Boston Beer (SAM) – I would tend to be concerned that the return possible if you hold the stock forever might be adequate but your chances of getting a good return and being able to sell out of the stock at an even higher annualized gain within the next 1 to 3 years is low.
So, for example, Boston Beer and Dun & Bradstreet (DNB) have pretty similar looking buy and hold forever return potential. That’s because Boston Beer has a lot of room for reinvestment in the business. While DNB has none.
However, I might prefer DNB to Boston Beer at the moment – in fact, I bought a little DNB around these prices but own zero Boston Beer shares – simply because DNB looks fine on both a buy and hold forever basis and any sort of “appraisal” method I can use. By this I mean that comparing DNB to companies with similar economic characteristics, to where it itself traded at in the past, to what control buyers have paid for companies most like DNB, etc. tells me DNB is cheap. The same appraisal methods applied to Boston Beer would not tell me that stock is cheap.
There is no single right way to value a stock. If there was, the stock market probably would be perfectly efficient. It is the element of genuine – rational – uncertainty mixed with emotion, momentum, etc. that causes prices to vary so much. If all stocks deserved to trade at the same price-to-book, price-to-sales, EV/EBITDA, etc. there would be fewer opportunities for mispricing.
Having said that, there are certain accepted ideas about how to value certain kinds of companies. There are certain multiples that are very popular.
I’ve talked about the “forever return potential” of a stock before. I’ll probably talk about it again in the future. It’s a much more complicated approach.
Today, I’ll just talk about the very simple method of comparing a stock to its peers. Those could be industry peers – they will be here. But they can also be peers in terms of predictability of cash flows, width of the moat, etc.
For example, DNB has no industry peers in the sense we normally use that term. But there are companies that share some similarities with DNB. In fact, I owned one. It was called IMS Health.
The valuation ratio used to compare companies often varies by industry. We’ll start with the most famous peer comparison ratio of all.
Media Companies: EV/EBITDA
For a media business with predictable – in the long-term – cash flows, the conventional measure is Enterprise Value (EV) to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
All data in this post is from Bloomberg’s free website (Bloomberg.com). Anyone can access it.
Let’s take a look at the EV/EBITDA ratio for 4 similar companies. They all own a movie studio and cable channels in the U.S.:
Viacom (VIAB): 7.4x
Time Warner (TWX): 7.6x
News Corp (NWS): 8.6x
Disney (DIS): 9.8x
Advertising Agencies: EV/Sales
Much of the value of an advertising agency is in its existing client relationships. Advertising is somewhat cyclical. Employee compensation at ad agencies is tremendously high. It is by far the biggest expense. And while it is adjustable – employees do get fired when big accounts are lost – it is not perfectly and instantaneously adjustable. So, an ad agency might have an operating margin of 15% in good times and 10% in bad times. To compensate for this, it is best to use the Enterprise Value to Sales ratio.
You buy an ad agency when the future looks bright and the Enterprise Value to Sales ratio is low. Not necessarily when the P/E ratio is low.
That’s because price competition is not important in the advertising business.
Competition for clients is important. And corporate efficiency is important. If we use the most recent sales number, we’re basically capturing the existing client relationships. And if we take a look at the long-term margin of the company we may get some idea of how valuable each dollar of sales tends to be in terms of actual profits generated.
There’s another reason for using EV/Sales when valuing advertising agencies. In the media business, a new owner is unlikely to be able to change the amount of free cash flow a property generates. What they get to control – how they might alter the value of the business – is the way they capitalize the property (use of debt or equity) and the uses they put the cash flow to.
Things are a little different in advertising agencies. Historically, it had been possible for a conglomerate of agencies to take over an existing agency and squeeze more profits out of it. This is where it was possible for a control buyer to add value. Not through sales increases. But through cost cuts.
So, in a media business, a new owner will tend to see cash flows as being relatively fixed and constant – not something he can goose. While in an advertising agency, a new owner will probably see sales as totally fixed in the sense that they will rise at the same rate whether he or a competitor owns the agency. But the level of profitability may not be constant. A buyer may believe he can change the costs of running an agency. This was probably more true in the past than it is today. There were once some smaller agencies that were wonderful in terms of clients and talent but terrible in terms of costs.
Now, let’s take a look at the EV/Sales ratio of the 4 biggest advertising companies.
