Market Myths vs Market Reality
“The quest for value drives scarce resources to their most productive uses and their most efficient users” - G. Bennett Steward III
Accounting Model of value: The apeal is simplicity. Shortcoming is the lack of realism, as it assumes that P/E never change.
Using the accounting model of valuation: When you set the price of a company based on the Ernings-Per-Share (EPS) at an appropiate Price/Earning (P/E) multiple.
Example: Apple Computer: Apple Inc. (NasdaqGS: AAPL )
From the Security Exchange Commision SEC (EDGAR):
Net Income (Annual Ending Sept 25, 2010 ) ….............14.013.000 $
Net Income (Quarter ending March 31, 2011) ............ 5,987,000 $
Total Apple common shares (Basic)............................. 923,196
Total Apple common shares (Diluted) …...................... 935.944 (March 31, 2011)
Total Apple common shares (Diluted) …...................... 924.712 (Sept 25, 2010)
In Sept 25, EPS was approximately 15.15 $ (14.013.000 / 924.712)
The Apple share by Sept 25, 2010 was 292,32 $.
This implies a P/E of : 292.32/15.15 = 19.30
On July 15, 2011
Real Time 326.73
| P/E (ttm): | 15.57 |
| EPS (ttm): | 20.99 |
Trailing Twelve Months - TTM the price/earnings ratio is often quoted as P/E (ttm), meaning they're using the EPS
Accounting Model Valuation would predict a 15.57 x 20,99 = 326,81 price !
from the past twelve months.
The P/E changes all the time, as the result of Acquisitions, change of financial structure or accounting policies, new investment opportunities, or in short, it adjust to the “quality of the company’s earnings”
Economic model of Value: Holds that share prices are determined by smart investors who care about two things: The cash generated over the life of a business, and the risks of the cash receipts. In other words, the value of a firm is determined by discounting the Free Cash Flow (FCF) back to the present value, at a rate that represents the cost of capital.
FCF is the cash generated by the operations of a company, that is free of the new capital invested for growth.
Important Notes:
1) A profitable company investing large amounts of capital to expand could have a NEGATIVE FCF, while an unprofitable company selling their assets to pay creditors could generate a positive FCF.
2) What matters is the FCF over the entire life of a business. FCF in any one year is NOT a measure of performance.
| What matters is to examine THE QUALITY of the FCF: The rate of return earned on the investments. |
3) Most companies’ earnings and Cash Flow move together most of the time.
Accounting Model vs Economic Model: Accounting model is based on two different financial statements (Income and Balance Sheet), whereas the economic model is based on Origin and Sources of Cash Flow.
LIFO vs FIFO (Inventory costing)
Profesor Shyram Sunder demonstrated that companies that switched FIFO to LIFO inventory costing, in times of raising prices, experienced a 5% increase in share price on the date the intended change was announced. The increase is proportion to the present value of the taxes to be saved by making the switch. In this case, share prices change by cash generation, not by earnings as earning will go down using LIFO because of the higher cost of inventory. A company adopting LIFO will sell at a higher value, unless their inventory prices lower with time (Example: Technology Companies)
| The company’s P/E is not the primary cause of its stock price, but is a consequence!. A company’s earning explain its share price only to the extent that earnings reflect cash! |
Amortization of Goodwill:
Any premium paid over the estimated fair value of the seller’s asset is assigned to goodwill, and amortized against earnings over a period of time (No longer than 40 years).
It is a Non Cash, non tax deductible expense, so it has no consequence in the economic model. In the accounting model it has impact as reduces the earnings.
R&D Expenditure or Expense?
Accountants are required to expense R&D outlays as if their potential contribution to value is always exhausted in the period incurred.
If you consider Pharmaceutical companies, they invest huge amounts in R&D expecting a payout for many years. This is why they have higher P/E ratios: R&D is aimed to create value!.
R&D like any capital expenditure expecting to create value. R&D should be capitalized in the Balance Sheet, and amortized against earnings over the period of the projected payoff.
The accountants will only classify R&D as expenditure during acquisitions, were they will classify as an expenditure to be capitalized (Goodwill), but if it’s “home grown R&D” its classified y accountants as expense.
One objection that might be raised to capitalize R&D is that it may leave assets in the company book that no longer have any value. What if the R&D fails to pay off?
The issue of successful efforts vs full cost accounting is well illustrated by oil companies: With successful efforts accounting an oil company capitalizes only the costs associated to actual finding oil. All drilling expenditures that fail to discover economic quantities of oil are immediately expensed against earnings. This policy reduces earnings, but causes a permanent reduction on assets.
With full cost accounting, an oil company capitalizes all drilling outlays on its balance sheet and then amortizes them over the live of successful wells. As part of the costs associated with finding oil is that unsuccessful wells have to be drilled, then full cost accounting must be employed to measure an oil company’s capital investment and its true rate of return.
Book value vs Market Value:
A company’s book value can not be a measure of the Market Value. Market Value are determined by the cashflow that can be obtained.
The cash that has been invested are irrecoverable sunk cost, irrelevant to computing value.
