Building A Valuation Framework

Part 4 in a series of tutorials on value investing: When it comes to valuing stocks, one size does not fit all.

Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The Investor’s Toolkit

Part 4: Building a Valuation Framework:

Fair Value Is An Opinion

As I’ve said before, fair value is an opinion, not a fact. You can’t directly measure fair value. What looks fair to one investor will look overpriced to another. Professional stock market analysts can put together incredibly complex valuation models. They can make detailed earnings estimates stretching 5 or 10 years into the future and then extrapolate back to the present to come up with a target price to the nearest penny. Their reports can stretch to 25 pages or more with fancy graphs and charts that attempt to look at the business from every possible angle. While there is sure to be valuable information and insights in these reports and I, myself often spend hours researching a company before pulling the trigger, the detailed estimates they come up with are misleadingly precise. And, judging by the overall track record of most analysts, may not be worth the price of the paper they are printed on.

The business world is a chaotic place. Companies rise and fall and fortunes can turn on a dime. While thorough research and understanding are key, you can’t let yourself get too enamoured with your own analysis. I have found a few general valuation rules of thumb to be far more useful than trying to predict future earnings to the nearest penny. There is no way of knowing if a company should rightly be worth a p:e of 14 or 15 or 16 or if earnings will come in next year at $1.00 or $1.10 or 90¢. And that’s okay. All you need to do is get in the right ballpark. Because you’re always buying companies at a huge discount to what admittedly can only ever be a rough estimate of their true worth, if you’re ultimately off by 10% or 20%, you’ll still come out ahead in the long run. And for every company that disappoints and ends up being worth less than you thought it might, there is one that pleasantly surprises you and ends up being worth considerably more than what you had expected.

A Simple Strategy

One approach to investing in the market would be to simply buy the stocks that had the lowest p:e ratios. While not terribly sophisticated, it’s actually been shown that this approach would have been surprisingly successful, outperforming the overall market by a percent or two a year. With this approach, you’d end up owning a lot of crappy businesses, but every so often one of them would manage to pull a rabbit out of its hat and the resulting gains would make up for all the losses on the ones that didn’t fare so well.

By applying a bit of refinement to this basic low p:e strategy, you can build a portfolio that isn’t quite as stomach-churning and come away with better overall returns to boot.

Red Fish, Blue Fish

The stock market is a Suessian wonderland of different companies. There are technology superstars, blue chip stalwarts, young companies with fresh, new ideas and aging icons of industry from yesteryear. How does an investor even begin to make sense of this chaotic jumble of opportunities?

For starters, I simply discard from consideration many of the companies that make up the market. Entire sectors of the market get the cold shoulder from me. The resource industries: mining, oil and gas and forestry tend not to lend themselves well to my sort of earnings-based analysis. Certainly, the exploration companies are beyond my ken. I don’t have the expertise to know if a patch of moose-pasture in Saskatchewan has a high-grade vein of gold lying under it or not. Even the production companies give me problems; their fortunes are closely tied to future commodity prices and once again, I have no particular insight into what the price of zinc will be in a year’s time. I do invest in the companies that service the resource industries, though. These seem a bit more amenable to my style of analysis.

The banking and real estate sectors also get a pass from me. Banking is too much of a black box for my liking and real estate companies are priced more on the asset value of their property holdings than they are on the earnings (if any) they might be generating. I ignore biotech as well. I don’t have any idea which experimental drugs may successfully run the long gauntlet of clinical trials and which will not. Utility companies generally carry far too much debt for my liking.

Any company with a long history of losing money gets a pass from me. My analysis typically centers around a company’s earnings, or more accurately, what I expect its future stream of earnings to look like. And to help determine this, I look to its past record of profitability. Companies that have never made a profit don’t tend to lend themselves very well to my sort of analysis. I know where my strengths lie and it is not in being a future visionary, assessing the impact of paradigm-shifting new technologies or the strength of a company’s network effects. My analysis is often much more grounded than that. Is the company making money? How much? And how much do I have to pay to get a piece of that action? This means I miss out on many of the hottest investing fads of the day. The glamour or story stocks that make for exciting coffee shop chatter and speculation rarely show up on my screens. And that’s just fine. My stodgy old portfolio has provided me with plenty of excitement over the years. A construction company may not have the sparkle and shine of a biotech company working on a break-through drug, but when the stock quadruples in value, it can still get the heart racing.

