With the long Bank Holiday weekend I really have no excuses for not getting on with the First Draft but needless to say all my plans for how my day would pan out have been totally gazumped. I squeezed in a quick trip to the local Garden Centre to get some Slug Pellets and got nabbed by one of my wonderfully kind neighbours on the way back who wanted to test out her new Strimmer on the tiny bit of grass at the front of Wheelie Towers. Of course, this then became an epic event and at some point another neighbour turns up with his Formula 1 Racing Lawn Mower (I am sure it was the same Green colour as those old Jaguar F1 Cars which Johnny Herbert had a go in I think - hey, he nearly ran me over at the Goodwood Festival of Speed you know !!), and to shorten this detour I essentially lost 2 hours of my day - so I am starting this blog at 11.42pm on a Saturday night !!
Mr Buffett on Price and Value
It is probably fair to say that if you ever get stuck on where to go with a Blog, then throw in some Warren Buffett. In this case, I do know where this is going (I have actually done a proper plan for this one on 2 sides of A4 - although I am not entirely sure I can read my own scribbles) and the ‘quote’ I wish to use from the Great Man is this one:
“Price is what you pay and Value is what you get.”
Well, I put quote in ‘’ because it might not actually be a word for word quote, but this is the essence of what he said I think and even if it isn’t, that makes no difference because if fits what I want to write about anyway (and giving it an attribution to Warren Buff gives my Blog a certain credibility it may not deserve !!). I guess the obvious takeaway from this ‘quote’ is that WB clearly sees Price and Value as very different animals - and it is not Fake News…..
The concept of thinking as if you were the 100% Owner of a Business you are thinking of buying Shares in does come into play here, but it is really about understanding that for a Long Term Investor, the Value that you think you are getting for a given Price, means that you have a high degree of confidence that you will make a large Profitable Return from it over time and that you have a sufficiently large ‘Margin of Safety’ in the Price you pay for that Value so that if something goes wrong, you are not necessarily in serious trouble. Ok, that is all a bit vague and waffly, but I will try and explain it clearer as we move on.
As I mentioned earlier, this is really all for a Long Term Investor - which is very much what I see myself as and I know a lot of WD Readers see themselves as similar beasties - however, from many of the comments I see on Twitter and suchlike, I am not convinced that people really understand the differences between Long Term Investment and being a Price Trader or Speculator - hopefully this Blog Series should clear this up and help Readers hone in on what their Specialism/Approach is and how they can refine and tweak it to get superior Returns from a viable Edge.
When we talk about “Value” in a Business, what do we mean?
Having just typed that heading (and having already produced an A4 Plan), it does strike me that this is quite a ‘fluffy’ or nebulous concept - but I will see if I can make some sense of it. I really get the impression that ‘Value’ is one of those terms/concepts we all bandy around everyday but actually if we stop and think about it, what does it actually mean?
Unfortunate, brainwashed and addicted WD Readers might recall those epic Blogs I wrote about Valuation and I guess to a large part the concept of Value very much stems from the writings I did in those (at the bottom of this Blog I have put a link in so you can refer back to these Blogs - I remember they were very well received so it might be worth a refresher even if you have read them already).
The way I can probably best explain ‘Value’ in a Stock (or perhaps it would be more accurate to say “Value in the underlying Business“) is to consider the Quality of the Business and the Valuation in terms of P/E Ratio (Price/Earnings Ratio), Growth Rate (PEG), Dividend Yield and Net Asset Value (NAV). In terms of the Quality, this is very much the essence of the ‘Qualitative Analysis’ that we undertake on a Stock, so this is sort of intangible and judgemental stuff which might be around things such as:
- A perceived Economic Moat.
- How good you think the Directors are.
- The standard of the Products and their appeal.
- How fast you think the Company can grow in its particular market.
- Any Economies of Scale that the Company has.
- Any Brand Names and other intangibles that help the Moatiness (is that a word?)
- The level of Competition in the Market and how easy it is for new Entrants to emerge.
- ‘Skin in the game’ with regard to Director Shareholdings.
- Top Fund Managers who are involved.
- Etc. etc.
