The primary purpose of Socratic questioning is to get to the truth of complex ideas ‘ex duco’ (by leading out) which is the root of the word ‘education’.
Instead of the ‘chalk and talk’ method of teaching, Socrates believed that questioning the very idea of even asking a question allowed his students to develop a deeper way of thinking about achieving their ultimate goal – an answer to their original question.
Socrates’ conviction led to his own death; he was tried and executed for failing to recognise the gods recognised by the state, introducing new deities and corrupting the youth.
It is interesting to me at least, that a 70 year old bisexual philosopher who was put to death over 2,400 years ago should have an influence on the way teachers teach today – if it ain’t broke, don’t fix it.
Mehul a reader and newsletter subscriber, has kindly asked if I could write about how a specific set of valuation metrics and ratios fit into the overall picture of valuing a stock and if one of them does not indicate undervaluation whether or not the stock should be purchased.
Value Investing Ratios And Formulas
Lets have a look at the specific ratios and formulas Mehul has mentioned in more detail (chalk and talk):
- EBITDA – The most popular use for EBITDA is to use it in conjunction with another metric called Enterprise Value (EV) to end up with the EV/EBITDA ratio (the enterprise multiple). EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. Jargon that disguises the fact that managements are free to include and exclude items in this non GAAP metric in ways that make it unreliable (is any ratio/metric 100% reliable?). Still, EBITDA has a large following especially to users of the enterprise multiple because this measures the potential value as a takeover target by including debt in the valuation.
- Net-Net – An balance sheet/asset based formula that refers to a stock that is selling below its net net working capital (NNWC) and was first introduced by Benjamin Graham. The idea behind the formula is that stocks that are selling below their NNWC are in quite serious trouble and have an increased risk of going bust. The formula for NNWC seeks to value a company on the basis that it would go through a liquidation with the result of having a cash value at the end to be distributed to shareholders. The formula: cash and short term investments, plus 75% of accounts receivable, plus 50% of inventory, minus total liabilities. Only 75% of accounts receivable is used because not all of it will be collectable in a fire sale. Similarly, inventories will almost certainly be discounted in a fire sale hence why only 50% of their value is included.
- NCAV – Stands for Net Current Asset Value (NCAV), the formula of which is current assets minus total liabilities. A lot simpler that the net net formula which is one of its advantages. Like net nets, the idea behind NCAV is to value a company based on its assets but only taking into account its most liquid (valuable) assets – the current assets – and ensuring that they can pay off ALL liabilities and still have assets left over, the value of which can be distributed to shareholders of the stock after all liabilities are paid off. As with NNWC stocks, NCAV stocks are in serious trouble and usually for a good reason. They are also thinly traded which means you will have difficulties buying and selling stock at prices that would normally be okay with say large cap stocks. The formula is still in use today as is NNWC among professional value investors.
- P/E Ratio – The PE (Price To Earnings) ratio measures a company’s earnings against it’s current share price. There are variations to the formula depending on which financial website you are getting your PE data from. The most basic formula for the PE ratio is share price divided by earnings per share. Ben Graham suggested that if you investing in large cap stocks, then avoid PE ratios above 20 to ensure you are not buying growth stocks which are more speculative in nature since they need to continue growing earnings into the future to provide a good return. There is a more detailed post on the PE ratio and it’s usefulness in valuing company’s here.
- EPS – Stands for ‘Earnings Per Share’, the basic formula for which is profit divided by weighted average number of shares. The are a few variations to this formula depending on which financial website you are getting your information from but they all try to do the same thing – apportion a company’s profit to each share that the company has issued. As we have seen the main use for EPS is for the calculation of a company’s PE Ratio. Although it is required by GAAP its major flaw is that earnings can be easily manipulated by managements. Despite this, Wall Street loves to project earnings as use it as a basis of a company’s present value.
- Cash Flow Per Share – Sometimes referred to as operating cash flow per share, it focusses on revenue excluding preferred dividends. The formula is operating cash flow minus preferred dividends divided by outstanding common shares. Its attractiveness as a valuation tool is the same as free cash flow: it is harder for managements to manipulate cash flow per share than it is to manipulate EPS. Like the PE Ratio, cash flow per share is useful for comparing a stocks with other stocks in its industry.