Apples To Oranges

Even when limiting myself to the more prosaic sectors of the market, there are still a wide variety of companies to deal with. How do you compare a large auto parts manufacturer with a global footprint to a regional chain of coffee shops? Or a rapidly growing software company to a struggling newspaper publisher? In other words, how do you compare stock market apples to stock market oranges?

To handle this confusing cornucopia of investment opportunities, I have 6 separate categories that I use to characterize the different kinds of companies I typically encounter. Between them, these 6 categories cover a broad enough cross section of the marketplace that I can usually find enough deep value opportunities to fill my portfolio. Once I’ve properly categorized a stock and calculated its approximate fair value, I can use this information to more accurately compare it to sometimes quite dissimilar companies in other categories. I simply buy whichever stock is trading at the biggest discount to its fair value.

I’m not just buying the lowest p:e stocks I can find, but what I am doing is not that far off. I’m essentially buying the lowest p:e stocks (or, in the case of an asset play, the lowest p:b stock) in each of the different categories. Provided, of course, that they pass a thorough vetting process first. (Most don’t.)

Here, then, are the 6 different categories that I’ve used to develop a more complete valuation framework.

Perfectly Average

One of the main factors I use to determine which category to slot a company in to is its growth rate. Given that a company’s value is primarily tied to its future earnings, it stands to reason that a company that is expected to double its earnings over the next few years is worth considerably more than a company that appears to be stuck in a rut.

You can’t be too precise when estimating a company’s future growth. There are a lot of factors that are going to determine that rate of growth and many of them are simply unforeseeable. When categorizing companies in terms of their growth profile, I typically only use four broad categories. I’ve labelled these categories “high growth”, “compounders”, “average growth” and “no growth”. This gives me enough wiggle room so that I don’t have to get too obsessive about trying to estimate growth rates to the nearest percentage point.

Over the past 60 years or so, the stock market (as measured by the S&P 500) has risen by 5.7% per year over inflation, once you factor in dividends. The start and end points I used in this calculation were chosen to reflect periods when the market was trading at a similar overall p:e ratio. Which means, conceptually, that earnings at the average company would have also been expected to have risen at a rate of around 6% per year, provided the company was re-investing all of those earnings in its future growth.

This is the rate that I use when I refer to “average” growth. To qualify as average, I am looking for companies that are growing at around 6% a year over inflation. At that rate, you’d expect the company to have roughly doubled in size over the past 12 years. If you were to look back at the company’s results from 12 years previously, you should see that sales, earnings and book value were all roughly half of what they are today. Again, we don’t have to be too precise. If sales have climbed by 8% a year while earnings have risen by 5% and book value has climbed by 4%, that’s close enough. I’m just trying to ballpark things here.

An important exception occurs if the company has been issuing a high dividend. If the company is dividending out most of its earnings to shareholders, it is unreasonable to expect it to also be able to reinvest in its own growth. So a high payout ratio (which measures the percent of earnings that are paid out as dividends every year) can get a company into the average growth category even if earnings appear to have flat-lined.

Even though their growth may be wholly unremarkable, these kinds of stocks can still make wonderful investments if you can buy them at a big enough discount. In fact, this category of stock has probably made up the majority of my investments over the years. However, I’ll often try to tilt the odds in my favour by searching out those companies which may have exhibited average growth in the past but have some tricks up their sleeve which might end up surprising investors with higher growth in the future. Maybe they have a pile of cash on their balance sheet or a new product about to be introduced into the marketplace. Because the market is not expecting too much out of them, they are less likely to disappoint and may pleasantly surprise you instead.

Because of this potential, and because of the values you can often find here, I like to think of these stocks as not just average but “perfectly average”.

No Growth

Moving down the growth spectrum, I have my “no-growth” companies. These are companies that are just treading water. They don’t pay out much of a dividend so we can’t give them a pass for that. Despite their best efforts, profits have been stagnating or declining for the past number of years. Maybe they are in a dying industry or are struggling with a legacy product that no one wants anymore. Maybe the company is just very badly run. For whatever reason, they are going nowhere fast. But every dog has its day. Sometimes they can get their act together and turn things around. Pivot into new lines of business, develop new products, hire more competent managers. If they do, the stock price can soar. I need to be able to buy this at a discount to make the gamble worth it, but even a dog like this has its price. I set my target p:e ratio for this category of company about 25% below what I would pay for a perfectly average company.

