How to Value Stocks: Security Analysis

Quality: A Measure of Excellence

How to Value Stocks

By Randy Befumo

  • Rule 5: Cheap crap is still crap.
  • Rule 6: Excess returns come from buying moderate to high quality businesses at low to moderate prices.
  • Rule 7: Higher-risk excess returns come from shorting low quality businesses when they attain high prices.

Much of the investing media is preternaturally intent on valuation. The price/earnings ratio and growth rates routinely grace the pages of even the most podunk and picayune business section, but very little ink is spilt on the issue of business quality. This may be the result of "quality" being a much more esoteric and diffuse issue than valuation. Or it simply may be out of ignorance. While all you need to do valuation is the numbers and a calculator, determining the underlying quality of the enterprise actually requires that you know more than simple math. It requires that you understand what a business is and how it functions as a conceptual, capitalist construct.

Valuation as a discipline benefits the most from the systematic exposition found in Ben Graham's seminal text Security Analysis -- a text that even today is widely used in business schools across the country. Unfortunately for students of business quality, there has been no similar work that neatly circumscribes the issue of business quality. A few books and other publications cover the major issues -- the most readable and comprehensive of which include Phil Fisher's Common Stocks and Uncommon Profits, G. Bennett Stewart's Quest for Value, and Robert Higgins' Analysis for Financial Management. Many more books exist beyond this, as the emphasis on business quality has enjoyed many fathers -- with maybe a mother or two thrown in for good measure.

What kinds of measures look at business quality? Certainly Pierre DuPont's breakdown of return on equity is the most comprehensive (described in the Fool School's Return on Equity series), but the development and widespread use of return on invested capital in the '60s and the emergence of Economic Value Added (EVA) consulting in the '80s have focused investor attention on quality issues in the last decade or two. Widely used asset management ratios like inventory turns, days sales outstanding, overall asset turnover, growth, margins, leverage, and interest coverage also contribute equally to the qualitative picture. In fact, every ratio you are familiar with that does not neatly fall under the category of "valuation" is a business quality ratio.

Business quality is important because in the end, cheap is not enough. Investors who routinely buy shares because they trade at low price/earnings ratios or low price/sales ratios often find that the earnings are in a state of decline or the sales are quickly disappearing. Although various studies indicate that you can marginally beat the market if you buy a diversified basket of distressed securities at low valuations (a la Ben Graham), gigantic returns like those posted by the patron saint of investing, Warren Buffett, come from buying high quality businesses at low to medium prices. Taking the last few puffs from a cigar butt you find in the street might seem like a good deal, but actually getting a case of premium cigars for a relatively moderate price is not only more sanitary, it creates more in the way of value.

Surprisingly, business quality is not hard to evaluate once you understand the basic principles. The important inputs are the amount of cash required to run the business and the amount of cash the business spits out relative to that cash. Return on equity, for instance, just measures the after-tax earnings a company generates relative to its net investment in assets. Return on invested capital tries to be even more precise, tracking the actual dollars invested in a company through the proxy of total assets less non-interest bearing liabilities and compares this number to the after-tax earnings. Even inventory turns and days sales outstanding end up being measures of how much money is tied up in the business at any one time. If you carry a lot of inventories or don't collect your receivables very quickly, you have to put more into working capital than a similar business operated more efficiently.

Not all qualitative factors are reducible to cash in versus cash out, although they are related. Leverage, for instance, simply tells you how much you have borrowed to get the cash out that you are enjoying. Interest leverage tells you how affordable this debt is. Growth of sales, cash flow, and the various flavors of earnings tell you how quickly the cash out is increasing. The various margins tell you how much cash out you are getting relative to every dollar taken in. Despite the fact that none of these are as obviously a measure of cash in versus cash out as return on equity, return on invested capital, return on assets, or return on capital, they are all intended to demonstrate how efficient the company is in deploying capital and collecting the returns. To these clear measures I normally also consider "intangibles" like proven (not perceived) management savvy, the conservative value of trademarks or brand, and the soundness of the company's capital allocation policy. Capital allocation, in short, is how a company uses the money its creates -- acquisitions, dividends, share buybacks, debt repayment (all good), or if they just leave that cash sitting on the balance sheet (bad, very bad).

Intuitively, it seems clear that investors should assess valuation and compare this with business quality. While this is a process that is difficult to completely convert into numbers, it may not be all that awful to leave human judgment squarely in the process. While much has been made of mechanical models and automated trading strategies in the computer-crazed 1990s, the consistent and patient application of intelligence to the process of value creation is what creates millionaires according to the actual statistical evidence. If you only draw one lesson out of Stanley and Danko's The Millionaire Next Door: The Surprising Secrets of America's Wealthy, it is that these people own quite a bit of common stock, they apply the same logic to buying this stock as to running the small businesses most of them control, and they do not really trade all that often.

In the world of human judgment (judgment that we must parenthetically emphasize sits squarely behind Shakespeare's entire corpus, Beethoven's symphonies and Einstein's Theory of Relativity, as well as Jenny McCarthy's rise to marketing superstar from second banana on MTV's game show Singled Out), the comparison between valuation and quality is quite straightforward. Just do the math on the valuation side and determine whether the stock has a low, moderate, or high valuation. On the quality side, do the math there as well, add in whatever bias you want for management savvy, trade brand value, or market dominance, and assess this as being low, moderate, or high as well. Then compare the two with an eye toward buying companies that carry low valuations that are of moderate or high quality or, if you are a little more of a risk taker, buying companies that have medium valuations that carry high quality. Conversely, a great short is a company of low business quality with a high valuation.

By comparing valuation and quality, you identify areas where excess returns -- returns over and above the market average -- are possible. The next article looks at how to pinpoint even more finely where to make investments by considering the depth of your knowledge about a company.

Next: Depth of Knowledge: The Circle of Competence »