Posts tagged ‘PE ratio’

Investing Holy Grail: Brain or Machine?

Source: Photobucket

Paul Meehl was a versatile academic who held numerous faculty positions, covering the diverse disciplines of psychology, law, psychiatry, neurology, and yes, even philosophy. The crux of his research was focused on how well clinical analysis fared versus statistical analysis. Or in other words, he looked to answer the controversial question, “What is a better predictor of outcomes, a brain or an equation?” His conclusion was straightforward – mechanical methods using quantitative measures are much more efficient than the professional judgments of humans in coming to more accurate predictions.

Those who have read my book, How I Managed $20,000,000,000.00 by Age 32 know where I stand on this topic – I firmly believe successful investing requires a healthy balance between both art and science (i.e., “brain and equation”). A trader who only relies on intuition and his gut to make all of his/her decisions is likely to fall on their face. On the other hand, a quantitative engineer’s sole dependence on a robotic multi-factor model to make trades is likely to fail too. My skepticism is adequately outlined in my Butter in Bangladesh article, which describes how irrational statistical games can be misleading and overused.

As much as I would like to attribute all of my investment success to my brain, the emotion-controlling power of numbers has played an important role in my investment accomplishments as well. The power of numbers simply cannot be ignored. More than 50 years after Paul Meehl’s seminal research was published, about two hundred studies comparing brain power versus statistical power have shown that machines beat brains in predictive accuracy in the majority of cases. Even when expert judgments have won over formulas, human consistency and reliability have muddied the accuracy of predictions.

Daniel Kahneman, a Nobel Prize winner in Economics, highlights another important decision making researcher, Robyn Dawes. What Dawes discovers in her research is that the fancy and complex multiple regression methods used in conventional software adds little to no value in the predictive decision-making process. Kahneman describes Dawes’s findings more specifically here:

“A formula that combines these predictors with equal weights is likely to be just as accurate in predicting new cases as the multiple-regression formula…Formulas that assign equal weights to all the predictors are often superior, because they are not affected by accidents of sampling…It is possible to develop useful algorithms without any prior statistical research. Simple equally weighted formulas based on existing statistics or on common sense are often very good predictors of significant outcomes.”

 

The results of Dawes’s classic research have significant application to the field of stock picking. As a matter of fact, this type of research has had a significant impact on Sidoxia’s stock selection process.

How Sweet It Is!

                       

In the emotional roller-coaster equity markets we’ve experienced over the last decade or two, overreliance on gut-driven sentiments in the investment process has left masses of casualties in the wake of losses. If you doubt the destructive after-effects on investors’ psyches, then I urge you to check out my Fund Flow Paradox article that shows the debilitating effects of volatility on investors’ behavior.

In order to more objectively exploit investment opportunities, the Sidoxia Capital Management investment  team has successfully formed and utilized our own proprietary quantitative tool. The results were so sweet, we decided to call it SHGR (pronounced “S-U-G-A-R”), or Sidoxia Holy Grail Ranking.

My close to two decades of experience at William O’Neil & Co., Nicholas Applegate, American Century Investments, and now Sidoxia Capital Management has allowed me to build a firm foundation of growth investing competency – however understanding growth alone is not sufficient to succeed. In fact, growth investing can be hazardous to your investment health if not kept properly in check with other key factors.

Here are some of the key factors in our Sidoxia SHGR ranking system:

Valuation:

  • Free cash flow yield
  • Price/earnings ratio
  • PEG ratio
  • Dividend yield

Quality:

  • Financials: Profit margin trends; balance sheet leverage
  • Management Team: Track record; capital stewardship
  • Market Share: Industry position; runway for growth

Contrarian Sentiment Indicators:

  • Analyst ratings
  • Short interest

Growth:

  • Earnings growth
  • Sales growth

Our proprietary SHGR ranking system not only allows us to prioritize our asset allocation on existing stock holdings, but it also serves as an efficient tool to screen new ideas for client portfolio additions. Most importantly, having a quantitative model like Sidoxia’s Holy Grail Ranking system allows investors to objectively implement a disciplined investment process, whether there is a presidential election, Fiscal Cliff, international fiscal crisis, slowing growth in China, and/or uncertain tax legislation. At Sidoxia we have managed to create a Holy Grail machine, but like other quantitative tools it cannot replace the artistic powers of the brain.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