In practice, with experience you get to be able to estimate a potential Value for a Company by using things such as P/E Ratios and NAV Discounts etc., whilst tweaking your assumptions in light of the Qualitative Factors along the lines I have listed above. In terms of how we can use P/E Ratios to help get an understanding of a Stock’s Value, let me take the example of Paysafe PAYS which is a stock I hold that I think is extremely undervalued.
At the moment, at a Price of 511p, PAYS is trading on a Forward P/E Ratio of 12.9 - which I see as hugely undervalued. In the ePayments Sector, there are many Companies trading on far higher Multiples (another word for P/E Ratios !!) - for example, I also hold PayPal PYPL which is on a Forward P/E of something like 34. If you were a bit clueless, you could make an argument that PAYS should be on a Forward P/E of 34 also which would put PAYS on a Price of about 1350p !!
Of course this is silly, because PAYS should not be on a similar P/E to PYPL because the latter has been around for many many years longer and is very dominant in its own Market Niche - sadly PAYS does not have quite the same characteristics. Experience tells me that a Stock like PAYS in the current Red Hot Tech Market (and in truth Global Stockmarkets in general are in a massively bullish phase) could easily trade on a Forward P/E of 20. Now this is where the Qualitative aspects that I mentioned above come into play - you could take that ‘normal’ Forward P/E of 20 and drop it down a bit because you think that PAYS is carrying a fair chunk of Debt - so you might say a Forward P/E of 18 is about right - but bear in mind that still implies a Price Target for PAYS of about 715p (that is 40% upside).
You might of course analyse the Qualitative factors and decide that PAYS is superior to most of the businesses in that sector and you might give it a higher Forward P/E Rating - 23 or something, which would mean a higher Target Price at around 915p.
Already from this example it should be clear to you how the Price of PAYS (511p at the time of writing) is very different to what I think the ‘Value’ is - both in Qualitative and Quantitative terms. A similar exercise can be undertaken to tweak the Price Target for Growth Rates using the PEG (Price Earnings divided by Growth Ratio) and/or by using a Discount/Premium to NAV or Book Value if that is your chosen approach for Quantitative Valuation.
In terms of NAV, you might be looking at a Property REIT Stock with a Discount to NAV of 35% and you think it should be on something more like a 10% Discount when you consider other similar Stocks - in which case the Price you are paying when it has a 35% Discount leaves a decent bit of Upside Potential. I think I used a similar method to this when I bought into Quintain Estates QED a couple of years ago - I was ‘right’ because they got Taken over not long after I bought them. I have put a link to the QED Blog at the bottom of this one which shows this Valuation technique in action.
I have talked here about the Valuation techniques I always use but I know some people use stuff like Discounted Cashflow Models (DCF) - but however you do the Quantitative stuff, the fact is that the Price you can buy the Shares at and the Target Price (which indicates your judgement of ‘True’ Value) are totally different things.
At the end I have included a Blog about how I do Targets and stuff but once you get in the habit and swing of doing Targets, the idea of Value and Price being separate things (2 sides of a coin is a good way of thinking of them) becomes more distinct and of more use. This is most definitely the case in terms of ‘Margin of Safety’ where you might assess the Value of a Stock at perhaps 300p, but the Price today might be perhaps 250p. In this case, the Upside Potential you can see at the time you can buy the Shares is 20% - and it could well be that you do not think this is worth going for because it does not give you much, if any, Margin of Safety and also because there are perhaps other Stocks out there where you feel the Return could be 50% or more and these have a better Risk/Reward profile.
I have no fixed rule for this, but in general I like to buy things where I can see at least 50% Upside and for an Initial Purchase I might want much more than this. Perhaps if I have held a Stock for a long time and I know the Company very well, I might be happy to Add to my Stake even though there might only be another 25% or something to go for - it depends really, I have no set rule as such.
That’s it for Part 1 - Part 2 will look at things like Stoplosses in relation to this and more to help with ‘Thinking like an Owner’ and the distinctions between Investor and Trader.
Here is the Last Part of the Valuation Blogs - if you scroll to the bottom there are links to the earlier parts. There are also links on all 3 of the Targets blogs:
Here is the Quintain Estates QED Blog (sorry, you can‘t buy QED Shares now - but it shows you how to use NAV Discount to value):