Different valuation models for different types of plays

[kai99]

Dear members,

 

I am new to value investing and hope to learn as much from everyone. It has always boggled me to which valuation models work best for different scenarios. I've got a couple of questions for everyone.

 

1. For Peter Lynch's classification of stocks, which valuation models would you feel is most suitable for the following groups (slow growers, stalwarts, fast growers, cyclicals, turnarounds, asset plays)

 

2. I notice Ben Graham has 4 very popular formulas, in which scenarios would you apply either (Grahams number, Graham's growth, Net-Net W/C or liquidation value)

 

3. Anyone applying models from Seth Klarman? Mainly NPV and liquidation value?

 

Thanks a lot in advance!:)

[vinod1]

Dear members,

 

I am new to value investing and hope to learn as much from everyone. It has always boggled me to which valuation models work best for different scenarios. I've got a couple of questions for everyone.

 

1. For Peter Lynch's classification of stocks, which valuation models would you feel is most suitable for the following groups (slow growers, stalwarts, fast growers, cyclicals, turnarounds, asset plays)

 

2. I notice Ben Graham has 4 very popular formulas, in which scenarios would you apply either (Grahams number, Graham's growth, Net-Net W/C or liquidation value)

 

3. Anyone applying models from Seth Klarman? Mainly NPV and liquidation value?

 

Thanks a lot in advance!:)

 

Instead of looking at it in the manner you laid out, it is better to think in terms of competitive advantage and viability of the business. The best book by far on this topic is "Value Investing - From Graham to Buffett and Beyond" by Greenwald.

 

Basically at a high level

 

1. Business not viable - liquidation value of assets less liabilities

2. Viable business but no competitive advantage - reproduction value of net assets less liabilities. Earnings power should roughly equal the reproduction value here and thus serves as a check.

3. Business with competitive advantage - earnings power value

 

This is a much better way to quickly get to the heart of valuation.

 

Vinod

 

[kai99]

Hi Vinod thank you very much for your advice. That was really helpful. Do you have any advice on how to read annual statements; in particular maybe someone with a cheat sheet to spot lines which describe positive plays or ref flags?

 

It really brings us to another thing cos companies can actually be more than one of the 3 you mentioned.

[kai99]

I am also wondering in particular EU banks. i notice a lot of them such as DB, RBS, BCS have very high cash per share. Does this mean  a pretty good margin of safety when buying them? Since they have rules to maintain re-capitalisation ratios.

[Fat Pitch]

When it comes down to financials, especially banks you have to look at qualitative factors. Banks are highly leveraged entities and it is very easy to zero out the equity on the balance sheet from a few mistakes.  Remember you can't compound zero at any rate. Management and culture is crucial in this sector. Take a look at Citigroup to see an example of poor management which leads to permanent loss of capital. Wells Fargo is a great example of how outstanding culture and deep management leads to satisfactory results.

 

Some quantitative factors to consider when looking at banks is Return on Assets (ROA) and leverage. Superior money center institutions should be able to earn above 1% ROA... anything below requires more leverage (more risk) to make satisfactory returns on equity. As for EU banks, they operate at much higher leverage ratios than US banks. Unless you have a deep understanding how regulators are going to treat equity holders during times of stress I would avoid these entities. There are simply too many factors for investors to take into account.

 

[kai99]

hi fat pitch thx for your reply, do you mind sharing with me what do you mean by zeroing out the equity on the balance sheet from a few mistakes?

 

1% ROA seems pretty high though, considering a lot of banks even GS and JPM are doing below that. Not to mention many of their EU counterparts.

[Fat Pitch]

When you are levered 10 to 1, a 1% move in assets will change the equity by 10%. European banks tend to run their leverage at 25 to 1 or more which I think is sheer insanity. A moderate recession can easily wipe out the equity in the bank and possibly impair depositors money. This is why central banks are needed to "bail" out the  banks. Since fractional-reserve banking is inherently unstable you need a lender of last resort.

 

1% ROA isn't high for banks. This is a great metric to weed out banks that are effectively utilizing their assets versus those who are not. Obviously the bigger the institution the lower the ROA. Wells Fargo with their 1.4 trillion balance sheet are able to earn 1.5%+ ROA and you have correctly pointed out other banks are earning below 1% ROA. Focus on the crème of the crop.