 

July 15, 2012 at 12:12 pm Leave a comment

NASDAQ: The Ugly Stepchild Index

All the recent media focus has been fixated on whether the Dow Jones Industrial Average index (“The Dow”) will close above the 13,000 level. In the whole scheme of things, this specific value doesn’t mean a whole lot, but it does make for a great topic of conversation at a cocktail party. Today, the Dow is trading at 12,983, a level not achieved in more than three and a half years. Not a bad accomplishment, given the historic financial crisis on our shores and the debacle going on overseas, but I’m still not so convinced a miniscule +0.1% move in the Dow means much. While the Dow and the S&P 500 indexes garner the hearts and minds of journalists and TV reporters, the ugly stepchild index, the NASDAQ, gets about as much respect as Rodney Dangerfield (see also No Respect in the Investment World).

While the S&P 500 hundred has NOT even reached the level from one year ago, the technology-heavy NASDAQ index has hit a 11+ year record high. Yes that’s right; the NASDAQ has not reached these levels since December 2000. Sure, the NASDAQ  receives a lot of snickers since the technology bubble burst in 2000, when the index peaked at over 5,100 and subsequently plummeted to 1,108 (-78%) over the ensuing 31 months. But now the ugly stepchild index is making an extraordinary comeback into maturity. Since September 2002, near the lows, the NASDAQ has outperformed both the Dow and the S&P 500 indexes by more than a whopping 80%+, excluding dividends.

With the NASDAQ (and NASDAQ 100) hitting a new decade-plus high, are we approaching bubble-esque P/E ratios (price-earnings) of the 2000 era? Not even close. According to Birinyi Associates, the NASDAQ 100 index (QQQ) forward P/E ratio is priced at a reasonable 14x level – much lower than the 100x+ ratios we experienced right before the NASDAQ crash of 2000 and close to the P/E of the S&P 500.

With these NASDAQ indexes hitting new highs, does this tell us they are going to go significantly higher? No, not necessarily…just ask buyers of the NASDAQ in the late 1990s how that strategy worked then. Trying to time the market is a fruitless cause, and will always remain so. A few people will be able to do it occasionally, but doing so on a sustained basis is extremely difficult (if not impossible). If you don’t believe me, just ask Alan Greenspan, former Federal Reserve Chairman, who in 1996 said the tech boom had created “irrational exuberance.” When he made this infamous statement in 1996, the NASDAQ was trading around 1,300 – I guess Greenspan was only off by about another 3,800 points before the exuberance exhausted.

While a significantly outperforming index may not give you information on future prices, leadership indexes and sectors can direct you to fertile areas of research. Trends can be easy to identify, but the heavy lifting and sweat lies in the research of determining whether the trends are sustainable. With the significant outperformance of the NASDAQ index over the last decade it should be no surprise that technology has been leading the index brigade.  The NASDAQ composite data is difficult to come by, but with the Technology sector accounting for 65% of the NASDAQ 100 index weighting, it makes sense that this index and sector should not be ignored. Cloud computing, mobility, e-commerce, alternative energy, and nanotechnology are but just a few of the drivers catapulting technology’s prominence in financial markets. Globalization is here to stay and technology is flattening the world so that countries and their populations can participate in the ever-expanding technology revolution.

Investors can continue to myopically focus on the narrow group of 30 Dow stocks and its arbitrary short-term target of 13,000, however those ignoring the leadership of the ugly stepchild index (NASDAQ) should do so at their own peril. Ugliness has a way of turning to beauty when people are not paying attention.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, including SPY, but at the time of publishing SCM had no direct position in QQQ, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

February 27, 2012 at 2:15 am Leave a comment

Markets Race Out of 2012 Gate

Article includes excerpts from Sidoxia Capital Management’s 2/1/2012 newsletter. Subscribe on right side of page.