High Growth

Some companies will have a line on something more exciting. Maybe a new technology, process, brand or service that lets them grow at a significantly higher rate. There’s often something proprietary or unique about what they do. These companies can make great investments if you can find them at the right price. To qualify as a high growth company, I am looking for earnings to double over the next few years.

If I expect earnings to double in the short term, I should then reasonably expect to pay almost twice as much, on a p:e basis, for this sort of company as I would for a company without any earnings growth. In other words, a bargain price here is not the same as a bargain price for an average growth or no-growth sort of company; it’s a good deal higher. While these sorts of companies rarely come cheap, occasionally you’ll find one whose growth prospects are being overlooked or under-rated by the market and you can get in at a reasonable price. Not only do I stand the chance of getting a nice ride from the p:e ratio re-rating upwards if my predictions of growth turn out to be true, but I’ll enjoy an added tailwind along the way from an increase in the underlying earnings.

It is easy to get carried away and project rapid growth years into the future. That’s how a lot of investors trip themselves up and end up overpaying for the latest sexy, high growth stock. If you try to look too far out into the future, your crystal ball starts to get pretty cloudy. Competitors can muscle in, consumer trends can shift, markets can get saturated. Which is why I don’t let myself get too carried away with breathless projections of future riches. I’m only willing to extrapolate very high growth rates a few years into the future. I’ll pay up for a good growth story, but not too much. Generally speaking, about 2/3 more than what I’d be willing to pay for a similar “average growth” story.

Compounders

Lying in between the “average growth” segment of the market, which is where you’ll find most companies hanging out, and the relatively rare “high growth” sector, lies a segment of the market that I admittedly have never felt overly comfortable in. I call these the “compounders”. These are companies with a long track record of consistent, above average growth. To put some more specific numbers on it, let’s say somewhere around the 12% per year mark. Their success is often not due to any unique product or service but instead is simply due to consistent and efficient business execution. Often, they will have grown though a steady string of well-executed acquisitions.

If I don’t have confidence that the company can continue to outperform for at least the next 5 years, then I don’t slot it into this category; it gets bumped back down to average growth. As I’ve said, I don’t feel my crystal ball is that accurate, so I’m always reluctant to extend my forecast too far into the future, which is why I’m always hesitant to slot companies into this category. Some investors, including a certain famous investor out in Omaha, will try to identify these perennial outperformers by the “moat” they have built around their businesses. I’ve never been able to see those supposed moats very clearly myself but if the company has a good track record behind it and I see no obvious reason why growth would slow in the future, then I will grudgingly give it extra marks for its superior growth profile and valuation-wise I’ll slot it in about midway between my average growth and high growth categories.

The Turnaround

Most of the companies I look at will fall into one of these 4 growth categories, but there are a couple of special situations that warrant mentioning. The first of these is the turnaround. In these situations, growth doesn’t really enter into the equation. In fact, quite the opposite: earnings have taken a trip into the cellar. These are companies that have fallen on hard times. Often the company will be losing money or just scraping by. However, there is good reason to expect that the downturn is temporary. It may be due to external factors that are cyclical in nature. A recession may have dampened sales at a clothing retailer, or a drilling rig operator may have got caught up in the periodic boom and bust cycle of the oil patch. The decline could also be due to company specific factors that you think can be rectified. Maybe the company launched a new advertising campaign that was a huge flop, and this has temporarily hurt their results.

You can’t use a regular p:e ratio to value these companies because they often don’t have any earnings at the moment or, if they do, they are severely depressed and not indicative of what the company might make going forward. In these turnaround situations, I still use a p:e ratio to evaluate their fair value but I go back and use an earnings number from before the downturn that I feel is representative of what they might earn once they get back on their feet. As well, I’ll demand a lower p:e ratio to these “peak earnings” (about 25% lower) when compared to what I’d pay for the typical “average growth” company to compensate for the added risk that things may not, in fact, turn around as quickly or as completely as I expect. Practically speaking, this means that I essentially value a turnaround play the same way that I value a “no growth” type company. Both get assigned a p:e ratio that is 3/4 that of an average growth company. The difference is that with a turnaround play I am using previous, peak earnings and with a “no growth” company I am using current, trailing earnings.