 

A general rule for valuing banks is to simply take ROA and use that as your multiple for book value.  A bank like Wells Fargo should be trading at 1.5x book and perhaps higher when you factor in they have a long run way for 5%+ growth.

 

[kai99]

hi fat pitch thx for your reply again. is there any way to find out banks leverage ATM. i believe a lot of them hold a lot of cash though to meet the basel ratios.

[vinod1]

Hi Vinod thank you very much for your advice. That was really helpful. Do you have any advice on how to read annual statements; in particular maybe someone with a cheat sheet to spot lines which describe positive plays or ref flags?

 

It really brings us to another thing cos companies can actually be more than one of the 3 you mentioned.

 

Do not have a cheat sheet or anything like that. When I first started out, I just read annual reports from a few different industries. The first few did not make any sense, but I kept plowing anyway.

 

What I would suggest is pick an industry, find two or three largest in that industry and a couple of smaller ones and read them cover to cover, highlighter in hand. There is usually a lot of industry specific jargon you need to get familiar with and you can look up the terms you do not understand on the net. Then go ahead and try to value them, putting a 1-2 page report. Once you get the hang of it for a particular industry and you know a few companies really well, you would be able to go through other companies in the industry relatively easily. You would know what to look for in that industry and you would not be reading cover to cover, you would be looking for specific things in the 10-k that you have questions on.

 

Start of with an industry that you like and are excited about, but preferable something easy like retail or manufacturing. I picked P&C, just because Buffett is in it, but it is probably not a good first choice as it is bit complicated.

 

Best of luck and do not worry if you do not understand everything on the first pass. Keep chugging.

 

Vinod

 

[vinod1]

Also you might want to get started with reading an Annual Report rather than trying to learn lots and lots of valuation and accounting books.

 

Someone actually gave me that advice way back in 2006/2007 on this predecessor board and I am grateful for that.

 

Vinod

[kai99]

Hi Vinod, many thanks for the advice and encouragement, i will definitely start ploughing away. I agree with you i should start with a specific industry. I am getting confused with too many industries and jargons atm!

[siddharth18]

I'm far from a seasoned investor but one book that really helped me when I knew literally knew nothing about stocks was this book: http://www.amazon.com/Why-Stocks-Go-Up-Down/dp/0966677501 - You might be able a used version for around $10 incl. shipping.

 

PS: It is recommended by Dr. Mike Burry!

[peter1234]

+1.

 

He recently released a new and greatly expanded edition Why Stocks Go Up and Down, 4E

 

http://www.amazon.com/dp/0989298205/ref=pe_385040_30332200_pe_309540_26725410_item_image1

 

 

[ni-co]

Instead of looking at it in the manner you laid out, it is better to think in terms of competitive advantage and viability of the business. The best book by far on this topic is "Value Investing - From Graham to Buffett and Beyond" by Greenwald.

 

Basically at a high level

 

1. Business not viable - liquidation value of assets less liabilities

2. Viable business but no competitive advantage - reproduction value of net assets less liabilities. Earnings power should roughly equal the reproduction value here and thus serves as a check.

3. Business with competitive advantage - earnings power value

 

This is a much better way to quickly get to the heart of valuation.

 

Vinod

 

Some great advice, Vinod! At an even higher level or as kind of a sanity check I always ask myself: How much money do I pay vs. how much am I going to get back within the next 5-10 years?

 

Present net asset values + free cash flow (if negative: - cash burn rate) within this time frame.

 

Don't simply put the reported numbers in there but think hard about it, e.g. is book value the right figure for the company's real estate? Is FCF/cash burn rate stable or increasing/decreasing. If you think hard about these attributes, all the qualitative aspects play into it. The harder it is to determine any of the above the more margin of safety I demand.

[kai99]

many thanks for all the suggestions guys! will check the resources. :)

 

In any case does anyone know wad factors or attributes a 'shareholder friendly' company has. Ive been reading that some companies structure might be profitable and beneficial to the company but not necessarily positive for shareholders. Any advice on this?

[kai99]

Does anyone have any recommendations for comments on factors to look at when considering maturity of notes. How will all these affect the organisation especially when it's troubled?