There are a few other ways to value Stocks but probably the only one I use a lot is the ‘Discount to NAV’ approach. I have very rarely used the Price to Sales Ratio (PSR) but I just don’t see any need to over complicate things although many people do seem to use some incredibly complex approaches.
Discount to Net Asset Value (NAV)
This is an extremely useful and important method and regular Readers (it’s that All Bran again) may have seen me use such an approach with my Buy Rationale Blogs on Quintain Estates QED and Avation AVAP (there are links to these Blogs at the end of this one). I will try and explain this in simple terms - in essence we take the Net Asset Value (NAV) of the Company and compare this to the Market Capitalisation and really we want to see a decent Discount - in other words, the Market Cap needs to be a fair bit less than the NAV.
The Liabilities have a similar split with ‘Non-Current Liabilities’ which means stuff with a Life longer than 1 year - so this is Long Term Debt, Leases on Property maybe, Vehicle Leases, that sort of thing. You then get ‘Current Liabilities’ which are for 1 year - this means in effect demands for Cash from the Company that will fall due in 1 Accounting Year; this is stuff like Bank Overdraft, Short Term Loans, Trade Creditors (these are entities which the Company owes money to for Trading Purposes - unlike the Long Term Debt which is sort of different. Anyway, you add it all up and take one from the other and you get the Net Asset Value.
Trained Professional Accountants please note - much of this might be wrong, but hey, it’s been a long time !!
You then compare the NAV (don’t worry, you can just take the figure from the Balance Sheet - unless of course you want to do any adjustments yourself) to the Market Cap and personally I like something like 10% to 15% Discount or perhaps more - although as with anything, too big a Discount might hint at trouble ahead. Sometimes I use a Forecast NAV (ok, to be honest this is probably what I use mostly, after having sense checked it) and look at the Discount to this - for instance, in the last couple of years, Property Values have been racing ahead so nearly always on a Commercial Property Company (these are nearly always REITs these days - Real Estate Investment Companies) the NAV was expected to rise - so if we could buy earlier on a tasty 15% Discount to that Forward NAV then it might be a good bet. In effect, if you are buying at a Discount it is like you are buying a Pound Coin for 85p - I almost never buy at a ‘Premium’ to NAV - in such a case, you are paying perhaps 110p for a 1 Pound Coin - in most cases that is probably quite a dumb thing to do.
As with all these things, to a large extent, a Discount to NAV is just a guide - you still need to turn the Slow-Thinking part of your Brain on and dig around the likelihood of the Company meeting NAV Forecasts and how the Stock / Sector is likely to perform in the future. For instance, back in 2008 when we had the Credit Crunch, Commercial Property Stocks were hugely out of favour (often because they had huge Debt Piles backed against rapidly devaluing Properties) and many got very close to going Bust (I can’t remember but I suspect a few did actually go ‘pop‘).
In such an environment, the Value of Commercial Buildings rapidly fell and of course this means the Assets of such Companies fell with the consequence that the NAV’s fell - so obviously the Share Price of the Stocks had to fall to drop the Market Capitalisations down to match the new Reality of Building Values - and because of the fear, the Discounts to NAV widened - perhaps from 5% Discount before the problems to maybe as much as 50% Discount at the worst point - imagine the impact this had on Share Prices as they got the ‘Double Whammy’ to the downside of tanking NAVs combined with widening Discounts to NAV. Sharp Readers may be reminded here of the ‘Re-Rating’ and ‘De-Rating’ I talked about with regard to P/Es in an earlier Part of this Blog Series (sorry to give you such vivid and unwelcome Flashbacks).
As a general principle, Stocks should always trade at a small Discount to NAV - the simple reason for this is that if you perhaps have a Property Stock with 20 Buildings, if they have to wind the Company up then they will become a ‘Distressed Seller’ and will be forced to Sell Buildings which other Participants in that Market will know about - so they will struggle to get the Full Value of the Buildings and any Money realised with the Winding-Up may be a lot less than the NAV of the Stock before the problems. A normal Discount might be 5% to 10% so ideally we want to be buying at perhaps 20% Discount although in a fast moving and buoyant Market for the Properties, then maybe we can pay a bit more.
I have gone on about Property here so far but another category of Stocks to value via the NAV is Investment Trusts (you know, those sort of Fund things that are not Unit Trusts but are listed on the Stock Market - go to the ‘Funds’ page of my Website and there are definitions on there). As an example, imagine you had an IT which had 80 Stocks within it - for such an example, depending on the Skills and Track Record of the Fund Manager and the Sector/Geography/Specialism that the IT invests in, we might want to be buying at perhaps 15% Discount to NAV or more.