Equity markets largely remained caged in during 2011, but U.S. stocks came racing out of the gate at the beginning of 2012. The S&P 500 index rose +4.4% in January; the Dow Jones Industrials climbed +3.4%; and the NASDAQ index sprinted out to a +8.0% return. Broader concerns have not disappeared over a European financial meltdown, high U.S. unemployment, and large unsustainable debts and deficits, but several key factors are providing firmer footing for financial race horses in 2012:

•  Record Corporate Profits: 2012 S&P operating profits were recently forecasted to reach a record level of $106, or +9% versus a year ago. Accelerating GDP (Gross Domestic Product Growth) to +2.8% in the fourth quarter also provided a tailwind to corporations.

•   Mountains of Cash: Companies are sitting on record levels of cash. In late 2011, U.S. non-financial corporations were sitting on $1.73 trillion in cash, which was +50% higher as a percentage of assets relative to 2007 when the credit crunch began in earnest.

•  Employment Trends Improving: It’s difficult to fall off the floor, but since the unemployment rate peaked at 10.2% in October 2009, the rate has slowly improved to 8.5% today. Data junkies need not fret – we have fresh new employment numbers to look at this Friday.

•   Consumer Optimism on Rise: The University of Michigan’s consumer sentiment index showed optimism improved in January to the highest level in almost a year, increasing to 75.0 from 69.9 in December.

•   Federal Reserve to the Rescue: Federal Reserve Chairman, Ben Bernanke, and the Fed recently announced the extension of their 0% interest rate policy, designed to assist economic expansion, through the end of 2014. In addition, Bernanke did not rule out further stimulative asset purchases (a.k.a., QE3 or quantitative easing) if necessary. If executed as planned, this dovish stance will extend for an unprecedented six year period (2008 -2014).

Europe on the Comeback Trail?

Source: Calafia Beach Pundit

Europe is by no means out of the woods and tracking the day to day volatility of the happenings overseas can be a difficult chore. One fairly easy way to track the European progress (or lack thereof) is by following the interest rate trends in the PIIGS countries (Portugal, Ireland, Italy, Greece, and Spain). Quite simply, higher interest rates generally mean more uncertainty and risk, while lower interest rates mean more confidence and certainty. The bad news is that Greece is still in the midst of a very complex restructuring of its debt, which means Greek interest rates have been exploding upwards and investors are bracing for significant losses on their sovereign debt investments. Portugal is not in as bad shape as Greece, but the trends have been moving in a negative direction. The good news, as you can see from the chart above (Calafia Beach Pundit), is that interest rates in Ireland, Italy and Spain have been constructively moving lower thanks to austerity measures, European Central Bank (ECB) actions, and coordination of eurozone policies to create more unity and fiscal accountability.

Political Horse Race

Source: Real Clear Politics via The Financial Times

The other horse race going on now is the battle for the Republican presidential nomination between former Massachusetts governor Mitt Romney and former House of Representatives Speaker Newt Gingrich. Some increased feistiness mixed with a little Super-Pac TV smear campaigns helped whip Romney’s horse to a decisive victory in Florida – Gingrich ended up losing by a whopping 14%. Unlike traditional horse races, we don’t know how long this Republican primary race will last, but chances are this thing should be wrapped up by “Super Tuesday” on March 6th when there will be 10 simultaneous primaries and caucuses. Romney may be the lead horse now, but we are likely to see a few more horses drop out before all is said and done.

Flies in the Ointment

As indicated previously, although 2012 has gotten off to a strong start, there are still some flies in the ointment:

•   European Crisis Not Over: Many European countries are at or near recessionary levels. The U.S. may be insulated from some of the weakness, but is not completely immune from the European financial crisis. Weaker fourth quarter revenue growth was suffered by companies like Exxon Mobil Corp (XOM), Citigroup Inc. (C), JP Morgan Chase & Co (JPM), Microsoft Corp (MSFT), and IBM, in part because of European exposure.

•   Slowing Profit Growth: Although at record levels, profit growth is slowing and peak profit margins are starting to feel the pressure. Only so much cost-cutting can be done before growth initiatives, such as hiring, must be implemented to boost profits.

•   Election Uncertainty: As mentioned earlier, 2012 is a presidential election year, and policy uncertainty and political gridlock have the potential of further spooking investors. Much of these issues is not new news to the financial markets. Rather than reading stale, old headlines of the multi-year financial crisis, determining what happens next and ascertaining how much uncertainty is already factored into current asset prices is a much more constructive exercise.

