Part 2 in a series of tutorials on value investing: Putting theory into practice. How we might begin to value an old time general store.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The 5 Year P:E
Part 4: Hitting The Books
Part 5: How To Find Winning Stocks
Part 6: When To Sell
Assessing Fair Value
In part 1 of this series, I explained my basic value investing philosophy. When I buy a stock, I like to think of myself as buying the whole company, not just a small piece of it. I like to buy with a long-term outlook, mentally prepared to hold on to this investment through thick and thin. Finally, and most importantly, I only buy companies that are trading at a big discount to what I think they’re worth.
This is where things get slippery. Value is an opinion, not a fact. Ask 10 different value investors what the fair value of a company is and you will get 10 different answers. This is what separates the successful value investors from the unsuccessful ones. The successful value investors are those who have developed a framework that lets them appraise the potential value of a company more accurately than the rest of the market. The more accurate their framework, the better they can identify the companies whose stock prices have been the most egregiously mispriced and the more they are likely to profit when that mispricing gets corrected.
The approach I use has led me to outperform the market by a wide margin over a long period of time. It’s far from perfect and I’m sure many investors would find cause to criticize various aspects of it, but the proof is in the pudding. I’ve beaten the market by over 12% annually for close to three decades. The naysayers out there have probably not. Here then, is how I think about the value of a company…
Case Study: The Local General Store
In the small town where I live, there is a wonderful general store. The main floor is taken up by a well-stocked grocery section with lots of fresh, local produce and all the basic staples you might need. Upstairs is a gift store with an interesting collection of knick-knacks and next to this is a restaurant with a stunning view looking out over the water. I have spent many mornings here over the years with a stack of pancakes doused in maple syrup, a bottomless cup of coffee and the business section of the Globe and Mail spread out in front of me.
If I wanted to buy this business, how would I determine what a fair price to pay for it would be? For this thought experiment, let’s say that the business has a competent manager who intends to stay on in this role. As the new owner of the business, we are simply going to sit back, let this manager do their job and collect our payout. As amazing as it seems, this sort of free ride is exactly what you get in the stock market, so let’s pretend that this is how our private investment will work as well.
In this scenario, how would we determine a fair asking price for this fine establishment? In other words, how would we assess the true value of this business? The first place I would start, as I do with any new stock that I look at, is with the business’s financial statements. These are a treasure trove of information and include all sorts of interesting financial details about the company; its total sales, its profit or loss, the value of its real estate, its inventory, the way that money flows in to and out of the company, the value of any dividends it might pay, its tax rate, etc. Out of all of these numbers, however, there is one that stands head and shoulders above the rest in helping me put a reasonable price on the business. Before we get to that, though, let’s look at some of the other numbers someone might think of using to value this enterprise.
Book Value
The store sits in its own building in a beautiful location, right off of main street, next to a park and overlooking the water. This building is a valuable piece of real estate. We could perhaps ask for the appraised value of the building and base our offering price on that. But we’d have to know if the building was owned outright or if it was rented. If it was owned we’d want to know if there was a large mortgage outstanding on it. And this ignores any other assets or liabilities the business might have. There’s the value of all that inventory, for instance. On the other side of the ledger, the owner might have taken out a large loan from the bank to do some major renovations a few years back and we’d have to factor this into our calculations as well. If we added up all the things the company owned (its assets) and subtracted out all of the money it owed (its liabilities) we’d come up with a final number that is commonly referred to as tangible book value. One possibility might be to use this book value figure as our estimate of fair value and base our offering price on that.
But this ignores a lot of intangible value that the company might have. The owner has spent years building this business, establishing a brand and a reputation and perfecting its day to day operations. There is a good chance that the business is worth significantly more than just the value of its hard, physical assets. We could certainly offer the owner a price equal to the book value of his business. We could even try to lowball him to see if we could get the business at a discount to its book value. If he agreed to our offer, though, we’d have to pause and ask ourselves why he was willing to sell us the business for only the value of its assets, giving no additional consideration to the business he has built on top of those assets. Perhaps we have just bought ourselves a lemon!
