The Nuances of Valuation

Main inspiration from this write up came from a problem I was facing while valuing a financial  company and prof Bakshi’s blog (https://fundooprofessor.com/2020/10/06/the-relevance-of-price-book/) .

There are four basic Principles of any investment analysis:

1) Business Quality (Competitive Advantage, No Excessive tail risk)- This shows persistence and slightly less volatility in our future predictions vs completely random. 

2) Management Quality (Integrity plus efficiency)

3) Growth Prospects

4) Valuation  (Margin of Safety)- To be bought cheap

These four principles can be applied at sectoral level (when comparing sectors) or national level (when comparing industries) or asset class level (when comparing cash, real estate, stocks, bonds,etc).

I will just focused on the valuation aspect by discussing various cases and seeing how nuanced it can be. I will first focus on first investments in companies (stocks). We can learn this through many cases:

When P/E is important

You know the company has good competitive advantage. Then whatever be the sector its better to value the company on the basis of its P/E (Price to Earnings), where E is your earning power estimate of the company. Lets think most asset heavy industries and financial companies are valued at Book value (Price to Book) however if you find a company which has good competitive advantage in such a sector its better to focus on P/E because the assets of the company are already protected, hence P/B becomes irrelevant. (Price to book may be high, while P/E is cheap)

Similarly many startups or fast growing companies generally are being valued at P/S (Price to sales high, where the sales is important). However, if you find a company which has a very good competitive advantage and its sales is protected, its P/S may be high while P/E could be cheap. It makes sense to abandon P/S in such a case and focus on P/E.

When P/E is not important

  Suppose, the company has no competitive advantage. Then in almost every industry it makes sense to use P/B (your estimate of book value) metric and if there is significant discount to that then it may be an attractive opportunity. Here it also depends on the catalyst being present for that value to be realised. 

In fact, P/E is never a good valuation criteria without competitive advantage. So if your company even if it operates in consumer or retail sector and has no competitive advantage P/E is useless, it’s better to use P/B.

Similarly in some industries P/S  may be used and you may significantly discount them based on your analysis and look for a catalyst for the market to realise that.

Applying the Same Principle to Industries and Countries: 

Similar principles of valuation of Earnings or Asset values could be used to compare industries. Comparing Paint Sector (Now competitive advantage being hit, lets ignore that for a while) vs may be Textile. If you believe competitive advantage of Paint is intact along with other aspects, then when valuing entire industry  by Market Cap to Earnings could be used while valuing entire Textile Sector (If you believe has no competitive advantage) Market Cap to Book could be used. 

Similarly while valuing countries looking at Index P/E or GDP may make sense in only those cases where you believe the country has strong competitive advantage, good management quality, good growth prospects or else focus on asset values of those countries indexes like P/B or tangible assets or something else along with some catalyst (I am not much expert in the same)

Applying To Other Asset Classes 

Similar principles can be applied while buying real estate. If you are sure about the competitive advantage of a building, then you may focus on the rental yield, else it’s better to focus on its asset value and some catalyst.

Comparing Real estate vs Stocks vs  Bonds, depends a lot on what metric you use to value them. Normally stocks are valued using P/E (its not always true) depends on what you think about stocks competitive advantage vs other asset classes in a country where you are investing. 

I wont go more deep its better to think about these simple principles and not arrive at knee jerk reactions when valuing something Its nuanced.

 These nuances are well understood generally by the market and aren’t new. However, now and then they throw opportunities, when a sector is generally valued by a particular metric every company is painted by the same brush, while one metric may be cheap the other is expensive.