Stocks on Sale for a Discount

Source: Calafia Beach Pundit

A lot of the previous concerns (flies) mentioned is not new news to investors and many of these worries are already factored into the cheap equity prices we are witnessing. If everything was all roses, stocks would not be selling for a significant discount to the long-term averages.

A key ratio measuring the priceyness of the stock market is the Price/Earnings (P/E) ratio. History has taught us the best long-term returns have been earned when purchases were made at lower P/E ratio levels. As you can see from the 60-year chart above (Calafia Beach Pundit), stocks can become cheaper (resulting in lower P/Es) for many years, similar to the challenging period experienced through the early 1980s and somewhat analogous to the lower P/E ratios we are presently witnessing (estimated 2012 P/E of approximately 12.4). However, the major difference between then and now is that the Federal Funds interest rate was about 20% back in the early-’80s, while the same rate is closer to 0% currently. Simple math and logic tell us that stocks and other asset-based earnings streams deserve higher prices in periods of low interest rates like today.

We are only one month through the 2012 financial market race, so it much too early to declare a Triple Crown victory, but we are off to a nice start. As I’ve said before, investing has arguably never been as difficult as it is today, but investing has also never been as important. Inflation, whether you are talking about food, energy, healthcare, leisure, or educational costs continue to grind higher. Burying your head in the sand or stuffing your money in low yielding assets may work for a wealthy few and feel good in the short-run, but for much of the masses the destructive inflation-eroding characteristics of purported “safe investments” will likely do more damage than good in the long-run. A low-cost diversified global portfolio of thoroughbred investments that balances income and growth with your risk tolerance and time horizon is a better way to maneuver yourself to the investment winner’s circle.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in XOM, MSFT, JPM, IBM, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

February 3, 2012 at 2:25 pm 4 comments

P/E Binoculars, Not Foggy Rearview Mirror

Robert Shiller is best known for his correctly bearish forecasts on the housing market, which we are continually reminded of through the ubiquitous Case-Shiller housing index, and his aptly timed 2000 book entitled Irrational Exuberance. Shiller is also well known for his cyclically adjusted 10-year price-earnings tool, also known as P/E-10. This tool chooses to take a rearview mirror look at the 10-year rolling average of the S&P composite stock index to determine whether the equity market is currently a good or bad buy. Below average multiples are considered to be predictive of higher future returns, and higher than average multiples are considered to produce lower future returns (see scatterplot chart). 

Source: http://www.mebanefaber.com (June 2010)

Foggy Mirror

If you were purchasing a home, would the price 10 years ago be a major factor in your purchase decision? Probably not. Call me crazy, but I would be more interested in today’s price and even more interested in the price of the home 10 years into the future. The financial markets factor in forward looking data (not backward looking data). Conventional valuation techniques applied to various assets, take for example a bond, involve the discounting of future cash flow values back to the present – in order to determine the relative attractiveness of today’s asset price. The previous 10-years of data are irrelevant in this calculation.

Although I believe current and future expectations are much more important than stale historical data, I can appreciate the insights that can be drawn by comparing current information with historical averages. In other words, if I was purchasing a house, I would be interested in comparing today’s price to the historical 10-year average price. Currently, the P/E-10 ratio stands at a level around 22x – 38% more expensive than the 16x average value for the previous decade. That same 22x current P/E-10 ratio compares to a current forward P/E ratio of 13x. A big problem is the 22x P/E-10 is not adequately taking into account the dramatic growth in earnings that is taking place (estimated 2010 operating earnings are expected to register in at a whopping +45% growth).

Mean P/E 10 Value is 16.4x Source: http://www.multpl.com

Additional problems with P/E-10:

1)      The future 10 years might not be representative of the extreme technology and credit bubble we experienced over the last 10 years. Perhaps excluding the outlier years of 2000 and 2009 would make the ratio more relevant.

2)      The current P/E-10 ratio is being anchored down by extreme prices from a narrow sector of technology a decade ago. Value stocks significantly outperformed technology over the last 10 years, much like small cap stocks outperformed in the 1970s when the Nifty Fifty stocks dominated the index and then unraveled.