In normal times all ITs tend to trade on a Discount of perhaps 5% to 10% but in another quirk of the strange times we live in currently (arguably a consequence of QE and NIRP Central Bank Policies), many ITs are trading on Premiums to NAV - often as much as 15%. As you probably have guessed, I would not be at all happy with this because if you are buying a Pound for 115p, then you are probably a mug. To stretch this further, imagine if you pay a 15% Premium but then we revert back to more ‘normal’ times, then you might see a quick Loss of perhaps 25% as the IT reverts from a 15% Premium to a more usual 10% Discount - ouch. Anyone buying an IT on a Premium is relying on the underlying Stocks appreciating - this is a huge gamble I think.
For someone seeking Income from Dividends, then maybe there is a case for paying a SMALL PREMIUM if the Divvy Yield is sufficiently high and reliable - but this needs to be very carefully thought about as it is not good gaining loads on the Divvy if you are getting spanked on the Capital you invested in the IT.
On that subject, I noticed the other day that Infrastructure Funds like HICL Infrastructure Fund (HICL) and John Laing Infrastructure Fund (JLIF) are on really high Premiums to NAV - 24% for the former and 17% for the latter - these are really very high. In terms of Dividend Yields, HICL is due to pay around 5% next year and JLIF probably 6% - so I can understand People buying these for the Income. However, something worth thinking about, rather than throwing all your Cash in at once, it might be sensible to feed the Cash in over time - buy Stakes when there is a pullback in the Price. I note that HICL is hugging its 50 day Moving Average Line - so perhaps this is a good place to be buying when it pulls back to that line or preferably a bit below.
In a way this is very similar to what I wrote above with regards to NAV. Whereas I regularly use NAV myself to get a sense of Value with regards to Property Stocks and Investment Trusts etc., what I am referring to here is when Investors use the concept of ‘Book Value’ as their main Valuation technique and they are actively and deliberately seeking out Businesses where the Book Value (similar to the NAV) is higher than the Market Cap of the Stock.
Ah, I need to explain that better. With the NAV discussion above, I was really talking about specific types of Businesses - when I say ‘Book Value’ here I am thinking of perhaps an example of a Manufacturing Business that makes metal stuff and has a Factory full of equipment for bashing out the products. In such an example I would obviously use the normal P/E kind of Valuation methods but say for instance that the Business had really struggled for a few years and the Shares had got really beaten up and it was loss making and generally thought of as ‘Trash’ (see the bit lower down about Price to Sales Ratio as it is linked to this).
Needless to say I would steer very clear of something like this because there is a huge Risk that it will go bankrupt - no thank you very much. However, there are a few People out there who thrive on this kind of ‘Cigar Butt’ Investing - they are trying to figure out if the Value of the Factory and Equipment etc. is worth more than the Figure in the Accounts as the ‘Book Value’ and/or if the Value is much less than the Market Cap. Look at it this way - say in our example the Book Value of the Factory and Equipment added up to 120p a Share but the Share Price in the Market was only 75p (this is because Investor Sentiment is totally against the Stock and people are just dumping it and driving down the Share Price - and because it is so junky, no one is all that keen to Buy the Stock unless the Price is very low - usual stuff on how the Stockmarket works) - then the Investor would be very excited because there is clear upside if he/she is patient.
And to push things further, how about if the Investor discovers that the Factory Premises have not be revalued for 10 years or something and he thinks that allowing for this understatement the Book Value should really be as much as 150p a Share - you can see this would get them salivating.
My silly little example is probably enough to make you realise that this is a very specialist type of Investing and really it is for Deep-Dive Accountants and people with a particular bent. Often when you see an Activist Investor start buying into the Shares of a small Manufacturing Business or similar, it is because they are close to the Company and they know something about the true Value that we as Desk-research based Investors are unable to get access to.
In the old days this kind of ‘Book Value’ investing was done by people spending hours and hours scanning the Accounts in minute detail but over time the opportunities to find these sorts of Investments are increasingly rare - simply because access to such Information is hugely easier and because People are aware of the possible opportunities. Believe it or not when Benjamin Graham (the mentor to Warren Buffett and the author of ‘The Intelligent Investor’ - you can get a copy from Wheelie’s Bookshop but it is a very difficult read so buy a different book instead !!) started out he was very much a Book Value Investor - but over time he found that the opportunities reduced as people started to learn about the technique and the Valuation Gap to the Market was arbitraged away.