Ratios, Formulas And Their Relevance
As we have seen, ratios and formulas have their place. They are also full of jargon and need to be applied with care.
Stocks that are trading below their Net Current Asset Value (NCAV) are traditionally only valued with this one metric although some value investors also look for a catalyst to be in place that will unlock value such as a new appointment, an activist investor or a successful turnaround.
Value investors build an investment strategy that suits their own personality and circle of competence.
If you only feel confident investing in large cap stocks then you could build a strategy around The Relatively Unpopular Large Company. The NCAV and Net-Net metrics would be irrelevant in this case since the vast majority of large cap stocks never trade at such low valuations.
The P/E Ratio and how to use it to value stocks is built-in to The Relatively Unpopular Large Company investing strategy. But if you felt that EV/EBITDA or price to cash flow would suit the way you value companies then you could add them.
Experiment. Open a virtual portfolio on a website like ADVFN and see how you get on.
For further guidance on the use of ratios to value stocks, take a look at the value metrics in these portfolios based on strategies from Ben Graham.
The Essence Of Value Investing
Value investing is not a ratio fest. It is something much more basic.
To help frame the direction of this post, here are some Socratic style questions for you to think about.
Question #1: What is the point of learning about ratios and metrics?
Question #2: Why are ratios and metrics important to you?
Question #3: What would you do if you were faced with a stock that had:
- EV/EDBITDA of 7.48
- P/E Ratio of 10.4
- EPS of $44.64
- Cash Flow Per Share of $47.92
Question #4: Why do you think I left out NNWC and NCAV from the valuation metrics in Question #3 above?
Here is a Socratic style question that was posed to me on twitter recently:
@djthomas being a Value Investor, what do you think is the key thing to look for in a stock ?
— Investor Community (@InvestorComm) June 23, 2013
@InvestorComm the question I always seek to answer is: does a price decline represent a large enough margin of safety? — David Thomas (@djthomas) June 23, 2013
Ratios, metrics, formulas, spreadsheets, 10K’s, annual reports, ADVFN/Morningstar statistical data, news reports – I use them all to answer this basic question.
A great example of this is ‘How To Find Undervalued Stocks‘.
At the time the normal sets of ratios I use to value stocks as an initial ‘screen’ were telling me that the stock was undervalued. It soon became clear that this idea was an illusion.
In this instance, ratios that flashed ‘undervalued’ pointed me towards a potentially undervalued stock that ultimately turned out not to be. I only found that out by conducting what I call ‘first tier due diligence’ which basically entails going through RNS announcements with a highly sceptical approach as a background check, building up a picture of it’s near and medium term past.
In the aforementioned case study, it quickly became apparent that although the value ratios and metrics pointed towards an undervalued stock, first tier due diligence revealed that it was not – no margin of safety.
I actually ended up going short this stock due to the results of first tier due diligence.
The usefulness of ratios in value investing for me at least are to serve as an initial screen after which I can start more in-depth research directed towards finding out if a large enough margin of safety exists for me to buy a stock. If one or two of the ratios are not screaming ‘undervalued’ it may or may not have an influence on my decision to conduct first tier due diligence.
For example, if a large cap stock is trading at 5x NCAV then it is unlikely to deter me from conducting first tier due diligence because as we’ve seen, large caps are not known for trading below their net current asset value. If a large cap stock has a PE ratio of 22 then there would need to be a very good reason for me to continue further research – these are my biases/strategies for dealing with stocks and they may not necessarily be a good fit for you.
This has been a gargantuan post relative to what is normally published and I do hope you’ve found some value from it. But for now, here’s a great tip that you can use to take action straight away:
Go and look at your written investment strategy (You do have one don’t you? :)) Critically assess any ratios that you feel do not contribute to your investment success, remembering that investment success is not how much money you make its how successful you are at finding a margin of safety. If you don’t have a written plan, now’s a good time to write one. 🙂