3)      Earnings are rising faster than prices are increasing, so investors waiting for the P/E-10 to come down could be missing out on the opportunity cost of price appreciation. The distorted P/E ratios earlier in the decade virtually guarantee the P/E-10 to drop, absent a current market melt-up, because P/E ratios were so high back then.

4)      The tool has been a horrible predictor over very long periods of time. For example, had you followed the tool, the red light would have caused you to miss the massive appreciation in the 1990s, and the green light in the early 1970s would have led to little to no appreciation for close to 10 years.

Shiller himself understands the shortcomings of P/E-10:

“It is also dangerous to assume that historical relations are necessarily applicable to the future. There could be fundamental structural changes occurring now that mean that the past of the stock market is no longer a guide to the future.”

 

How good an indicator was P/E-10 for the proponent himself at the bottom of the market in February 2009? Shiller said he would get back in the market after another 30% drop in the ratio (click here for video). As we know, shortly thereafter, the market went on a near +70% upwards rampage. I guess Shiller just needs another -55% drop in the ratio from here to invest in the market?

Incidentally, Shiller did not invent the cyclically adjusted P/E tool, as famed value investor Benjamin Graham also used a similar tool. The average investor loves simplicity, but what P/E-10 offers with ease-of-use, it lacks in usefulness. I agree with the P/E-10 intent of smoothing out volatile cycle data (artificially inflated in booms and falsely depressed in recessions), but I recommend investors pull out a pair of binoculars (current and forward P/Es) rather than rely on a foggy rearview mirror.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

November 4, 2010 at 11:49 pm 11 comments

Marathon Investing: Genesis of Cheap Stocks

It was Mark Twain who famously stated, “The reports of my death have been greatly exaggerated.” So too has the death of equities been overstated.  Long-term stock bulls don’t have a lot to point to since the market, as measured by the S&P 500 index, has done absolutely nothing over the last 12 years (see Lost Decade). Over the last 10 years, the market is actually down about -20% without dividends (and about flat if you account for reinvested dividends).  So if equities belong at the morgue, why not just short the market, burn your dollars, and hang out in a cave with a pile of gold? Well, behind the scenes, and off the radar of nanosecond, high frequency, day-trading CNBC junkies, there has been a quiet but deliberate strengthening in the earnings foundation of the market. In the investing world it’s difficult to move forward through sand. Even without a sturdy running foundation, sprinters can race to the front of the pack, but those disciplined runners who systematically train for marathons are the ones who successfully make it to the finish line.

Prices Chopped in Half

What many pundits and media mavens fail to recognize is S&P corporate profits have virtually doubled since 1998 (a historically elevated base), despite market prices stuck in quicksand for a dozen years. What does this say about the valuation of the market when prices go nowhere and profits double? Simple math tells us that all stock market inventory is selling for -50% off (the market multiple has been chopped in half). That’s exactly what we have seen – the June 1998 market multiple (valuation) stood around 27x’s earnings and today’s 2010 earnings estimates imply a multiple of about 13.5 x’s  projected profits. With the rear-view mirror assisting us, it’s easy to understand why pre-2000 (tech bubble) valuations were expensive. By coupling more reasonable valuations with a 10-Year Treasury Note trading at 3.19% and lofty bond prices, I would expect stocks to be poised for a much better decade of relative performance versus bonds. The case becomes even stronger if you believe 2011 S&P 500 estimates are achievable (12x’s earnings).

In order to make the decade long valuation contraction more apparent, I wanted include a random group of stocks (mixture of healthcare, media, retailer, consumer non-discretionary, and financial services) to liven up my argument:

Data sources: S&P, ADVFN & Yahoo! Finance

 

What Next?

From a stock market standpoint, there are certainly plenty of believable “double dip” scenarios out there along with thoughtful observers who question the attainability of next year’s earnings forecasts. With that said, I do have problems  with those bears like John Mauldin (read The Man Who Cries Wolf)  who just last year pointed to a market trading at a “(negative)  -467” P/E ratio, only to subsequently watch stocks advance some 80%+ over the following months.

