We originally wrote this note in December, 2020, but it serves as a timeless reminder that understanding intrinsic value and wealth creation is critical to successful investing.
From the Applied Finance Team – Happy Holidays.
DEAR EDITOR: I am an investor. Experts say valuation does not matter. Please tell me the truth; does valuation matter?
115 WEST NINETY-FIFTH STREET.
VIRGINIA, they are wrong. For the past 60 years, finance experts have been telling the world that the important activity addressed by valuation – trying to understand if a company is trading above or below its intrinsic value is irrelevant. Instead, academic theories and self-interested marketing by many firms preach repeatedly that it is much better to just buy stocks with some combination of attractive accounting ratios such as high: book to price, earnings to price, sales to price, among others. Yet it is clear, market prices over and under react but with time find their proper intrinsic values.
But VIRGINIA, it is impossible to understand the intrinsic value of a company through such ratios. How can static measures capture the dynamic interactions of economic profitability, investment strategy, risk, and competition? It is impossible, and everyone knows it. While such simplistic ratios are somewhat correlated to intrinsic value, after disentangling simple price ratios from intrinsic value, the ratios alone or in combination have no ability to explain subsequent stock returns. In fact, when such ratios are uncorrelated to intrinsic value, they result in portfolios with negative risk adjusted returns. A detailed study on deconstructing value in the working paper Valuation Beta by Applied Finance shows this is clearly the case. VIRGINIA, understand there are billions of dollars at stake to convince you and everyone else that valuation does not exist.
Yes, VIRGINIA, valuation matters. But there are no shortcuts to performing useful valuations through easy to calculate ratios or relying on unrealistic perpetuity assumptions. That is why so many investors have been fooled over the past few years thinking the overall market is so expensive. Yes, relative to historic norms, many ratios made the market look very expensive since 2018. But what is expensive when interest rates are 1% is very different from what is expensive when interest rates are 10%. Without a clear, complete understanding of corporate performance and required rate of return, it is impossible to comment intelligently about market valuations. When the entire market is valued over the years, in real time, with a comprehensive valuation framework applied in the same manner for decades, it is readily apparent that the overall market has not been expensive over the past few years, but just recently became expensive, despite the calls from “value experts” to the contrary. VIRGINIA, do not listen to experts that do not study live, out-of-sample data. The models from such experts typically are rife with confirmation bias and data snooping. It is easy to build models about the past when you already know the answer.
Wait, you don’t believe in Valuation! You might as well not believe in Supply and Demand! No doubt the market does get irrational from time to time and puts crazy values on companies and their business models. In 2000 it was Pets.com, in 2020 it is food delivery companies, but what does that prove? Ultimately it will just prove someone did not understand a stock’s valuation, either the buyer or the seller. You see VIRGINIA, a stock price is nothing more than a reflection of future cash flow expectations. Over time, a company’s performance will prove the expectations embedded in the price today are either too optimistic, or pessimistic. Those that have better approaches to quantify those expectations are better prepared to capitalize when market prices do not make sense.
Let me tell you about a company called Nvidia. Its stock has gone up 40- fold in the past 9 years! Most quantitative value experts hated it back then because, its price ratios were much higher than the market, and it was aggressively reinvesting in its business. VIRGINIA, can you imagine that people listen to experts saying those things? Can you imagine that a finance expert analyzing stocks would say that a company should not invest in profitable projects, because its stock price will go down? The empirical studies reaching such conclusions, that so many firms copy rather than objectively critique, lack understanding that investment and profitability are intertwined, and you must consider the interaction of the two to understand wealth creation. It is crazy ideas like “the low investment factor” that make people skeptical about valuation. After all, if finance experts preach such nonsense, does finance have any value? But properly performed valuations do exist, and a strategy called The Valuation 50® bought Nvidia (NVDA) at $13.86 in 2011 and enjoyed the stock’s continued appreciation until it was well above $500. Nvidia’s multiples became greater and greater during that time, but its true value has appreciated even faster – as the company’s economic profitability and growth have more than doubled.
It is imperative VIRGINIA to understand that markets do not reflect a stock’s intrinsic value at every moment. However, just because every investor does not believe in valuation does not make it any less real. Sometimes investors that believe in growth above all else, dominate the market and “buy buy buy” regardless of a stock’s price relative to its intrinsic value. That is why we do not believe in passive investing VIRGINIA, it is a false bargain. Over time, passive market capitalization weighted indices such as the S&P 500 have delivered negative risk adjusted returns. Why? It is simple, they ignore valuation.
Passive indexes invest too much in overvalued stocks and too little in undervalued stocks. Tesla is a great company, but at its current price it is likely overvalued. Investors that own it will likely suffer over time. But it is a significant component of the S&P 500 and passive investors have to buy it. The same thing happened to Cisco in 2000. Do not be jealous of silly short-term price movements VIRGINIA, be patient in owning well priced, well run companies. Learn from history, as Applied Finance’s database of over 20 million live, out of sample intrinsic value estimates consistently shows – overvalued stocks tend to underperform. Further, the more overvalued a company is at a point in time, the more it tends to underperform in the future.
Is valuation real? Ah, VIRGINIA, in all this investing world there is nothing else real and abiding, regardless of what those with vested franchises and interests may tell you otherwise. Understanding economic profitability, intrinsic value, and stewardship, is a better path to successful investing than focusing on “cheapness” or growth. From “value” investors confused by low investment growth and cheapness multiples, to growth investors that blindly focus on accelerating company fundamentals rather than economic profit expectations, to passive investors that mis-allocate funds, intrinsic Valuation Driven Investing® bests them all over time.
No Valuation! Thank God! Valuation thrives and thrives forever. A thousand years from now, Virginia, nay, ten times ten thousand years from now, valuation will continue as it always has to be the foundation of proper and efficient capital allocation, and the source for safe, secure long-term investing.
Related Follow-Up Article: Quantitative Value Investing is Broken