Review the Basics: Thoughts on Valuation (1997) – Mauboussin

Michael Mauboussin is a highly respected investor, teacher, speaker and book writer. I came across a number of his notes in the past (including this one which I liked a lot). Thanks to the Internet and the many people who share good thinking, most of his notes are there to grasp and read.

While re-populating my blog, I came into his 1997 reflections on valuation. As Graham/Buffett nicely put it: price is what you paid, value is what you get. So to earn decent return when investing, you need to know the value so you can pay a price that gives you a good margin of safety.

The full note is available to read here. I just wrote down a couple of remarks that make sense to me and hopefully give you a quick overview of why it might be useful and what you will find inside.

Key purpose of the note is to defend the value-based approach of investing,  to keep in mind what really matters in valuation and not to fall into « market myths ».

Key points:

  • Defend « value-based analysis » because it is « a powerful tool for both investors and the corporations ».
  • Focus on market myths, critical review of valuation techniques and why value-based models are better.
  • First off, definition of value-based models
  • Debunking market myths:
    • Earnings per share matter (cash earnings and growth of earnings probably matter way more than EPS which relys on accounting choices and are far from the economic reality of the firm);
    • « P/E multiples are not a determinant of value, but rather a function of value ». « Value is determined by the present value of a stream of future cash flows, and the P/E falls out of that equation ».
    • EPS growth drives valuation.
    • Market is very short-term oriented:
    • Market is unsophisticated or in some instances « irrational »:
  • Valuation techniques pros and cons:
    • P/E multiples (P/E is the most known and used valuation metric in the market, because it’s so easy to calculate… but as seen with EPS, it’s easily distorted by accounting practices and doesn’t necessarily mean anything in isolation). Per Mauboussin, main cons are that P/Es ignore risk, capital needs nor time value for money.
    • P/B ratio (especially used to value financial institutions): also very easy to compute, helps at determining a margin of safety and indicates value creation (P/B <1 means a company doesn’t earn its cost of capital). Minuses: manipulation, doesn’t capture « key issues of value », and is very sensitive to events such as write-offs, M&A, share repurchases…
    • EV/EBITDA « gets close to reflecting the economics of business », also simple to use, is useful in M&A analysis. Key drawbacks are the same as for P/Es. One key point here, using Buffett’s own thoughts on the matter, is that « we cannot talk about the appropriate multiples for a company without understanding its capital requirements. »
    • Dividend Discount Model: first established by John Burr Williams in 1938 (one of the founding fathers of valuation techniques) and one of the foundation of DCF models. It fully incorporate time value of money, reflects capital needs and product/service lifecycle. Main minuses are how you determine the discount rate, how you incorporate the (non)-distribution of dividends and the fact that it requires a large number of assumptions…
  • What’s the value-based model: a mixture of cash-flow, risk and forecast horizon.
    • NOPAT and cash earnings: NOPAT is the « unlevered cash earnings of a business » which helps compare companies within sectors, across sectors and geographies ; we take NOPAT and add back non-tax deductible, noncash amortization of goodwill. This helps calculate the return on invested capital, free cash flow or EVA®.
    • Investment in future growth: investments required to generate future NOPAT (needs a good understanding/assessment of capital allocation within a corporation). It encompasses change in net working capital + capex (net of depreciation) + acquisitions (net of divestures).
    • The importance of free cash-flow (FCF) = NOPAT – Investments
    • Value creation approach (EVA®) based on NOPAT (which derives from sales, EBITDA margin and cash taxes) and invested capital (net working capital, net fixed capital, goodwill and any other operating assets), provided that you take into account the economic reality of it and not historical cost.
    • Risk is taken into account through the cost of capital.
    • To make this useful, you also need to take into account the « Competitive Advantage Period » (CAP) which determines how long a company will enjoy above-average return on capital before new entrants/competitors come in its market and contribute in reducing its returns.
    • CAP relies on 3 variables : current return on capital, rate of industry change (length of CAP) and barriers to entry.
    • This ultimately depend on « balance sheet management » and what policies you take to expand the CAP. This ultimately relies on the « Economic Moat », a concept developed by Warren Buffett which has roots in industrial economics (Karl Marx, Alfred Marshall and Joseph Schumpeter are probably the most influencial thinkers in this field – French speaking readers can have a look at the intro to the book Théorie de l’évolution économique written by François Perroux).