Sales
So what else could we use to value this business? We could look at its total sales (also called revenues). All of the bunches of organic kale, the loaves of fresh baked bread, the boxes of macaroni and cheese and the plates of hungry man breakfasts that it serves, all added up over the course of a year will give us a number for the general store’s total revenues. Could we base our offering price on this number? Not really. Grocery stores are a low margin business. The store might sell a lot of stuff, but if its expenses are too high it might actually be losing money. Buying a business that is losing money probably isn’t what we had in mind.
Profit
Sales and book value are valuable pieces of information to have but at the end of the day what we really want to know is how much money the company makes. Once the store has paid all of it’s myriad expenses, once it’s paid the farmers for their pints of fresh picked blueberries, once it’s paid my son (who worked there one summer) to wash the breakfast dishes, once it’s paid the electric company to keep the lights on, once it’s paid the bank the interest on the mortgage and paid the tax man his share, how much is left over? The amount that’s left over is the store’s profit. (This is also frequently referred to as earnings, income or net earnings or net income.) If I could have only one piece of information about a company, this would be it: the company’s annual profit.
As a new owner of the business, this profit is the money that is left over for me, free and clear, after everyone else gets their piece of the pie. It is not earmarked for anything. If the accounting has been done properly, I can take this money out of the business (by way of a dividend) and the store would not suffer in any way. I can use this money to pay for my son’s university education or buy a new car. Or, I could simply sock it away in my bank account.
This profit is the return that I am hoping to get from my investment in the general store and so plays a big role in determining what price I am willing to pay for that investment. Let’s say that after paying the general manager his salary and paying all the other expenses that come with running a business, the store is clearing $100 000 in profit a year. What then would be a fair price to pay for the business?
What’s The Payoff?
It might help to start by identifying what wouldn’t be fair. If the current owner was asking $3 million for his business, I would say, “thanks, but no thanks.” It might be a wonderful establishment to frequent as a customer but as a potential new owner, the payoff at this price is just not there. If the annual net earnings of this business were $100 000, that’s how much I could take out of the business every year. At a $3 million asking price, it would take me 30 years just to make back my initial investment. 30 years is a long time. A lot can go wrong in 30 years. Perhaps a new highway will be built bypassing main street. Or perhaps we’ll all be having our groceries delivered by drone by then.
Looked at another way, the $100 000 in annual earnings that this store is generating would represent a return of 3.3% on our initial investment of $3 million. We would say that the earnings yield of this investment was 3.3%. Better than the interest you could get in your bank account perhaps but considering the fairly substantial risks inherent in owning a small business, this is just not enough of a potential return to make it worth our while. The price is going to have to be lower to entice us to buy.
What if we offered $500 000? Now the math is looking much more favourable. At this price, the return on our investment would be 20% ($100 000 being 20% of $500 000). If we took all of this money out of the business, we’d have made back our initial grubstake in only 5 years. After that, the highway planning committee can do as it wants. Of course, the current owner is no dummy and is unlikely to sell off his baby at such a low price.
The Mighty P:E Ratio
The ratio of the purchase price of a business to its underlying earnings is known as its price:earnings ratio or p:e ratio for short. Price divided by earnings. In our general store example, to calculate the p:e ratio of this investment we simply take the price that we would have to pay to buy the entire business and divide it by the earnings or profit that that business is generating every year. At a purchase price of $3 million, we’d be paying a p:e of 30 for this investment and at a price of $500 000, we’d be looking at a p:e of 5.
