--By Hom Nath Gaire
What does it mean to value a stock as a business? How does it differ from the way most investors think about investing in stocks? These are the fundamental questions one should ask while planning to invest in stock market. To answer these questions, let’s start by considering what a stock actually is. In simple terms, a stock of a company represents a share of ownership of an actual business.
But as Warren Buffett, prominent American stock investor, often says, most people tend to think of a stock as a ticker symbol with a squiggly line attached. Most people think it is easier to look at a stock chart and try to predict whether its price will go up or down than it is to understand the underlying business and its performance. But the truth is, almost nobody is good at this. It takes an extremely rare individual to do it with enough consistency to make money.
Some professional and dedicated part-time traders succeed by buying and selling stocks using short-term strategies. But the overwhelming majority of investors would make a lot more money – and lose a lot less – if they learned to approach stocks in the way they would move toward ownership in a business. However, it is not an easy task to find a business that is simple enough to fully understand than to consistently predict where the price of its stock is going next.
Still, there are a number of benefits of this approach about investment. Several of the world’s greatest investors have shown that this approach is one of the simplest, safest, and most consistent ways to make money from the stock market. But perhaps even more important is the peace of mind. Let’s go through an example to clarify the concept. Suppose there are two investors who are buying stock in the same company, say X. Investor A, approaches investing as a business owner and does a little homework on the underlying business. He believes company X is a wonderful business trading at a good price, and he decided to buys a sizeable number of shares. But investor B is like most people and decides to buy share of X without any real understanding of the underlying business. May be he saw the stock X is being advertised on local news paper or television, heard this or that famous investor was buying it, or has a friend who made a lot of money in it.
If the share price of company X goes up, both investors will probably be feeling good about their decision. But what if the price was to suddenly fall by 5 percent, 10 percent or even more? Or the market experiences a serious correction that takes most stocks down with it?
In this case, the investor A is much more likely to sleep well at night. He knows he bought a quality business and he knows he paid a good price for it. Like wise, he also knows the fluctuations in the share price have nothing to do with the underlying business. In fact, he may actually be happy to see the price fall – as Warren Buffett used to say – because it will allow him to buy more shares or reinvest his dividends at a better price. On the other hand, Investor B would probably be in worry. Because, he has no idea what the underlying business is actually worth or what a fair price for it is. He only knows that he has lost money. He is probably still speculating whether it will be a 5 percent correction or a 30 percent crash and whether he should sell his ownership right now or wait it out.
The fact is, one normally can not know those things in any kind of reliable manner. But what he knows is that great businesses consistently make money all the way through good times and bad ones. And he can have a lot of certainty that over the long run, he will be rewarded from that great business as a shareholder. Thus, all should try to take decision like investor A, in our example rather than like B. Then only we can sleep well at night and simultaneously we can make money from the stock market.
Just look at the history of the 20th Century in global stock market. What calamity didn’t happen in the 20th Century? There were two world wars and various smaller ones, a great depression, hyperinflation, unemployment and even stagflation. All the productive resources were either seized by the government of destroyed in the wars and calamities; there were 50 percent to 90 percent marginal tax rates for many of those years. Nevertheless over the century, the Dow Jones Industrial Average (DJIA), world’s oldest stock index soared thousands fold. Likewise, the Bombay Stock Exchange’s sensitive index, SENSEX has also gained thousands fold over the same period.
These two examples, of course, stand witness that companies would have done better even under the government-created problems, though the business suffered from the politics, wars, the economy and inflation. However, there are never any guarantees in the stock market, betting on great businesses was always the right thing to do over the last 100 years. And there is a very high probability that you’ll do well buying great businesses over the next 100 years. Thus let’s start to think differently about the stock market.
How to Identify a Great Business?
