Valuation Driven Investing begins and ends with calculating the intrinsic value of every stock in a benchmark against which a portfolio is constructed, and comparing those values against traded prices. All of Applied Finance’s portfolios are Valuation Driven, which differs significantly from a “value” perspective. To gain a better understanding into Applied Finance’s Valuation Driven approach, let’s first review traditional approaches to “Value”.
The traditional approaches to finding undervalued stocks use a simple ratio such as P/E or P/B, or a mix of them. These common approaches to value come with many shortcomings:
- They Rely on noisy accounting data
- They look at a static point in time, assuming world stays constant.
- There is no link to Intrinsic Value. Having a low multiple might just mean the stock is in financial distress.
- They are commodity factors, available to everyone on Yahoo! Finance.
Efforts made by well intended managers using traditional Discounted Cashflow Models (DCF) have their own shortcomings:
- Perpetuity assumptions Ignore the fact that companies will face competition
- Such models are highly sensitive to changes in discount rates or growth rates, leading to drastic variance in values
- Up to 70% of NPV of estimated cashflows typically come from perpetuity assumptions,
- Growth, Risk, and Competition estimates are subjective and inconsistent from one analyst to another.
With this in mind, nobody should be surprised by the fact that the majority of money managers underperform.
In contrast, Applied Finance’s Valuation Driven approach is distinctly different and superior.
Unlike traditional valuation approaches that utilize highly sensitive perpetuity assumptions, the Applied Finance approach incorporates the widely accepted economic reality of competition by gradually decaying Economic Margins to zero. This essentially eliminates the excess spread a firm generates above or below its cost of capital to then discount those cashflows without a perpetuity.
Economic Margin Decay
Applied Finance summarizes this information in their Intrinsic Value report, which is available for 20,000 companies worldwide. Below is an example intrinsic value report of Constellation Brands, which has traded below its intrinsic value
and has been a long-term holding.
How the Applied Finance Intrinsic Value Chart:
• The Blue Bars represent the high and low trading range for a stock for 1 year.
• The dotted line represents our default Intrinsic Value through time.
• When the dotted line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.
• When the dotted line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued.
Applied Finance has estimated an intrinsic value for each company in its database, on a weekly basis for over two decades, leading to over 20,000,000 company specific valuations. This rich research asset enables Applied Finance to better understand its investment decisions relative to other investment managers. It’s an Analytical Advantage no other firm comes close to replicating.
While others chase returns, Applied Finance knows that patience is required for the intrinsic value gap to close.