The balance sheet is the best measure of the capital : Debt and Equity. The capital will reflect the value depending on management’s success on earning high enough discounted cash flow on the return on Capital. That judgment is left to the stock market!
To make realistic decisions of performance and value, accounting statements must be re-expressed into the perspective of the shareholders. The investment made in R&D along with book keeping provisions (deferred tax, warranty reserve, bad debt reserve, inventory obsolescence reserve, defered income reserve...) must be taken out of earnings and put into equity capital.
Watch out with Earnings Per Share (EPS):
ACQUISITIONS:
Example: Two companies both with 1.000 $ Earnings and 1.000 Shares => 1,00 $ EPS.
Company 1: Price (value) at 20.000 $ (P/E = 20, Price per Share = 20)
Company 2: Price (value) at 10.000 $ (P/E = 10, Price per Share = 10)
Let’s analyze what happens when Company 1 buys Company two, and then what happens when Company 2 buys Company 1.
Company 1 buys Company 2: Has to issue shares to raise 10.000 $ => 10.000 / 20 = 500 shares.
Result: New Company1-2:
2.000 $ Earnings and 1.500 Shares => 1,33 $ EPS ( Improved! )
Price (value) at 30.000 $ (P/E = 15, Price per Share = 20)Company 2 buys Company 1: Has to issue shares to raise 20.000 $ => 20.000 / 10 = 2.000 shares!
Result: New Company2-1:
2.000 $ Earnings and 3.000 Shares => 0.67 $ EPS ( Deteriorated! )
Price (value) at 30.000 $ (P/E = 15, Price per Share = 20)Same company, same P/E, same total price, very different EPS! It can be perceived as a Good Deal or a Bad deal if you use an Accounting Focus, while both transactions are the similar.
EPS does not matter as in an acquisition, P/E ratio will vary to reflect the deterioration or improvement on the earnings. Getting a lower P/E should not be a corcearn. It could bring higher growth to the company as result of the new acquisition.
SPIN Off:
Will be the opposite of the previous case:
There is a company with a Market Value of 30.000 $, P/E = 15, Price per share = 20 $
Will it make financial sense to split two company divisions in order to boost P/E?
The benefits of the spin-off are not measured by by accounting model of value!
Earning Growth:
Growth = Rate of Return x Investment Rate
Investment Rate = New Capital Investment (for working Capital and Fixed Assets) / Earnings
Example:
Company A: Growing Earnings at 10%. Has to invest 100% of earnings to achieve this rate.
Company B: Growing Earnings at 10%. Has to invest 80% of their earnings to achieve this rate.
Company B has a higher rate of return ( 12,5% = Growth / Investment Rate)
You could be tempted to say that company A is worth less than B as company A is not paying dividends and company B has a higher rate of return. BUT: Company A could still pay dividends by raising new debt or equity.
Note: The stock market prices are set by “the smartest money in the game” leaving the majority of investors as mere price takers. About 55% of the volume of the NYSE consists in blocks of 40.000 shares or more. Over ⅔ consists in trades of 5.000 shares or more. The importance of the small, unsophisticated investor has been exaggerated. This is similar as the price of Oil is set.
Investment Philosophy:
O. Mason Hawkins - President of Southeastern Asset Management, Inc (SAM)
“We look for good businesses, run by good people, and selling for a good price.”
Trying to buy stocks at a significant discount from what we appraise their private market value to be.
i) Determine what is the free cash flow and what can it be for the coming business cycle under normalized conditions. Then buy the company at a very reasonable multiple of the free cash flow.
ii) Liquidating value: Simply add all the assets of the balance sheet, and subtract the liabilities, and adjust things as inventory and real state, over-funded/underfunded pensions, adjust plant and equipment, franchises, brand names. This is the net value that the company could be liquidated. Buy the company at a significant discount.
iii) Take sales in the marketplace, and check what others are paying for Business versus the Market value.
iv) Talk to managers, clients and competitors. Reach most of your conclusions by analyzing the numbers.
v) Look inside: Management, board members.
Dividends:
By paying dividends managers have less money available to finance growth.
If management raises Equity instead of using available earnings it deludes shareholders interests.
If new debt is raised then cash flows now include future claims, but corporate taxes are saved (lowered) as the effect of replacing equity with debt.
On the other hand, by not paying dividends companies could become cash rich and therefore start to over-invest. Additionally, companies need to think on investors needed cash for consumption.
Professors Fisher Black and Myron Scholes demonstrated that the return to investors is explained by the level of risk, and its not affected by how this return is divided between dividends and capital gains. The advise to companies is to formulate the dividend policy based on the company’s own investment needs and financing options, and explain them to investors.
Conclusions:
Earnings, EPS, earnings growth are misleading measures of corporate performance. They are measures on the quantity of earnings, not on the Quality, that is reflected on the P/E.
Rapid earning growth could be manufactured. Earning an adequate rate of return is more important.
Bibliography:
The Quest for Value - G. Bennett Stewart, III - Harper Business
Chapters II and III
The New Corporate Finance - Donald H. Chew, Jr. - McGraw-Hill
Section I - Man and Markets