Interpublic (IPG): 0.7x
Banks: Price/Tangible Book
The idea of enterprise value has no meaning at banks. A bank’s biggest liability – its deposits – is often the company’s greatest competitive advantage. Banks are complicated creatures. Even a measure like price-to-book fails to take into account differences in how two companies reserve against losses.
For example, take two New Jersey banks.
Valley National (VLY) has tangible book value of $5.30 a share. Reserves for loan losses are 67 cents a share. And non-performing assets are 91 cents a share. The stock trades at $10.32.
Parke Bancorp (PKBK) has tangible book value of $16.04 a share. Reserves for loan losses are $3.59 a share. And non-performing assets are $13.74 a share. The stock trades at $5.41.
Let’s take a look at the price to tangible book ratio for these 2 New Jersey banks.
Doesn’t that mean investors must be valuing the banks on something other than tangible book value?
How can a dollar of Valley’s tangible equity be priced at 6 times a dollar of Parke’s equity?
Distressed Investments – Perceived Risks Set Prices
Because investors think Parke might fail. But Valley won’t.
One common measure of a bank’s risk of failure is its Texas Ratio. The Texas Ratio looks at a bank’s bad assets and compares them to the reserves and equity – basically the amount of pain shareholders can absorb – that protects deposit holders. Banks tend to fail when their Texas ratio nears 100%. I’m oversimplifying things a bit.
But the Texas Ratio difference between Valley and Parke illustrates how much more risk investors see in Parke than they do in Valley.
Here is the Texas Ratio for each bank.
Valley also has a long history as a bank and a public company. It has generally been a conservative lender. And the company has the same top management it did when it weathered other tough times for banks.
Meanwhile, Parke is a young bank – it was founded in 2005 – with no seasoned history of surviving past crises.
So, when looking at two banks – or two anythings – using a single valuation ratio, it’s important to remember why that ratio may be so different.
Sometimes a ratio is high for one stock and low for another because of the perceived risk difference between the two stocks.
In these cases, we shouldn’t be any more surprised that one bank trades at a much lower price-to-book ratio than we are when we see one bond trades at a much higher yield. It’s really the same principle in action.
Imagine two bonds are issued in 2005. A Valley National bond and a Parke bond. Both are originally sold for $100 each. And both pay the holder $5 a year. For the sake of illustration, we’ll assume these are perpetual bonds – they never mature and can never be called. In a liquidation, they are supposed to pay $100 to the holder.
Based on the results of each bank through the worst of the crisis in 2007 and 2008 – and their recovery in the subsequent years – the bond prices diverge dramatically. The Valley bond rises from its $100 original offer price to trade at $190 today. It is considered investment grade. Meanwhile, the Parke bond drifts lower and lower. Over the years, the Parke bond falls from its original offer price of $100 to trade at just $30 today. It is considered junk.
At the moment, both bonds could still be paying that $5 a year. It is not necessary for Parke to actually fail to make that payment for the bond to drop 70% in price – as long as investors believe there is a very good chance they will fail to pay $5 a year in the future and they will never repay even the much lower $30 market price in the event of a default.
For a bank, equity investors fear the worst. They probably see the situation as one where the upside is huge if the bank recovers. But the stock goes to zero if the bank does not recover.
In this way, two seemingly similar companies – Valley and Parke – are valued in entirely different ways. Valley is valued as an investment grade bank. Parke is valued as a distressed bank.
The difference in valuation on the industry’s key valuation metric – price-to-book – is due to a huge gap in the perceived risk of holding each security.
There is another reason why a favorite industry valuation metric – like price-to-book – might be very different for two stocks.
Quality Companies – Perceived Returns Set Prices
The economics of both Parke and Valley are good. Both banks are capable of earning better returns on tangible equity than their peers. Of course, to do this, they must survive and they must make good loans. But there is no reason why Parke – given its deposit base and branch operating costs – should not achieve good returns on tangible equity if it survives.
In fact, we can look at the divergence of each bank’s share price as being driven by a different factor. Parke is priced 70% below its tangible book value because it is seen as risky. Valley is not priced at 90% above its tangible book value merely because it is seen as safe. Safety is a necessary but not a sufficient reason for a bank being priced 90% above tangible book value.
It is Valley’s perceived quality – its superior return potential – that allows the stock to trade at a premium to tangible book.
