How to Value Stocks: Security Analysis

Valuation: The Price Paid In Relation to the Cash Created

How to Value Stocks

By Randy Befumo

  • Rule 2: When you buy a business, the price you pay should relate directly to the cash you expect the business to generate.
  • Rule 3: Context, context, context. It is critical to understand a company's economic model on its own terms, in relation to industry peers, and in relation to the business environment as a whole.
  • Rule 4: Valuation determines future returns.

As much as purely quantitative criteria outside of any business context alarm me, valuation is probably the most important parameter to consider when committing capital to a business. The reason for this is the underlying and indisputable logic for purchasing publicly traded businesses. Aside from any superficial psychological benefit to owning shares in various corporations, when you purchase a stock you are buying that business because you believe the future value of the cash the business will generate will end up being worth more than the current value of the dollars you are paying.

Literalists might wince at this description, given that with publicly traded companies you rarely receive all of the cash that they generate, but I must again stress the axiomatic assumption made in the last installment -- "Investing in businesses makes the most sense when it is business-like." Whether or not you actually receive the stream of cash, were you to buy the whole company you would have absolute discretion over what to do with all of the money that the company made. As we are assuming the same rigor in buying portions of a company as when we buy the whole thing, the fact that if you only own shares you don't actually get the earnings or the cash flow the company generates is an entirely moot point.

A business exists to generate profits using whatever assets it has. After generating these profits, the business can decide to reinvest, make acquisitions, pay dividends, or repurchase portions of itself from other owners. The earnings you can reasonably assume to make over the lifetime of the business put in today's dollars is the value of a company at any given space in time. Current events and wild speculation may change the perceived amount of these cash flows, but in the end, the business is worth the cash it can generate with its assets, whether they be tangible, like a factory, or intangible, like a tradename.

Ever wonder why the price/earnings ratio has become the Holy Grail for investors? Sure, you may use it all of the time, but why is this even relevant? Why not the price/inventories ratio? Or the price/depreciation ratio? Both of those are concrete financial factors that almost every business can report. The reason is that the price/earnings ratio tells you how many years it will take at the current rate of earnings for you to make all of your money back. Nothing more, nothing less. If a company has a price/earnings ratio of 10, that means if the earnings stay constant you will make back in earnings the money paid to buy the stock in ten years. The price/earnings ratio is ubiquitous because it uses the same inescapable logic that any actual acquirer would apply to a business being acquired: How long will it take to make my money back? What is the current value being placed on the future earnings power of this company?

Certainly earnings are not the only variable we can use to approximate the actual cash a business can generate. In fact, sometimes earnings can become distorted due to temporary factors, making other numbers that correlate directly with the cash a company can produce -- like sales, cash flow, liquid assets, or even subscribers -- make more sense. The point is not to use a special, sacred tool to figure out what a company is worth -- the point is just to understand a company's economic model and with that understanding select the tool that best represents the value that the company can create in the form of cash generated. In this regard, the actual value of the company at any given moment in relation to a host of factors can be deemed important or not important depending on the type of company. While after-tax earnings are critical to a manufacturer, they are useless for a real-estate investment trust.

While the valuation method used depends on the company you are valuing, the ultimate impact of that valuation is indisputable. The wider the gap between the current value and the intrinsic value, the higher the return. Current valuation defines future returns, with higher valuations decreasing future returns by a proportional amount. If you overpay for the future earnings, you will either lose money or suffer through mediocre returns until the point where the valuation becomes attractive relative to the intrinsic value. The shares of stock can only increase in value if there is a significant difference between their value today and the cash they are going to generate in the future. If there is no difference, or if the shares have actually overestimated the cash that will be generated, they cannot mount a sustainable increase in value unless you assume that all parties involved will remain irrational.

While some like Jack Welch have argued that for large acquirers like General Electric (NYSE: GE), increased equity value can translate into higher future cash-flows through acquisitions -- meaning the property can never be overvalued -- there are several assumptions in this premise that are just not true. The first is that an organization can attain infinite size without sacrificing efficiency. The second is that there is an ample supply of skilled, motivated management to actually run these acquisitions. The third is that the supply of potential acquisitions that would actually affect the bottom line is infinite, which is simply not the case. Finally, acquisitions are a two-way street. The party being acquired has to believe that the shares of the acquirer reflect rational expectations about future cash flows or they will not accept them as tender. In fact, one could argue that valuation means a heck of a lot more to the acquired than to the acquirer, as the acquirer is always happy to do a deal when its shares are overvalued.

Without going into the innards of valuation, which can be found in the Fool's How to Value Stocks collection, the philosophy is simple. Valuation matters because valuation is an expression of the future cash that a company will generate. As buying at current prices gives you a right to that future cash, the price you pay today determines the returns that you can expect tomorrow. At some point, although it is arguable exactly when, a company can and will reflect an accurate valuation or an over-estimation of the cash it can reasonably generate over the foreseeable future. In the end, the higher the price you pay, the more likely your returns will either converge with the market returns for a significant period, or fall below them if you not only overpay but also buy a low-quality business. In the next article we will examine some aspects of business quality.

Next: Quality: A Measure of Excellence »