Books on Valuation models

[Shane]

Hello,

  I have been working on some stock valuation and I am having a really tough time online finding how value investors find specific price targets.  I have thought about buying security analysis, but I think it might be too outdated now.  Are there any books you think are particularly useful for value investors to create valuation models?

  I am trying to start a mock portfolio of micro-caps from a recommendation of a local fund manager, he says its good to show successes and mistakes via personal analysis so my future employer will know I have put in the effort to do it on my own.

[Myth465]

I would look at the Pabrai's second book.

 

You have assets, and earnings power in my opinion. I would probably pick up a Bruce Greenwalds book as well if you want valuation ideas. I do very simple valuations based on assets or fcf / growth. Most of my analysis is qualitative actually.

 

I think its pie in the sky and you will simple be precisely wrong if you get too detailed with valuations.

When you see a fat girl (or guy if thats your thing) do you need to know the weight to know they are fat.

 

I mangled the quote, but I think its one of Buffetts bet ones.

[matjone]

I got the 1962 edition of security analysis from the  library and it went into pretty good detail about methods for valuing stocks.  If I remember right they eventually came up with a standard equation for valuing going concerns that was based on a multiplier applied to estimated average earnings for the next 5-10 years or so.  The formula took into account dividends, capital structure, and of course the expected growth rate.

[zarley]

Greenwald's Value Investing book lays out the basic framework for various types of companies and provides several good examples of how it should be applied. 

 

http://www.amazon.com/Value-Investing-Graham-Buffett-Beyond/dp/0471381985

[twacowfca]

The way WEB approaches a long term investment in non controlling stock of a company and the way most other value investors approach an investment is quite different.  WEB looks at Integrity of management and key ratios like ROC, profit margin, etc as do others.  He also puts a high weight on true owner's earnings, past, present and future, as far as can be seen.  

 

However, what separates WEB's approach from others is the Attention paid to the length of the long term track record of the company and the industry regarding the same ratios.  The longer the track record of extraordinary returns, the better.  A recent secular improving trend in a long term record is also a big plus as for example with his purchase of Burlington Northern and Santa Fe.

 

Many value investors have profited by giving a high weight to Graham's PE 10 ratio.  WEB also looks at PE 10 and other ratios for ten years, but he goes far beyond that to see how the competitive position has changed over time. He will look at ratios going back as much as 100 years to see how these have changed over time before making his largest investments .

[vinod1]

You got great feedback from others. My 2 cents

 

1. I strongly recommend reading Security Analysis. You would find it astonishingly relevant to the current environment. However, it is not a book that teaches you how to value stocks. The most surprising thing I found after a very detailed study of Security Analysis is that Graham does not think it is necessary to actually value a business. "Instead Graham focused on how to ensure that what you are buying is very cheap, which means you don't know the value is, but you do know that the value is much higher than the price that you are paying. And then you diversify. So, when you follow that approach, for example, you don't have to do management interviews, you don't have to really worry about the industry prospects. Graham said that you don't need to value the business. It's too hard to value a business. Anyway, it is not the job of an investor to value a business, that's the job of a business valuer which is very different from the job of an investor.  The job of an investor, he felt, was to make sure that there is a big margin between the value that you are receiving and the price that you are paying." (Quoted from Sanjay Bakshi). If you read this book go with one of the first four editions, the other editions had much less Graham.

 

My notes to the book are at http://vinodp.com/documents/investing/security_analysis_index.html

 

2. The best practical book on valuation I found is "Value Investing" by Greenwald. This is a definite must read for developing the right method of thinking about valuation.

 

Vinod

 

 

[locutusoftexas]

The thing that bugs me is that most valuation measures implicitly presuppose that the investment is large enough to make the investor a "true owner." This worked for Warren even in his limited partnership days because he would buy an entire company and then make decisions that maximized his partners' return on investment.  To take this point of view is just wrong for the small investor (that is, someone with say less than $100 million). The small investor in today's framework has no owner's rights because the small investor has no actual power. A company can be very cheap and the Board can squander the assets (sometimes actually robbing the shareholders). Great managements will eventually be replaced by less capable or scrupulous people; there are just not that many truly great, shareholder-oriented managers out there.

