Investors use the words “undervalued” and “overvalued” a lot, but for all their popularity, they’re the two most misused words in finance. It seems to me “overvalued” is just something people say when they generally dislike a stock regardless of the facts, while “undervalued” is when they like it. Others confuse value and price completely, labelling “overvalued” as something that’s gone up in price, while “undervalued” is something that’s gone down. While every investor has an opinion of value, it seems many aren’t able to describe what “value” really means or can objectively know it when they see it. The best investors of our time (Buffett and Klarman stand out in this regard) systematically apply value objectively in evaluating investments.
Determining value comes down to two things: cashflow and the price you pay to obtain that cashflow. While price earnings ratios and the like can at times be moderately helpful, they really mean very little without the context of cashflow.
First, we can look at how much cashflow a company produces for its owners. Seven to ten years of cashflow history is a good starting point so you can watch the changes in that cashflow through an economic cycle. Stability is better than volatility in that regard. Next, compare the amount of that cashflow to the amount of capital invested in the business. For example, if a lemonade stand on average generates $20 of cashflow for every $100 of capital put into the business, its return on equity is 20% ($20/$100). For us, return on equity is a crucial way to determine business quality. A high and stable return on equity means a company can sustain high cashflows over an economic cycle, which points to a combination of strong management, product differentiation, and business discipline.
So we’ve found a high quality company. But what’s a reasonable amount to pay for it?
Here’s the fun part. We know that the economic value of a company is equal to its physical assets today, plus the future value of its cashflows. Since the high quality company we found produces relatively stable cashflows, and we don’t see any reason that might change anytime soon, we can reasonably extend those cashflows into the future at the same or similar rate. Evidence shows that companies with stable return on equity tend to remain stable over time, and companies with cyclical return on equity tend to remain cyclical. These things are obviously up for long term debate, and every company is a unique situation to a certain extent.
Next, we add up those future cashflows, and discount them by future inflation, cost of capital, or whatever your preferred discount rate is. Buffett uses the yield on long term treasury bonds to discount earnings, while others prefer using the average rate of return on the market. Whatever you pick, do it consistently. This discounting adjusts the value of future cashflows to determine what they’re worth in today’s dollars. Once we’ve figured out the value of future cashflows, we add the replacement cost of the company’s physical assets. The result is the company’s “economic value”. This would be the highest price a reasonable investor should be willing to pay for the company. Now yes we’ve made an assumption about future cashflows, and yes we made an assumption about the discount rate, and yes we’ve made an assumption about the replacement value of the company’s assets, but it sure beats the alternative of making random guesses.
So our lemonade stand generates $20 of cash on $100 of capital invested. We expect it to keep growing at that rate for the future, with a return on equity of 20%. Let’s assume the physical assets of the lemonade stand now cost $105 to replace. Finally, let’s discount our future cashflow by 5%, representing the opportunity cost of being able to invest in the TSX instead of lemonade. That means the economic value of our stand comes to about $405. That’s cashflows of 20% return on equity discounted by 5% on $100 of invested capital, plus the $105 replacement cost of assets. In other words, $405 is the maximum a reasonable investor would pay for the lemonade stand today.
Buying a business at its economic value means an investor meets their expectations of cashflow and should be happy about getting what they signed up for. Realistically, however, to account for errors on my part in judgement, the market’s part in volatility, and out a sense of general conservatism, I don’t make a habit of buying companies at their economic value. Instead, I look for companies priced at a 20% discount (at least) to their economic value. That 20% is my margin of safety, and protects my downside in the case of bad judgement. In other words, I can make a pretty big error in judgement, and still be content with the value of cashflows and assets going forward.
Now this all sounds quite reasonable and common sense, but you’d be amazed how few investors and professionals actually follow through on calculating the economic value of their investments. I’ve seen large firms with hundreds of analysts miss very simple math on very well-known companies. To me, the most entertaining part of the whole endeavour is that, contrary to all the analyst reports and talking heads, about 85% of companies are actually fairly priced most of the time based on economic value. In other words, most of the over- or under- valued commentary is fluff based on something other than actual value. We don’t tend to see many stocks trading well below or above their economic value for the simple reason that economic value acts as a tether. With enough time, the market gradually figures out economic value and prices companies relatively correctly in the long run. The short run is a different story however.
Economic value gives investors a tool to objectively evaluate investment opportunities. But it doesn’t only provide a framework to find high quality undervalued companies. Economic value proves that the only thing that’s consistently overvalued in the market is opinions, while the value investment process itself remains the most undervalued asset of all.