Other factors besides earnings become more important in these turnaround situations. The company has to be financially solid, with no or low debt levels so that it can last a year or two without any profits coming in. Cash in the bank is even better. I also like to see positive cash flow even if earnings are negative from an accounting perspective. (Earnings often include non-cash expenses like depreciation. Cash flow backs out these non-cash items and gives you a sense of how much cold, hard cash is actually flowing into or out of the company.)

The risks are definitely elevated with this sort of investment, but the rewards can be worth it.

The Asset Play

In the normal course of events, a company’s book value doesn’t figure heavily in to my calculations. It’s nice to see a relatively low price to book value ratio to give you some reassurance that there is something tangible there to support the stock price if things really go off the rails, but I will gladly buy a high-flyer for 5 or 6 times book value if the earnings and growth rate are there to support the decision. You can’t always have it all. It’s often the companies with relatively little in the way of hard, physical assets that can grow the most quickly.

However, for the more beaten up names in my portfolio, a bit of meat on the bones is a reassuring thing to have. In a turnaround situation, a large tangible asset base is something the company can fall back on to secure additional bank funding and help support the stock price, so I will pay more attention to the book value in these cases.

As well, there is a separate category of investment that I stumble across every now and then called the “asset play”. These are companies with a large asset that may be underappreciated by the market. Maybe it is a large hoard of cash or a valuable piece of real estate. Or maybe it is a fleet of unused drilling rigs that were mothballed in the last oil industry downturn. Whatever the source, the stock price is trading at a big discount to the value of this asset. The way in which the company will eventually manage to monetize this asset is often unclear, so this sort of investment requires patience and a bit of a leap of faith. But it helps to add a bit of variety to the portfolio.

For this category of stock, I use the price to book value ratio to assign it a fair value instead of the p:e. As a rough guideline, and a fairly conservative one at that, I’ll usually use a price to tangible book value of 1 as my estimate of fair value. If the company has significant assets and I can buy those assets at significantly less than their current dollar value then I feel I am getting a good deal.

The Market Environment

This overview of the valuation framework I use to value stocks wouldn’t be complete without mentioning the role that investor sentiment has on overall market prices. The market fluctuates between periods of over exuberance and irrational pessimism. I’ve had the privilege of getting a taste of both extremes on more than one occasion over the past 26 years. When the champagne is flowing on Wall Street, stock prices and average p:e ratios can get considerably higher than what you’d usually expect to see and when the tide turns the other way, p:e ratios and other valuation metrics can get driven down to unreasonably low levels. Any valuation framework or p:e guideline you use has to be able to adapt to these changing market conditions.

When stock prices have been bid up, ordinary, “perfectly average” companies may trade hands for as much as 20 times earnings. At the same time, the price of everything else tends to rise as well. A sexy, high growth company might trade at a p:e over 30 in this environment while even no-growth dinosaurs and risky turnaround situations can sell at a pricey 15 times earnings.

Conversely when prices drop, as they did during the Great Financial Crisis of 2008, there were many “perfectly average” companies to be had for only 10 times earnings. Sluggish, “no growth” companies were trading for even less, as low as 7 times earnings. My fair value calculations always have to take into account the kind of market environment I am in. When prices are high, I need to raise my fair value estimates and when times are tough, I need to dial them back down again.

Below is a table that illustrates the four broad growth categories of stocks I use to divide up the market universe. I’ve given the growth rate assumptions I’ve used for each category. (For those math and investing nerds out there, you can plug these assumptions into a discounted cash flow model and it should spit out the same numbers. I use a discount rate of 6% to match the long-term real rate of return of the market.)

I’ve given 3 market scenarios. One for a weak market where the average small cap company is trading at a p:e of 12, one for a more exuberant market where the average small cap p:e is 20 and one in the middle where the average p:e is 16. In each scenario, I show the target or “fair value” p:e ratio I’d expect to see for each of the four different growth categories of stock. (I use the same p:e targets for turnarounds that I use for “no growth” stocks. The difference is that for turnarounds I base that p:e ratio on peak earnings and for no growth stocks I base it on current earnings.)

