A successful individual investor recaps 2013 (Must Read) David Collum_2013_year_in_review
Note how few long-term decisions he made. Owning long-term bonds from 1980 to 1988, etc. Buying precious metals in 2001 and STILL holding on through 2013–now that is long-term investing! 2013 was only his second losing year in several decades thanks to gold and silver being down 39% and 55% this year.
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A Reader’s Question
I have a couple of valuation questions that I have been wrestling with recently. I would love to hear your take.
First, do you ever use a PE ratio for valuation? I have always used a EV to EBIT or something ratio whether pre-tax or after-tax. (I have an idea of the multiples that interest me in both cases.) Sometimes I come across something that has a low PE but not so low EV/EBIT. I think this is when the company has financial leverage and is paying an interest rate substantially below the earnings yield. If it’s a high quality business and the leverage does not harm the company is it sometimes better to use a PE?
John Chew: No, I would use EV (enterprise value which includes net debt) rather than “P” or market cap because debt is part of the price that you pay. Also, look at the terms and conditions of the debt. Note the quality as well as the quantity of the debt. Bank debt is more onerous than say company-issued bonds.
Also, if you are normalizing earnings, and current earnings are depressed and may be for a while, do you account for this in the valuation, perhaps as a liability? Or is this an effort to be overly precise? This quote from Jean-Marie Eveillard in The Value Investors suggests that the former method is overly precise because the future is uncertain:
“There is no point asking about a company’s earnings outlook because if we are investing for the long-term, then short-term earnings never affect our intrinsic value calculation. Asking management about long-term plans is also pointless to me because the world changes. No one can predict what will happen, and so what is important for us as analysts is to discover the underlying strengths and weaknesses of the business ourselves.”
John Chew: You do not count this as a liability when you normalize earnings. You look back over a long enough history 12 to 15 years (including the 2008/09 credit crisis) to sense what normal earnings are. Part of normalizing earning would be assessing the competitive advantage of the business or the uniqueness of the assets. For example, you should be able to have confidence in the earnings power of the assets owned by Compass Minerals (rock salt positioned near the Great Lakes giving a cost advantage).
Finally, I want to share a quote from Dylan Grice that I recently found and thought you may find interesting:
Dylan Grice in the July 17, 2012, Popular Delusions
The power of a discounted cashflow model is that it allows us to achieve a value which is objective. With a model based on discounted future cashflow we can arrive at intrinsic value.
But is this correct? Can cash flows be objectively valued? Suppose I’m a fund manager worried that if I underperform the market over a twelve-month period I’ll be out of a job. What value would I attach to a boring business with dependable and robust cash flows, and therefore represents an excellent place to allocate preserve and grow my client’s capital over time but which, nevertheless, is unlikely to ‘perform’ over the next twelve months? The likelihood is that I will value such cash flows less than an investor who considers himself the custodian of his family’s wealth, who attached great importance to the protection of existing wealth for future generations, values permanence highly, and is largely uninterested in the next twelve months.
In other words, an institutional fund manager might apply a ‘higher discount rate’ to those same expected cash flows than the investor of family wealth. They arrive at different answers to the same problem. The same cash flows are being valued subjectively and there is no such thing as an objective or ‘intrinsic value’ embedded in the asset, even though it has cash flows.
John Chew: Well, I agree that investors have different discount rates. You need to use one that fits your situation. We are discussing human beings making decisions under uncertainty or human action. All value is subjective. To learn more go to: http://mises.org/austecon/chap4.asp
Thanks for the questions and to all a Happy, Healthy and Prosperous New Year in 2014