We can apply the same math to investments we might make in the stock market. Here, you’re not buying an entire company, you’re just buying small pieces of a company (known as shares). Each share is entitled to a tiny piece of the overall company profits. If a company had earnings of $10 million a year and there were 10 million shares outstanding in the company, then the $10 million in profit gets divided up equally amongst all 10 million shares so that each share represents an ownership stake in $1 of those total profits. ($10 million profit / 10 million shares = $1 per share) This company would then be said to have earnings per share (EPS) of $1. If the share price was $15 then the p:e ratio of this stock would simply be the purchase price of a single share ($15) divided by that share’s small piece of the total earnings ($1). $15/$1 = 15. So this company would have a p:e of 15.
You can do the same sort of calculation using a company’s market cap. Market cap is short for market capitalization and is how much it would cost you to buy up the entire business by buying up all of its shares at the current share price. If you took the market cap of the company in our example above (10 million shares x $15 share price = $150 million) and divided that by the annual net earnings of $10 million, you’d get the same p:e ratio of 15.
Where Does All The Money Go?
The p:e ratio is a very common way to look at stock investments. It highlights the notion that when you buy a stock, you are buying an actual piece of a company and with that piece comes an ownership claim on a proportionate share of that company’s annual profit. With our general store example, as sole owner of the company, there was a straight and direct line between the profit the company was generating and our own personal bank account. With public stock market investments, that line is a little more hazy. One way or another, though, those profits still find their eventual way into our pocket.
For example, companies can choose to dividend out all of their earnings to shareholders. In this situation, we would quite literally get our share of the profits deposited directly into our brokerage account on a regular basis. But often the company will choose to retain some or all of these profits to reinvest in the growth and expansion of the business. While it might take longer, this money is still ultimately destined for our wallets. The company might use this money to make an acquisition, buying up another company. The added profits from this new acquisition will boost overall profits and thereby raise the value of the company and the price of our shares. Or it might invest more directly in its own growth by building a new factory or hiring more salespeople. Again, this should hopefully lead to higher profits and a higher share price. The company could also use the earnings it is generating to buy back shares, reducing the total number of shares and thereby increasing the proportion of the total earnings attributable to each of the remaining shares. Higher earnings per share should typically result in a higher share price.
One way or another, those earnings should find their way back into our pocket as a shareholder in the company. While a little more abstract, this is directly comparable to our example of the general store where we were taking direct ownership of the entire business, and it is how I look at all the investments I make. It’s the price I pay for every dollar of those earnings that determines whether I am making a good investment or a bad one.
The Search Begins
With p:e ratio in hand, we can now start to hunt down those elusive undervalued stock market deals. A low p:e ratio can be an indicator that the market is overlooking a potential bargain. If everything else about the company checks out okay, we can buy the low priced stock and wait patiently until other investors see the value that we have seen and bid the price back up. It could take months. It could take years. That part of the process is out of our control. But if we are patient and we have chosen carefully, then more often than not, we’ll be handsomely rewarded for our efforts.
The simple p:e ratio is a good place to start our stock market investigations but there is a large caveat. 9 out of every 10 low p:e stocks will likely have something wrong with them. There is a reason the current shareholders are willing to sell their shares so cheaply. A class action lawsuit, intensifying competition, the loss of a major contract. Every so often, though, if I look long and hard enough, I’ll come across a company with a low price to earnings ratio that is actually not too bad. After hours of exhaustive research, poring over financial statements and reading through conference call transcripts, I still won’t have found anything disastrously wrong with the company. Those are the stocks I buy.
The simple p:e ratio is a valuable tool and you could have a successful career as a value investor if this is as far as you went; spending your time searching for bargains at the bottom of the market. But it would be a somewhat harrowing ride. The regular p:e ratio tends to highlight the dregs of market society. You have to weed through a lot of stock market junk to find the occasional hidden gem. That’s because the regular p:e ratio makes no allowance for growth and it is growth that really grabs the market’s attention. Growth is the lifeblood of Wall Street. The promise of future growth is what gets the adrenaline pumping and the economy humming. That’s where we’re headed next.
In Part 3: The 5 Year P:E, we’ll expand on the simple p:e ratio by including an estimate of future growth, thereby creating our ultimate yardstick of value.