To illustrate this, let’s look at a safe bank that is believed to have poor return potential and see where that bank’s shares trade in relation to tangible book.
There’s No One Answer – Risk and Return Perceptions Can Offset Each Other
Now, let’s take a look at a bank on the complete opposite side of America – First National Bank Alaska (FBAK).
First National Bank Alaska has tangible book value of $1,347 a share. The bank has $37 per share in loan loss reserves. And $159 per share in non-performing assets. The stock trades at $1,565 a share.
Let’s compare the price-to-tangible book value of First National Bank Alaska and Valley National.
First National Bank Alaska: 1.2x
Valley National: 1.9x
Is Valley National any safer than First National Bank Alaska?
Probably not. Here are their Texas Ratios:
Valley National: 10%
First National Bank Alaska: 11%
If anything, First National Bank Alaska – being an Alaska bank rather than a New Jersey bank – is less correlated with the performance of the overall American economy.
I could recite a bunch of statistics that all say pretty much the same thing – investors are unlikely to prefer Valley National over First National Bank Alaska because they are seeking safety.
So, why are they willing to pay a 90% premium to tangible book for Valley National and only a 20% premium for First National Bank Alaska?
Well, Valley is a little bigger stock - $2 billion market cap vs. $500 million market cap for Bank Alaska. But that’s partially an identity argument. If Valley was valued the way Bank Alaska is – Valley would only have a market cap of $1.2 billion. Likewise, if Bank Alaska was valued the way Valley National is – it would have a market cap of $800 million.
Valley National is a lot more liquid. On average, Valley trades $10 million in stock a day. First National Bank Alaska trades about $100,000 worth of stock each day.
Illiquidity can turn some investors off. So, that could explain the difference right there. But a 35% discount for illiquidity seems extreme. Especially considering this stock still trades close to $100,000 a day. That should be all individual investors – of any size – need a stock to trade, assuming they are patient.
Yes. It’s a huge problem for funds. And that may be why Valley National trades at a much higher price-to-tangible book ratio than First National Bank Alaska.
But there’s another explanation. Over the last decade, First National Bank Alaska has tended to earn an 8% to 10% return on equity year after year. Meanwhile, Valley National has tended to earn an 8% to 23% return on equity. And the bank’s return on tangible equity has been even higher.
Today – in the midst of a rather mediocre market for loans and a very tough interest rate environment – Valley is able to earn about 13% on tangible equity.
If we assume First National Bank Alaska always earns 9% on its tangible equity and Valley always earns 13% – that explains more than half of the difference in how highly the market values a dollar of tangible equity at each bank. In fact, if investors are more forward looking they probably expect Valley National to one day earn a lot more than 13% on tangible equity. But they have no reason to believe First National Bank Alaska ever will.
So even if the safety of each bank is seen as identical – the return potential is not. It’s as if two bonds were issued. Both are originally sold at $100. But one bond pays $9 every year. The other pays more like $15 every year. If – over time – the two bonds are seen to be equally safe, why shouldn’t the price of the bond that pays $15 a year rise enough to provide the same 9% a year return on today’s price as the other bond offers.
Of course, there’s no reason why one bond has to rise. Or the other has to fall. But there is a reason for the yield of two equally safe bonds to move towards each other. This is done through price changes. It is obvious in bonds – which are often thought of in terms of yields – that an adjustment in future returns is happening. It is less obvious in stocks, because people tend to focus on price more than some sort of earnings yield measure.
Using Peer Comparions is a Simple But Sane Approach to Investing
Of course, even an earnings yield measure is too simple for stocks. Really, it is the combination of earnings and profitable future growth that matters.
But the idea of looking at equally safe or equally high quality businesses and comparing them makes a lot of sense.
It’s one of the valuation approaches I like best. And because I tend to always read about a company’s competitors at the same time I’m researching a specific stock – I’ll often turn up good ideas I didn’t think of until I did the comparison.
For example, you might be looking at Disney and then decide you like Time Warner or Viacom better. That’s natural. If you read about all 4 of the media companies I mentioned, you know the business well. And you may decide you prefer the prospects or price of one of them over the other 3.
So peer comparisons aren’t just good when used as a reality check on the stock you’re interested in buying today. They are also a good way to turn up new stock ideas for the future.