Apparently Buffett used to do this kind of ‘Cigar Butt’ Investing as well but when he met Charlie Munger he learnt that it was better to just buy “Good Companies at Fair Prices“ (and probably easier because it is difficult to do a Book Value based Approach when you have big amounts of Capital to deploy because many of the opportunities are low Market Caps).
Price to Sales Ratio (PSR)
This is a technique that can be used when dealing with Loss Making Companies or perhaps in situations where a Business has hit difficult times and the Shares have got really beaten up and the Profits have collapsed so you can’t work out a P/E with any real meaning. In this kind of possible Recovery Situation, if there is a high and fairly sustainable level of Sales, then it might be the case that by cutting Costs and refocusing Operations etc., the Business might be able to get itself back into Profits and Growth - this regularly happens and Recovery Situations can be extremely lucrative - although they are High Risk in many cases.
It is very rare that I have used this technique but there have been occasions in the past. To calculate the PSR you need to divided the Market Capitalisation by the Revenue of the company. I don’t really think there is a set figure for what this Ratio should be and it will depend on the Sector and what kind of Profit Margins are usual. For instance, in a Low Margin type of Business like Construction for example, you would expect the Sales to be very high in comparison with the Market Cap. I just looked at Costain COST and it has a Market Cap of £344m and Turnover (this is Sales or Revenue - same difference for our purposes) for next year is forecast as £1383m, so the PSR is 0.25 (344 divided by 1383).
Now, in a higher Margin business, like Computing stuff, we would expect the Sales to be closer to the Market Cap or even lower. As a random example, in the case of Sanderson SND, the Market Cap is £37.8m and the forecast Turnover for the coming year is £20.3m - this gives a PSR of 1.9 (37.8 divided by 20.3). As you can see, the Ratios for COST and SND are wildly different and both Businesses are doing reasonably well so they are not Recovery situations or anything like that. This really just illustrates that PSRs can vary wildly between Sectors and individual Stocks even within a Sector - so as with any of these things, the concept of PSR is just another Tool to try and help you figure out if there is Value in a given Stock or not. Shove it in your Toolbox and don’t forget it’s there because one day you might need it.
When looking at Loss Making Growth Companies the PSR can be useful - in a similar way to a Recovery Situation, if the Growth Company you are considering has a decent level of Sales and these are growing, you can do some careful extrapolation of where you think the Sales might get to in a couple of Years and work out a PSR. You can then look at the PSR for similar Stocks in a similar Sector and see how your Stock compares - this is not easy but as we all know, Valuing Loss Making Businesses is very difficult and we Humans have a habit of Overpaying in such circumstances.
Can be a way of Valuing Stocks in rare situations where the Accounting numbers are too opaque to value - this is particularly true with things like Banks, Life Insurance, General Insurance, and arguably it is useful for Investment Trusts and Unit Trusts. Where there are these kind of problems with regards to understanding and/or believing the Numbers, then maybe they are best Traded (or Invested) according to their Charts. Arguably this could apply to almost any huge Megacap FTSE100 Company (and of course such similar huge Businesses abroad) - the Numbers are pretty much meaningless (and out of date anyway) and they might be best ‘Valued’ using Divvy Yield and their Charts.
Obviously it worth bearing in mind that many Investors see a High Dividend Yield as a warning that there are problems in the Company - this must be considered and of particular interest should be the Cash Flow and you must take a view on how sustainable you think any Dividend is - although of course this is not easy when Accounts are hideously complex.
I do use the Dividend Yield as a Value Indicator but it is rare that I rely solely on that - usually I will look for a Stock on a Forward P/E of maybe 11 or something and I would want a Divvy around 3% or so. Divvys are extremely valuable for reinvestment (@SmallCappy on twitter refers to them as his “Free Money” and I wholehearted like that way of seeing things) but another side-effect is that they are a good discipline on the Company Directors to keep Shareholders in mind and it is often a sign of some Financial Strength because it is extremely rare that a Junky (or Fraudulent) Company pays out a Dividend - so it is like a simple, built in, check on a Company’s health (obviously there will be exceptions but as a general principle this holds true).