 

The small investor must make sure that he or she will be paid. In some of his thinking Graham agreed with this. However, rather than looking at earnings yield, the small investor should look at dividends - both payout rate and policy (e.g., propensity toward special dividends, when the company cannot properly allocate all of its capital on hand). I suppose that one could attempt to be paid by capital appreciation. However, as we have seen recently, this can evaporate over night.

 

So the only defense for the small investor lies in emphasizing dividend yield, dividend policy, and the locking-in of profits when they are realized.  Again, Warren can afford to wait for five years between market quotes -- when he owns the entire company! Otherwise, even he should be taking profits when he does not control the company.

 

Best wishes,

Tex

[CFA Omaha]

Buy CFA Level 2 equity books.  They have more than enough models to keep you going for a long long time. 

[prunes]

The problem with models is that most of the time they are sensitive enough to allow you to arrive at nearly any result you want! Models are only as good as the assumptions that go into them, and making the right assumptions is difficult. I work in the valuation industry and most of the time (not all) we start with a good idea of where value is going to be and work towards it. A lot of the work in valuation is supporting your estimate of value and designing a credible analysis.

[vinod1]

The thing that bugs me is that most valuation measures implicitly presuppose that the investment is large enough to make the investor a "true owner." This worked for Warren even in his limited partnership days because he would buy an entire company and then make decisions that maximized his partners' return on investment.  To take this point of view is just wrong for the small investor (that is, someone with say less than $100 million). The small investor in today's framework has no owner's rights because the small investor has no actual power. A company can be very cheap and the Board can squander the assets (sometimes actually robbing the shareholders). Great managements will eventually be replaced by less capable or scrupulous people; there are just not that many truly great, shareholder-oriented managers out there.

 

The small investor must make sure that he or she will be paid. In some of his thinking Graham agreed with this. However, rather than looking at earnings yield, the small investor should look at dividends - both payout rate and policy (e.g., propensity toward special dividends, when the company cannot properly allocate all of its capital on hand). I suppose that one could attempt to be paid by capital appreciation. However, as we have seen recently, this can evaporate over night.

 

So the only defense for the small investor lies in emphasizing dividend yield, dividend policy, and the locking-in of profits when they are realized.  Again, Warren can afford to wait for five years between market quotes -- when he owns the entire company! Otherwise, even he should be taking profits when he does not control the company.

 

Best wishes,

Tex

 

Here is my notes on Ben Graham's comments on Dividend Policy and how investors should approach dividends.

 

Vinod

 

• The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all important, but from another and equally valid standpoint it must be considered an accidental and minor factor.

• In the years until 1925, the price paid for a common stock would be determined chiefly by the amount of dividend. A common stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He aimed primarily at a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities. Even if one company had steady earnings and another company had irregular earnings, this had little impact on the price paid which is dominated by the dividend rate.

• Graham questions the established principle of corporate management which subordinates the current dividend to the future welfare of the company and its shareholders. It is considered proper managerial policy to withhold current earnings from stockholders to either strengthen the financial position or to increase productive capacity. The typical shareholder would most certainly prefer to have his dividend today and let tomorrow take care of itself.

• Graham questions the assumptions of the dividend policy

1. It is advantageous to the shareholders to leave a substantial part of annual earnings in the business.

 If a business pays out only a small part of the earnings in dividends, the value of the stock should increase over a period of years, but it is by no means certain that this increase will compensate the stockholders for the dividends withheld from them, particularly if interest on these amounts is compounded.

 An inductive study would undoubtedly show that the earning power of corporations does not in general expand proportionately with increases in accumulated surplus (retained earnings).

2. It is desirable to maintain steady dividend rate in the face of fluctuations in profits.

 Stability is usually accomplished by paying out a small part of the average earnings. The question that arises is if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity.