The first step for this approach is as simple as changing your thinking. It is nothing but just deciding you won’t buy a stock unless you can understand its business, even if it looks attractive and it’s reasonably priced. Most peoples would intuitively understand this if they were buying an actual business outright, but they seldom make the connection when buying stocks. What one should notice when to begin thinking this way is, very few stocks are likely to meet set criteria. When you really understand what you’re buying, you’ll tend to be much more selective and gravitate toward great businesses.
There are a few clues to identify a great business and to leave behind a poor one. The easiest one to identify is a profit margin of consistent thickness over many years, even if it’s a thin profit margin. For example, Wal-Mart’s net profit margin is thin, around 3%. But it is a very consistent and ranges every year like clockwork. Likewise, Microsoft’s gross margin has been around 80% for many years.
Consistent margins tell that something special is going on there. That business has been able to extract that profit out of the market because it’s doing something that people really want year after year and it has positioned itself in the marketplace so that it can keep doing it.
Another big clue of a great business is consistent free cash flow generation. That is a sign that the business does not require all kinds of expensive reinvestment year after year. It means the business can invest relatively little of that cash profit and put the rest toward things like paying out dividends, buying back shares, or making new investments in the future. A business gains a great deal of flexibility when it is able to generate a lot of free cash flow. A third clue is a history of dividend payments that rise every single year for many years (dividend grower). Not all great businesses have this trait, but many of them do. So it is something to look for. There are obviously more, but these are the big ones that most great businesses share.
How to Value a Business?
Once a great business is identified, the next problem is to determine the fair trading price or value of business. There are two primary ways to value a business. One is by net worth, and the other one is by profit generation. Net worth is calculated the same way we would do it for ourselves. If one wants to find out what his net worth is, add up all the cash and all assets, like house, cars, etc. Then he should subtract everything he owes – things like mortgage, credit cards, and car loans – and that difference is his net worth.
We can do the same thing with a company. For this, first of all we should look at a company’s balance sheet and assign a value to its cash and other assets, add them all up, subtract what it owes – debt and other liabilities – and get its net worth. This is a simple example. This calculation can get rather complicated, depending on the business. Sometimes, assets have to be revalued, for example, if the company owns a bunch of land that they paid very little for many years ago that’s worth much more now. But the basic idea is the same. This measure of value is best-suited for asset-heavy businesses or strict value investing situations – where one can buy assets in a significant discount and wait for the market to fairly value it. Fair valuations will vary significantly, depending on the industry and the situation.
The other way to value a business is based on profit generation, or how much free cash flow the company produces. This tends to be a better measure of value for really great businesses or a business that you’re confident are going to make more money next year, five years from now, and 20 years from now. We can look to history for a benchmark for valuing these great businesses. When companies have bought out or taken over really great businesses in the past they had a tendency to pay right around 30 times of free cash flow. So generally speaking, if you can find one of these really great businesses trading for around 15 or 16 times free cash flow, you are probably getting a really good deal that you should buy and hang on to for a long time.
Conclusion
Of course, the valuation of business or valuing companies is not an easy task. But this will get you started. There is a temptation for investors just learning to value businesses to focus on the “net worth”-type companies as mentioned earlier – the so-called “deep value” stocks – because they can appear to be much easier to value correctly. But what one may come to realize is many of those situations don’t work out very well. Oftentimes, what you’re really doing is buying a bad business that may be on its last steps.
So, after a while, many value investors may decide they don’t want to buy lousy businesses anymore. They may decide they would rather buy great businesses that are going to maintain and grow their value for a long time. That’s a typical transition for a value investor to make money from stock market. In fact, Warren Buffett himself made this transition over his career, which encourages new value investors to keep that in mind.
In our case in Nepal, the present stock market condition is quite favourable to choose the great business. First thing you’ll notice when you begin thinking this way is, very few stocks are likely to meet those criteria. When you really understand what you’re buying, you’ll tend to be much more selective and inclined toward great businesses.
The author is the Deputy Director of Confederation of Nepalese Industries and can be contacted via email at gaire_mukunda@hotmail.com. This article is based on an interview with value investor Dan Ferris published in The Daily Crux in December 2012.