Other Complex Methods
There are other extremely complicated ways to value Companies such as Discounted Cash Flow (DCF) Models, Net Present Value (NPV), Internal Rate of Return (IRR) etc. etc. to be honest, most of these are utter Bollox and pretty much useless - I take very little notice and just stick to the far more simpler (and therefore far more useable in practice) methods like P/Es and Discount/Premium to NAV.
Some people use them and have their particular favourites - Horses for Courses I guess.
I’m really pleased I have written this Series of Blogs because it really was a screaming omission from the Blog Archive and it is such an incredibly important area - although many Traders / Investors don’t put the same emphasis upon the importance of Valuation as I do. For me, my many years of experience (read ‘expensive practical learning opportunities’) have shown me that understanding different techniques to value Stocks and a deep understanding of how to interpret the results really makes a big difference to my Success or Failure with my Stockpicking.
Looking back I would say that discovering how to value Companies really gave me an ‘edge’ and it transformed my Success in the early years. Before I had got a grip on what ‘Value’ really meant, I was regularly overpaying for Stocks even though I had learnt to buy Quality and had been kicked many times (I am a slow Learner !!) for buying WheelieBin type Junk. It is imperative in my book that you buy Quality, but it is not good enough just to buy it at any Price - you need to buy Quality at a Cheap Price or at a Reasonable Price - remember, you will want to pass the Stock on to someone else at a point in the future, how will you be able to do this if it is already Pricey? You will be looking for a Muppet who doesn’t understand Valuation to pick it up off you when you want to Sell - there is no guarantee that the Muppet has not been reading this Blog Series and has twigged exactly how to avoid taking your Overpriced Stock !!
In many ways I see Valuation as similar to Technical Analysis - both are useful and important techniques/tools because most other Investors (and certainly most Professional Investors like Fund Managers and Pension Managers etc.) use similar concepts - so they become a Self-Fulfilling Prophecy - they work because everyone else uses them.
For me, the most important Valuation Tool is the ubiquitous P/E Ratio - other things like Discount to NAV and Divvy Yield have some value but for me the P/E is the King. When using P/Es just consider these additional thoughts also:
- Always bear in mind that ‘Creative Accounting’ can impact on P/E Calculations - such things as changes to Depreciation Policy, Discontinued Operations, Exceptional Charges and Gains etc. can artificially alter Earnings - usually to make them look better than they really are. With the P/E Ratio being the Share Price divided by the Earnings Per Share (EPS), if the EPS is artificially high then this will make the P/E look lower than it perhaps really should be. This is also worth bearing in mind when looking at Historic and Forecast Earnings - are they calculated on a common basis? If not, you need to adjust your EPS to reflect a truer reflection of the situation.
- When comparing P/Es across Companies, it’s appropriate to keep it within a Sector - there is little validity in comparing across Sectors except maybe in some very exceptional circumstances.
- In Robbie ‘Naked Trader’ Burns’ Book he says he doesn’t take much notice of P/E Ratios - but then he goes on to say that he likes to buy Companies where the Market Cap is 10 times the Profits - so although he isn’t calling it a ‘P/E Ratio’ as such, it is in effect exactly what he is doing - he is buying a Stock on a P/E of 10 (which we always say is where Stocks can be decent Value). In addition, in his Chapter on Strategies he also talks about buying ‘Undervalued’ Stocks - this is exactly the Low P/E principle.
OK, we are at the end. I have masochistically enjoyed writing this set of Blogs because it is so important and because I have really had to use my Brain and get my teeth stuck firmly into it. However, as much as I love doing these Educational type Blogs and the response to this lot has been wonderful (thanks people because it makes scribbling them worthwhile), I really fancy doing a Stock specific one so I will probably start work on that next week. I have no idea when it will come out, but it is a Stock I don’t own at the moment and I want to do some in-depth Research and Analysis on it and doing a Blog forces me to do so in a very Structured and Disciplined way - this can only help.
God I need a beer……..
Adios folks !! WD.
Related Blogs which might be worth a look if you’re really bored on a wet Wednesday afternoon
My thoughts on IPOs:
Here is a set of Blogs on how I do Targets:
Here is a Blog I wrote a long time ago on Accsys Technologies AXS - a High Risk situation but a very interesting business with a unique product:
In the ‘Discount to NAV’ section I talked about Blogs I wrote on Avation AVAP and Quintain Estates QED - here they are so you can see a practical application of the technique (go to the ‘Valuation’ bit) - don’t get too excited though because QED got taken-over (yippee !!):
Links to the other 3 Parts of this Blog Series