During bull markets, investors often ignore fundamentals like valuation and buy what is popular. This herd-like behavior was evident in many stocks last year. But the recent pullback in many of these same stocks is a stark reminder of the fact that, over the long run, valuation matters. If you want to be a successful long term investor, then you must pay attention to valuation. I will show you why valuation is so vitally important, and how you should think about your next stock investment. Irrational Exuberance Last year's raging bull market was led by spectacular gains in many "glamour" stocks - popular stocks with high growth expectations and high valuation multiples. Perhaps some of these gains can be explained by improving fundamentals like earnings, but the driving force most likely behind much of the rise in prices was, ironically, higher prices. This is known as a "positive feedback loop" and can lead to speculative bubbles. Recent Nobel Prize winner Robert Shiller has described speculative bubbles as "a period when investors are attracted to an investment irrationally because rising prices encourage them to expect, at some level of consciousness at least, more price increases. A feedback develops - as people become more and more attracted, there are more and more price increases." We saw this behavior in tech stocks in the late 1990s. We saw it with housing prices in the mid 2000s. And we likely saw it at least to some degree among many glamour stocks in 2013. Shiller himself warned of this in February on CNBC, stating: "We do have a little bit of bubble thinking... people are very impressed by high tech, probably too impressed... I like to look at long-term earnings." | ||||
| This Time Isn't Different Back in November 1999, right in the midst of the dot-com hysteria, Warren Buffett wrote in Fortune magazine: "The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings" Naturally, he was largely ignored or ridiculed at the time. During periods of irrational exuberance, people will argue passionately that the rules of investing have changed. You'll hear phrases like "valuations don't matter for this stock because blah, blah, blah" or "this time is different". That may be true for short periods of time, but history shows us time and again that over the long run, valuations indeed matter. Valuation Matters Study after study shows that over the long run, stocks with low valuation multiples outperform stocks with high valuation multiples. One study by Louis K.C. Chan and Josef Lakonishok in 2004 took a composite of several valuation metrics (price to book value, price to earnings, price to cash flow and price to sales). Portfolios were formed every calendar year-end by sorting stocks into 1 of 10 deciles based on their composite value metrics. The difference in returns between the top decile (glamour) stocks and the bottom decile (deep value) stocks was dramatic, whether it was a small cap or large cap stock.  Another study by Tweedy Browne showed similar results. Their study placed stocks into deciles by P/E ratio and looked at their average annual returns over a five year period. Once again, the higher the valuation multiple was, the lower the returns were.  While glamour stocks can outpace value stocks over short periods of time, history shows that in the end, the tortoise beats the hare - by a long shot. Good Business, Bad Stock I'm not advocating only buying stocks with low valuation multiples. Many such stocks are cheap for a good reason. But simply buying a stock just because you expect its earnings or cash flow to grow at a high rate over time isn't enough. You have to buy it at a reasonable price. As the father of value investing, Benjamin Graham, wrote many decades ago: "Obvious prospects for physical growth in a business do not translate into obvious profits for investors." Keep in mind that in most cases the market has already "priced in" a company's growth. And if its growth fails to meet (or even sometimes exceed) the market's expectations, then its stock can get pummeled. In other words, a sky-high P/E multiple will eventually contract if a company misses those lofty earnings expectations or when (not if) growth inevitably slows. Examples like this occur every earnings season. Investors would be well served to remember that a stock represents an ownership interest in a business. And as John Burr Williams wrote in his 1938 text The Theory of Investment Value : "The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset." Investors often lose sight of this fact during bull markets. The key is to keep your emotions in check and think about a stock as an ownership interest in a business. Pay attention to valuations and don't overpay for expected growth. You want to buy growth at a reasonable price, not growth at any price. The Bottom Line During periods of irrational exuberance, many investors lose sight of fundamentals and chase returns. But the key to successful investing is to keep your emotions in check and stay rational. Pay attention to valuations, and when you hear someone shouting "this time is different" , don't believe it. |
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Mergers and Acquisitions: Valuation Matters
By Ben McClure
Investors in a company that are aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth.
Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.
There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:
- Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
- Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
- Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.
- Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.
Synergy: The Premium for Potential Success
For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.
Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:
In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.
What to Look For It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:
- A reasonable purchase price - A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests.
- Cash transactions - Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside.
- Sensible appetite – An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers.
