Money is not a static quantity

Hey folks,

Proper valuation is one of the toughest things to do well, the reason being that many valuation methods fall logically short.  Take relative valuation.  Relative valuation makes us approach company valuation much the way a Realtor approaches valuing residential property: by examining comparables.  If you go to a Realtor and ask him or her to come up with a valuation for your home, he will look at the square footage (Let's say 10,000 square feet), then look at the price per square foot on homes that have recently been sold that share similar characteristics to yours, (Let's say they find that number is $10 per square foot), and then they multiply your square feet by the comparable's price per square foot and arrive at a number: $100,000.

So too does relative valuation look at comparable prices, and because shares of stock are traded many times per day, getting the price of competitors for use in a similar comparable valuation process is a very easy thing.  Instead of looking at the price per square foot, a person performing a relative valuation will look at other important ratios for businesses:  For example, price to earnings, price to EBITDA (This will tell you the earnings of the firm before financial charges and thus gives a good idea of the actual earning power of the enterprise), and so on.  Then they multiply the target company's net income by the average P/E, or the target company's EBITDA by the price to EBITDA ratio, and arrive at a number.

Not too hard, huh?

Yet relative valuation falls short.  When a Realtor values properties by using comparables, he arrives at a figure that makes sense given the current market climate.  But what if the market climate itself is wrong?  A perfect illustration of this in the financial markets is the tech boom in 2000.  Investment bankers assigned valuations to internet companies based on multiples of sales (not price to income, certainly, as many of these companies had no income!) or based on the number of webpage hits they got, etc. and arrived at a price.  At the time, these valuations seemed to be in line with the market-and yet we now know that both these valuations and the market itself was absurd.

Because of this, relative valuation is dangerous: If we make inappropriate valuations based on the inappropriate valuations of other companies, what will stop others from making even more inappropriate valuations based on our inappropriate valuations?  There is something called a feedback loop, which in laymans terms means an event that effects or modifies the causes of the event in the first place.  All financial bubbles are the result of feedback loops.  Get good at identifying events that feed into themselves because they will make you more aware of financial bubbles and help you avoid them.

Benjamin Graham suggests that our investment strategy should be based on current interest rates for highly rated corporations.  I hope to shed some light as to why this is in this article.

Money is not a static quantity.  When we buy a business, we are not looking for a lump sum payment.  In fact, we are looking to turn our lump sum payment into a series of cash flows that we hope will continue forever.  Constant vigilance of company financial filings will indicate to us whether the company is meeting the benchmarks we have set for them in terms of profits.  And yet, we can take this a step further-  why put down a lump sum of money when we can, ourselves, pay nothing out?  As I mentioned in my article about money, the true way to riches is to use other people's money to make yourself money.  Corporations exclusively think this way.

So what is another way we could acquire a company for, say, $10 billion that generates $1 billion in free cash flows? (A 10% return).  Well, we could borrow $10 billion from a bank and pay $500 million in interest per year.  (5% interest rate).  Even better, as a large corporation, we can set the terms of our own debt by issuing bonds.  This is why interest rates are so crucial when we value companies.  An alternative method of looking at the valuation of companies is as follows:  A larger company can exclusively use debt to buy a target company and generate a profit based on the difference between the amount they pay (in interest) and the amount the company earns them (the free cash flows).  Thus, the price of companies will never be largely below the price that it takes to make this happen.

So what does this mean for interest rates?  Well, if interest rates are at 2 - 3%, as they are now, a return of 6 - 7% should be attractive for a firm.  But what if interest rates are 13 - 14% for a large company's bonds?  In this case, companies demand a much higher return.  So, while companies are valued based on their cash flows, the price people are willing to pay for these cash flows is largely determined by going interest rates.

Imagine you are considering to buy a company that will have the 10% return.  In today's interest rate environment, this would be very appealing.  If interest rates are 13 - 14%, you are better off simply buying bonds.  Not only are bonds normally safer, but the yield is higher.  Always keep your eye on yield, as it will allow you to compare across all different investments.

How would this yield mentality fare in different market climates, you may ask?  Well, in the tech boom, if you followed the strategy of looking towards yields, you would have avoided the tech sector entirely.  You may have decided just to buy bonds, or perhaps out of favor low-tech companies.  Companies that are out of favor with the market will have a more attractive yield than other companies.  By just looking at the yields, you will immediately gravitate towards companies that the market does not like very much.  These companies are the bread and butter of the value investor.

The key aspects we look for in a firm is intrinsic value.  The price tag for our firm can be looked at not as a lump sum but as a loan- whenever you examine a company for purchase, think this way: if a AAA-rated company can borrow money through bonds or bank debt and buy a company outright, will they make money on the purchase?  If so, then the company will add value.  If the firm will not make the AAA-rated company money, then buying the stock will destroy value.  Examining money not as a static quantity but as a series of payments will help you significantly in your quest to understand good investments.

See you next week!