The main objection to the above is that stockholders receive both currently and ultimately too low a return in relation to the earnings of their property and that the saving up of profits for a rainy day often fails to safeguard even the moderate dividend rate when the rainy day actually arrives.

Gives the example of US Steel that earned a profit of $2.344 billion over the period 1901-1930 and retained $1.25 billon of it. Yet, a small loss over a 1.5 year period in 1931 was sufficient to outweigh the beneficial influence of 30 years of practically continuous reinvestment of profits.

Assuming that the reported earnings were actually available for distribution, then stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends.

• Graham questions the accepted notion that the determination of dividend polices is entirely a managerial function, in the same way as the general running of the business. This is because the board of directors consists largely of executive officers and their friends. The officers want to retain as much earnings as possible to simplify their financial problems, expand business for personal aggrandizement to secure higher salaries.

• Graham suggests European companies policy of paying out practically all earnings and any capital for expansion purposes be provided by sale of additional stock.

• Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus (retained earnings).

• Graham suggests that if an investor makes a small concession in dividend yield below the standard, he is entitled to demand a more than corresponding increase in earning power above standard. So if a stock is paying 5% div yield and 7% earnings yield and another company paying 4.4% yield, then the investor should demand an earnings of yield of perhaps 8% to compensate.

• The dividend rate is seen to be important apart from earnings, not only because the investor naturally wants cash income from his capital but also because the earnings that are not paid out in dividends have a tendency to lose part of their effective value for the stockholder.

• The principle for dividends should be for the management to retain or reinvest earnings only with the specific approval of the stockholders. Such “earnings” as must be retained to protect the company’s position are not true earnings at all. They should not be reported as profits but should be deducted in the income statement as necessary reserves, with an adequate explanation thereof. A compulsory surplus is an imaginary surplus.

• Summary

 In some cases stockholder derive positive benefits from an ultraconservative dividend policy i.e. through much larger eventual earnings and dividends. In such instances the market’s judgment proves to be wrong in penalizing the shares because of their small dividend.

 Far more frequently, however, the stockholders derive much greater benefits from dividend payments than from additions to surplus. This happens because either (a) the reinvested profits fail to add proportionately to the earning power or (b) they are not true profits at all but reserves that had to be retained merely to protect the business. In this majority of the cases the market’s disposition to emphasize the dividend and to ignore the additions to surplus turns out to be sound. A company earning $10 and paying $7 in dividends should increase the value of stock over a period of years. This may be true but at the same time the rate of increase in value may be substantially less than $3 per annum compounded.

 The confusion of though arises from the fact that the stockholders votes in accordance with the first premise and invests on the basis of the second.

 

[Shane]

Thank you for the suggestions, I'm placing an order for greenwalds book and hopefully the library will get security analysis back soon!  I do plan on taking the CFA after graduation but my studies are leaving me with little time to do much else.

[Myth465]

Very good article on valuation .

 

 

http://www.gurufocus.com/news.php?id=120188

 

 

[Shane]

Thanks Myth!

[turar]

You can check Professor Damodaran's page too: http://pages.stern.nyu.edu/~adamodar/  with valuation covered here: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm

[Myth465]

Gannon is the gift that keeps on giving. I find 2-3 very simple way of looking at value is all you need. I use the same method at WB, except I think most getting 10% return year after year is fair for the owner. I look for situations which will deliver 20% return and wait for Mr. Market to pay up.

 

http://www.gurufocus.com/news.php?id=120357

 

http://www.gannononinvesting.com/blog/15-valuation-walkthroughs.html

[Shane]

Great Stuff, I appreciate the direction.

[Shane]

vinod1 - I checked your link again (Notes on security analysis) and its down, any way I could get those notes from you?

[vinod1]

vinod1 - I checked your link again (Notes on security analysis) and its down, any way I could get those notes from you?

 

I just checked and it seems to be working fine. You can give it another shot and if you still have a problem, email me at vpalika in the hotmail.com domain.

 

Vinod