Growth Category	Growth Rate Assumptions	Relative P:E Ratios	Average P:E 12	Average P:E 16	Average P:E 20
High Growth	25% per year over 3 years	1.66	20	27	33
Compounder	12% per year over 5 years	1.33	16	21	27
Average Growth	6% per year	1	12	16	20
No Growth	0% per year over 5 years	0.75	9	12	15

This framework gives me a set of p:e ratio guidelines to work with. I just need to determine the overall, average p:e of the market and then everything else falls into place around that. Unfortunately, this “market average” p:e is a slippery number and can be hard to get a good handle on. Everyone calculates it a different way. Personally, I find the most accurate approach is to simply go through a long list of comparable, average growth type companies, rank them by p:e, and use the middle value as my “perfectly average” p:e anchor.

What matters more than the absolute number, though, is the relative valuation of the different types of stocks. This is what lets you makes those critical apples to oranges comparisons. If I’m comparing an average growth company with a high growth company, the framework above can tell me which is the cheaper of the two. I’d normally expect a high growth company to trade at a p:e 2/3 higher than the average growth company. That means that if the average growth company is trading at a p:e of 16, I’d expect the high growth company to sell for 27 times earnings. If it were only selling for 20 times earnings, that could represent a relative bargain.

Naturally, I don’t want to pay full price. I’m looking for at least a 40% discount to the target “fair value” p:e ratios in the table above to give me the value I’m looking for. That would mean in a middle of the road kind of market where the average small cap company is trading at 16 times earnings, I’d be hunting for a company with average growth characteristics trading at a p:e of 10 or less. In the same environment, a high growth company would be expected to trade at a p:e ratio of 27 so if I could pick one up for 16 or less, I’d be happy. I’m looking for the best ratio of price (p:e ratio) to growth that I can find. That could mean a high growth company trading at an average p:e or it could mean a no growth company trading at a truly rock-bottom p:e. Which growth category a company ends up being slotted into doesn’t matter. What matters is whether the p:e of that stock represents a large discount to my fair value target. I’ll buy whichever companies, in whatever growth categories, give me the biggest discounts.

The Valuation Framework

By using my 4 basic growth categories plus the asset play and turnaround special situations, I can cover a good cross section of the investment universe. Not everything qualifies. There is no category for “money losing internet stock” or “prospective mineral exploration property”. But if the company is making, has made or is likely to make a profit then I can usually find some category to shoehorn it into. It may not be an exact fit, but it gets me into the rough ballpark and if I’m always buying at a big discount to whatever fair value this leads me to, that’s been more than enough to produce impressive long-term returns.

I always provide myself an override. The framework I use is not written in stone. It is a guideline only. For example, investors tend to favour very large, stable companies and shy away from the more volatile micro cap sector. If I’m looking at a larger company with a long, consistent track record behind it, I might be willing to add on a few extra points to my target p:e ratio. If I’m focusing on the micro cap sector, then I’ll adjust my fair value target ranges a little lower. If my rules of thumb suggest a fair value p:e of 16 and yet the company that I’m looking at, in all of its past history, has never traded above 10, then I’ll take that into account and lower my expectations. Banks often trade at lower p:e ratios. So do companies in the resource sector. I’ll factor that in if I’m looking at buying a stock in one of those sectors. Theory is one thing, but good old-fashioned empiric observation can be just as valuable.

The valuation framework I use may sound overly simplistic. Professional analysts armed with a carefully constructed discounted cash flow analysis might scoff, but the simplicity of my approach is part of why I think it works well in practice. To find those undervalued gems, you’ve got to turn over a lot of rocks. It helps to have a broad framework that you can quickly apply to a wide range of different situations. This lets you sift through the thousands of stocks open to consideration without getting too bogged down in the details. Once you’ve zeroed in on a prospective candidate, you can always take the time to add some more nuance to your calculations, but honestly, I often simply fall back on my rough and ready growth categories. No one can see the future with any degree of accuracy and forcing yourself to use a more general framework helps you avoid the temptation to put too much weight on your own soothsaying abilities.

With this valuation framework in place, I can now move on to the real nitty gritty of stock analysis. In part 5, I dissect in detail the step by step process I use to evaluate every potential new stock investment.