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Which Valuation Matters

Posted on 06/06/202306/06/2023 by Keith McLachlan

Recently I was working through lists of companies that other people had valued (i.e. the JSE-listed HoldCo sector presentation I gave) and I realized that, perhaps, this article needed to be written.

There are lots of different ways to value the same listed share, but which one is the correct one?

As a “Rule of Thumb”, the best approach to valuing a business, group or listed share is to use the key metric that you expect to generate future return.

This is important, so I will say it again:

The best valuation approach to valuing equity is to use the attribute that you believe will drive future returns.

In most normal situations in stock markets, this would be a company’s profits (a.k.a. also “cash flows” or “free cash flows”). Sometimes the emphasis here is on historic profits and sometimes on future profits, but, generally, profits are key in driving shareholder returns.

Thus, using an ­earnings-based valuation approach would be most appropriate. Luckily there are plenty of them to choose from. For historic profits, Price Earnings (PE) and EV/EBITDA are good measures, for future profits the Discounted Free Cash Flow (DCF) approach works well.

The key caveats here are that the historic earnings may be a poor indicator of future earnings and future earnings are only ever an educated guess of what things may look like. 

But what if a company is not trading and being liquidated? Or its earnings are heavily distorted by IFRS and a “cleaner” metric needs to be selected? Or if the company does not earn profits but investment returns from a portfolio of other companies (i.e. a HoldCo)?

Well, then future profits will be driven by the stock’s Net Asset Value (NAV) and a valuation metric tracking this NAV should be selected. For example, a Price-to-Book (P/B) or Price-to-Tangible-Book (P/tB) ratio may be relevant. In the insurance space, this would be the Price-to-Embedded Value (P/EV) ratio.

The key caveats here are that the book value of a company may be overstated (due to fraud, negligence or the nuances of IFRS) and, even if book value is accurate, a sub-optimal return on these assets will be accurately reflected in the market as a discount to this book value.

But what about dividends?

Well, investing into normal equities for “yield” is a lot like picking up pennies in front of a steamroller. You are taking excessive risk for an underwhelming return. That said, some people do and, more importantly, some parts of the market are actually yield orientated (for example, property).

In this case, by all means, use dividend-based valuations like Dividend Yield (DY) or the Dividend Discount Model (DDM, also known as the “Gordon Growth Model”).

The key caveats here is two-fold: Firstly, management can decide what they pay out as dividends and, thus, to some degree, dividends over short periods of time are not always reflective of economics. Secondly and over long periods of time, dividends are dictated by profits and, thus, are you not just measuring a weak, lagging and somewhat manipulated version of profits here?

There are other reasons to buy stocks from merger arbitrage to diversification to negative beta (e.g. gold miners), but these are more exotic and not worth delving into with limited space here.

In conclusion, the best valuation approach to valuing equity is to use the attribute that you believe will drive future returns. If you are buying for earnings, valuing the earnings. Likewise with book and dividends. Though, in all cases, understand the caveats in these valuation metrics. No approach is perfect, the future is always uncertain, and all we can do is shift the odds in our favour and diversify.

ARTICLE ORIGINALLY APPEARED ON MONEYWEB

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