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The most crucial factor in valuing companies

Sep 1, 2010

In the previous article,In the previous article, we reflected on how Ben Graham points out at two major requirements of becoming a successful investor. Patience and a long term outlook. In this article, we shall discuss another important requirement of becoming a successful investor - independence.

Valuation: Independence more important than technique

"The so-called 'price-earnings ratio'... can scarcely be called a standard, since it is controlled by investment practice instead of controlling it. In other words the 'right' price-earnings ratio for any stock is what the market says it is. We can find no evidence that at any time from 1926 to date common-stock investors as a class have sold their holdings because the price-earnings ratios were too high."

Ben Graham said this in 1940. Seven decades later it continues to be true.

There is supposed to be an important difference between a lay investor and a professional. The latter should know how to value companies. Entire forests have been cleared in printing books on valuation. Detailed courses are devoted in business schools on this fine art. Usually the best and the brightest attend them. From the classrooms to the offices in India's financial districts, a lot of brain power and effort goes towards valuing companies.

So, one would expect that it must be some sort of an exact science. Take those intricate formulae, punch in your inputs, and lo and behold! The company's valuation is done. If only it were that simple. The truth is, valuation is an inexact science. It has two main problems. Most of the formulae are based on assumptions which do not confirm to real world situations. They are often oversimplifications. Oddly enough, the most intricate they get, the less they reflect the real world. Secondly, inputs are usually estimates of future corporate performance. And they are just that - estimates. Given this situation, valuations are actually very flexible. You can bend and twist the outcomes just by the click of a few buttons.

Stock quotes appear infallible

Now compare this with the apparent certainty of stock market quotes. There is no ambiguity about them. Every day, the stock market provides its valuation of companies. And it is an actionable figure.

Meaning, the investor can buy or sell broadly at that price. No wonder then, stock quotes take the aura of the gospel truth. And it is not just the common investor who thinks this way. Professionals subconsciously adjust the assumptions in their formulae and their inputs to moving stock prices. Actually, it is not even subconscious. Much of modern portfolio theory is based on the efficient market hypothesis (EMH). In plain English, EMH says that stock prices are right. Such inputs as 'risk' and 'cost of capital' are derived from crunching historical share price data.

So, we end up with the circular logic of beating the share market (which is one way of defining investing) by using share price data!

Be independent

The ideal way to go about investing is to value companies independently of the stock market. It helps if the investor doesn't operate with one eye on the stock ticker. If the formulae are inexact or indeterminate, he can compensate by being conservative in inputs. The investor should also insist on a margin of safety. Often he will have to give the investment a miss because he cannot come to any worthwhile conclusion. But on those occasions he does come to a conclusion, he should respect them and act accordingly. we reflected on how Ben Graham points out at two major requirements of becoming a successful investor. Patience and a long term outlook. In this article, we shall discuss another important requirement of becoming a successful investor - independence.

Valuation: Independence more important than technique

"The so-called 'price-earnings ratio'... can scarcely be called a standard, since it is controlled by investment practice instead of controlling it. In other words the 'right' price-earnings ratio for any stock is what the market says it is. We can find no evidence that at any time from 1926 to date common-stock investors as a class have sold their holdings because the price-earnings ratios were too high."

Ben Graham said this in 1940. Seven decades later it continues to be true.

There is supposed to be an important difference between a lay investor and a professional. The latter should know how to value companies. Entire forests have been cleared in printing books on valuation. Detailed courses are devoted in business schools on this fine art. Usually the best and the brightest attend them. From the classrooms to the offices in India's financial districts, a lot of brain power and effort goes towards valuing companies.

So, one would expect that it must be some sort of an exact science. Take those intricate formulae, punch in your inputs, and lo and behold! The company's valuation is done. If only it were that simple. The truth is, valuation is an inexact science. It has two main problems. Most of the formulae are based on assumptions which do not confirm to real world situations. They are often oversimplifications. Oddly enough, the most intricate they get, the less they reflect the real world. Secondly, inputs are usually estimates of future corporate performance. And they are just that - estimates. Given this situation, valuations are actually very flexible. You can bend and twist the outcomes just by the click of a few buttons.

Stock quotes appear infallible

Now compare this with the apparent certainty of stock market quotes. There is no ambiguity about them. Every day, the stock market provides its valuation of companies. And it is an actionable figure.

Meaning, the investor can buy or sell broadly at that price. No wonder then, stock quotes take the aura of the gospel truth. And it is not just the common investor who thinks this way. Professionals subconsciously adjust the assumptions in their formulae and their inputs to moving stock prices. Actually, it is not even subconscious. Much of modern portfolio theory is based on the efficient market hypothesis (EMH). In plain English, EMH says that stock prices are right. Such inputs as 'risk' and 'cost of capital' are derived from crunching historical share price data.

So, we end up with the circular logic of beating the share market (which is one way of defining investing) by using share price data!

Be independent

The ideal way to go about investing is to value companies independently of the stock market. It helps if the investor doesn't operate with one eye on the stock ticker. If the formulae are inexact or indeterminate, he can compensate by being conservative in inputs. The investor should also insist on a margin of safety. Often he will have to give the investment a miss because he cannot come to any worthwhile conclusion. But on those occasions he does come to a conclusion, he should respect them and act accordingly.

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3 Responses to "The most crucial factor in valuing companies"

RAVI SHANKAR R

Sep 12, 2010

TO THE AUTHOR - While the first part of the essay leads the reader to believe that its not wise to invest on the basis of bookish knowledge acquired thro' Study, by suggesting that the reality in the markets is far different, the latter part seems to support the same view again, when u say: "ideal way to go about investing is to value companies independently of the stock market. It helps if the investor doesn't operate with one eye on the stock ticker."

How does one reconcile the two, it looks contradictory and what is the real truth behind what u conclude??

Like 

Iqbal Fazal

Sep 7, 2010

I always look at the P/E ratio when deciding to sell.

We all have our individual benchmarks to sell above - say when it crosses 20 or 30.

However, when it goes skywards - above 60 - for example Raymond - making losses for the past around 2 years, you don't need to scratch your head. It's action time!

So have sold and am content with what I made and let HDFC Mutual Fund hang on to it for some time. Will get in when it cools off - after the game is over and the P/E sounds reasonable and in consonance with performance.

Like 

himanshu

Sep 4, 2010

I find one of the suitable way to weigh companies valuation is based on tracking P/E value and together with it tracking P/E * P/B value. If for a company mid or small cap, P/E crosses 15.0 then it's time to sell out stock. For Large cap also Stock shall be sold out if P/E crosses 20. Above all, it's important to track management intention, if it is not trustworthy, then stock shall not be bought even if valuations are very much attractive. Prefer low D/E and high projected growth company.

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