Regardless of disparate economic views, I contend objective market observers (even bearish ones) have trouble indicating the market is ridiculously expensive with a straight face – based on current corporate profit expectations. At the end of the day, sustainable earnings and cash flow growth are what ultimately drive durable, long-term price appreciation. As Peter Lynch stated with technical precision, “People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”

Running a marathon is always challenging, but with a sturdy foundation in which prices have been chopped in half (see also Market Dipstick article), reaching the goal and finish line for long-term investors will be much more achievable.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, and PAYX, but at the time of publishing SCM had no direct positions in ABT, CI, DIS, FRX, KO, KSS, MDT or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

June 18, 2010 at 1:06 am 7 comments

Metrics Mix-Up: Stocks and Real Estate Valuation

When it comes to making money, investors choose from a broad menu of investment categories, ranging all the way from baseball cards and wines to collectible cars and art. Two of the larger and more popular investment categories are stocks and real estate. Unfortunately for those poor souls (such as me) analyzing these two classes of assets, the stock and real estate investor bigwigs have not come together to create an integrated metric system. Much the same way the United States has chosen to go it alone on a proprietary customary unit measurement system with Burma and Liberia – choosing inches and feet over centimeters and meters. On the subject of stock and real estate valuation, investors and industry professionals have been stubbornly defiant in designing unique and cryptic terminology, despite sharing the exact same financial principles.

Who Cares About Real Estate?

Well, apparently everyone. Southern California doesn’t have a monopoly on real estate, but through my practice in Orange County, I find it difficult to not trip over real estate investors on a daily basis. I work in effectively what was “ground zero” of the subprime debacle and the commercial real estate pains continue to ripple through “the OC.”

Ramping up the real estate learning curve reminds me of my high school Spanish class – I understood enough Spanish to work my way through a Taco Bell menu but little else. In order to actually learn Spanish I had to completely immerse myself in the language, even if it meant continually speaking to my classmates in Spanish through my alias (Paco).

Real Estate Foundational Terms

Despite being a relative new resident in the Orange County area, engrossing myself in real estate hasn’t been much of a challenge. Over a brief period, my interactions and conversations taught me my financial degrees and credentials were just as applicable in the realty world as they were in the stock market world. While evaluating real estate valuation techniques, I discovered two new key terms:

1)      NOI (Net Operating Income): Unlike stock analysis, which uses “Net Income” as a core driver in determining an asset’s value, real estate relies on NOI. Net operating income is generally derived by calculating income before depreciation and interest expense. In finance, there are many versions of income. I’m sure there are more explanations, but two reasons behind the selection of NOI in real estate valuation over other metrics is due to the following: a) NOI may be used as a proxy for cash flow, which can be integral in many valuation techniques; and b) NOI is “capital structure neutral” if comparing multiple properties. Therefore, NOI allows an investor to compare varying properties on an apples-to-apples basis regardless of whether a property is massively leveraged or debt-free.

2)      Cap Rate (Capitalization Rate): This ratio is computed by taking the NOI and dividing it by a property’s initial cost (or value). In stock market language, you can think of a “cap rate” as an inverted P/E (Price – Earnings) ratio – an inverted P/E ratio has also been called the “earnings yield.” Complicating terminology matters is the interchangeable use of income and earnings in the investment world. In the case of the P/E ratio, the denominator generally used is “Net Income.”

A shortcoming to the cap rate ratio, in my view, is the failure to deduct taxes. Although comparability across properties may get muddied, if determining profit availability to investors is the main goal, then I think an adjusted NOI (subtracting taxes) would be a more useful proxy for valuation purposes. Tax benefits associated with REITS (Real Estate Investment Trusts) complicates the metric usage issue further.

The simplistic beauty of marrying NOI and a cap rate is that a crude valuation estimate can be constructed by merely blending these two metrics together. For example, a commercial real estate property generating $500,000 in NOI that applies a 5% cap rate to the property can arrive at a valuation estimate of $10,000,000 ($500,000/.05).

Similarities between Stocks & Real Estate

At the end of the day, the theoretical value of ANY asset can be calculated by taking the projected after-tax cash flows and discounting that stream back into today’s dollars – whether we are talking about a stock, bond, derivative, real estate property, or other asset. Both stock and real estate analysis use readily available income numbers and price ratios to estimate cash flows and valuations. Regrettably, since real estate and equity investors generally play in different leagues, the rules and language are different.

