Monday, August 30, 2010

Valuation Expansion

On Wall Street, a lot of educated monkeys like to talk about valuation expansion. Basically valuation expansion simply means that some stock trading at 15x PE should be trading at 25x PE bcos its industry is sexy, or the company has undergone transformation of its business to become the new growth story or some other cock-and-bull story.

So say the stock price today is $15, and the stock earns an EPS of $1 ie PE is 15x. Valuation expansion simply means that the stock should be $25 bcos PE should be 25x. The basis of this argument is that since the stock is in a growth industry, or has transformed its business, or watever crap reason, the future EPS is not just $1 but much higher. Since we are not sure what that would be, just give it a higher PE to justify this growth.

The ingenuity of this crap theory is that nothing changed, but the "value" of this stock just expanded 60%. This then can be used to justify buying the stock at any price bcos we can always assuming super normal growth and increase the valuation. We can even increase the target multiple further from 25x to 50x. This would expand the original "value" by 333%.

Let's just do a simple experiment the debunk this valuation expansion theory.

Yr 0 EPS $0.5 (Stock price $25, ie PE 50x)
Yr 1 EPS $1 (Stock price $25, ie PE 25x)
Yr 2 EPS $2
Yr 3 EPS $3
Yr 4 EPS $4
Average EPS $2.1
True intrinsic value (using PE 15x) = $2.1 x 15 = $31.5
Upside = $31.5/$25 = 26%
Upside per yr roughly 5%

So assuming today we are at Yr 0 and this company started out with an EPS of 50c but bcos of its super power growth, the stock market has already valued it at 50x PE current yr and 25x next yr. Of course this is assuming it didn't disappoint, its EPS doubled to $1. In fact it didn't disappoint for the next 4 yrs and its EPS grew from the initial 50c to $4. This stellar firm actually grew its earnings 8 folds in 5 yrs!

Now how spectacular can a normal company get? I would think this type of growth puts the world's best growth firm to shame. Look at APPL, the darling-est growth stock in our lives. Currently it's the 2nd biggest company in the world by market cap. Its net profit was $1.3bn 5 yrs ago. Last year, it was $8.3bn. The 5 yr growth alas is 6.4x, still a tad less than our hypothetical co. at 8x.

So 8 fold increase in EPS is really as good as it gets. But, if you have bought it for 25x or more, the return in stock price is likely to be single digit return. As I calculated, the intrinsic value is $31.5 vs today's price at $25. Of course, the stock might bounce up a lot, to say $50 then collapse, or it's price might continue to stay very much higher than its true value of $31.5, but we are value investors remember? We don't follow prices. We follow value.

What I am trying to say is this: when you buy a valuation expansion story, your rate of return is destined to be meager even if the story comes true. In our hypothetical case, the stock return over 5 yrs is about 5% per yr. How fantastic!

To me, valuation expansion is then just another variation of the Greater Fool Game. Valuation expansion means the earnings of the company is not great now, BUT bcos there are a lot of people willing to pay 25x now, therefore the stock price should rise by a huge magnitude.

I would think that a better way to make money would be the always buy below PE of 17-18x. Value investors would certainly do that. With valuation expansion, there is no margin of safety at all. What if the growth didnt come true? What if the genius CEO died?

So when you hear valuation expansion next time, pls beware!

PS: APPL did trade at 25x PE 5 yrs ago and you would have made a lot of money buying it at 25x 1 yr fwd and held it until today. But the better chance to buy was during the Lehman Crisis when the PE fell to 15x 1 yr fwd and you could have more than doubled your money in 2 yrs!

Wednesday, August 11, 2010

Did Buffett underpay Mrs B?

I did a post some time back highlighting that perhaps the acme of investing might actually be not to short-change anyone in any transaction. ie to buy a stock at its intrinsic value while waiting for the intrinsic value to grow. This is a very sensitive point when we are dealing with day-to-day business owners rather than the stock market.

Obviously buying at intrinsic value is also different from buying a company at a huge discount and then waiting for it to revert back to its intrinsic value, which is the original thesis of value investing.

I thought that Buffett might have just pulled this off, and that is why he is the greatest investor on Earth.

Recently I did some study on the exact transaction that he did: buying over Nebraska Furniture Mart from its long-time founder and operator Mrs B.

The story goes something like this. In 1983, Buffett on his birthday, simply went in to the Mart and asked Mrs B. if she would like to sell, and at what price?

Here are some no.s at the time the transaction was done.

Sales 100mn (reported)
NP 5-10mn (estimate by 8%pa)

GPM of NFM 60% (reported)
Furnture mkt OPM 10% (industry average)

$55mn of 80% stake (reported)
$69mn for 100% stake (reported)

Buffett paid 7-14x PE

Based on my estimate, Buffett probably paid 7-14x PE for NFM. Now this is a huge range. If he paid 7x, he would have obviously underpaid Mrs B. If he paid 14x, then it's probably fair. So did he underpay Mrs B?

Well, sadly we will never know for sure, but chances are Buffett probably did underpay somewhat, judging by his track record and considering how the firm grew over the past 30 years. However we must also note that Mrs B was a willing seller at $69mn. She quoted Buffett that price.

Also, Mrs B probably would not have gotten much more if she were to list her company in the stock market. The brokers will take a cut. She has to pay for some auditors. Perhaps hire a few more staff to handle Wall Street people etc. With Buffett, she got her $55mn check on that day. And the best part, she continues to do what she does bcos Buffett wanted her to continue to run the business. No Wall Street analysts on her back every quarter!

I guess the conclusion here is that Buffett might not have been as noble as I thought. He did underpay his acquaintance somewhat but judging from the circumstances, Mrs B didn't mind that she got a couple of millions less (that is assuming she actually bothered to go and do a thorough valuation of her own co.) and she gets to do her job exactly the same way she liked it.

In fact, a couple of years later, Mrs B sold another business to Buffett. If she felt cheated, would she had gone back to Buffett?

The real lesson learnt for me here would actually be thinking about the best solution for both parties in every transaction. This means disclosing all the pros and cons to each party about the transaction, not witholding any information at all and working out the seek the win-win situation. I think this is very possible if both parties are rational, honest and committed to a long term relationship.