The lingo used for analyzing separate asset classes may be unique, but the math and fundamental examination are the same. The formula for learning real estate is similar to that of Spanish – you need to dive in and immerse yourself into the new language. If you don’t believe me, just ask Paco.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in YUM or any other security mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 27, 2010 at 1:34 am 3 comments

Taking Facebook and Twitter Public

Facebook CEO Mark Zuckerberg

Facebook CEO Mark Zuckerberg

Valuing high growth companies is similar to answering a typical open-ended question posed to me during business school interviews: “Wade, how many ping pong balls can you fit in an empty 747 airplane?” Obviously, the estimation process is not an exact science, but rather an artistic exercise in which various techniques and strategies may be implemented to form a more educated guess. The same estimation principles apply to the tricky challenge of valuing high growth companies like Facebook and Twitter.

Cash is King

Where does one start? Conceptually, one method used to determine a company’s value is by taking the present value of all future cash flows. For growth companies, earnings and cash flows can vary dramatically and small changes in assumptions (i.e., revenue growth rates, profit margins, discount rates, taxes, etc.) can lead to drastically different valuations.  As I have mentioned in the past, cash flow analysis is a great way to value companies across a broad array of industries – excluding financial companies (see previous article on cash flow investing).

Mature companies operating in stable industries may be piling up cash because of limited revenue growth opportunities. Such companies may choose to pay out dividends, buyback stock, or possibly make acquisitions of target competitors. However, for hyper-growth companies earlier in their business life-cycles, (e.g., Facebook and Twitter), discretionary cash flow may be directly reinvested back into the company,  and/or allocated towards numerous growth projects. If these growth companies are not generating a lot of excess free cash flow (cash flow from operations minus capital expenditures), then how does one value such companies? Typically, under a traditional DCF (discounted cash flow model), modest early year cash flows are forecasted  until more substantial cash flows are generated in the future, at which point all cash flows are discounted back to today. This process is philosophically pure, but very imprecise and subject to the manipulation and bias of many inputs.

To combat the multi-year wiggle room of a subjective DCF, I choose to calculate what I call “adjusted free cash flow” (cash flow from operations minus depreciation and amortization). The adjusted free cash flow approach provides a perspective on how much cash a growth company theoretically can generate if it decides to not pursue incremental growth projects in excess of maintenance capital expenditures. In other words, I use depreciation and amortization as a proxy for maintenance CAPEX. I believe cash flow figures are much more reliable in valuing growth companies because such cash-based metrics are less subject to manipulation compared to traditional measures like earnings per share (EPS) and net income from the income statement.

Rationalizing Ratios

Other valuation methods to consider for growth companies*:

  • PE Ratio: The price-earnings ratio indicates how expensive a stock is by comparing its share price to the company’s earnings.
  • PEG Ratio (PE-to-Growth): This metric compares the PE ratio to the earnings growth rate percentage. As a rule of thumb, PEG ratios less than one are considered attractive to some investors, regardless of the absolute PE level.
  • Price-to-Sales: This ratio is less precise in my mind because companies can’t pay investors dividends, buy back stock, or make acquisitions with “sales” – discretionary capital comes from earnings and cash flows.
  • Price-to-Book: Compares the market capitalization (price) of the company with the book value (or equity) component on the balance sheet.
  • EV/EBITDA: Enterprise value (EV) is the total value of the market capitalization plus the value of the debt, divided by EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). Some investors use EBITDA as an income-based surrogate of cash flow.
  • FCF Yield: One of my personal favorites – you can think of this percentage as an inverted PE ratio that substitutes free cash flow for earnings. Rather than a yield on a bond, this ratio effectively provides investors with a discretionary cash yield on a stock.

*All The ratios above should be reviewed both on an absolute basis and relative basis in conjunction with comparable companies in an industry. Faster growing industries, in general, should carry higher ratio metrics.

Taking Facebook and Twitter Public

Before we can even take a stab at some of these growth company valuations, we need to look at the historical financial statements (income statement, balance sheet, and cash flow statement). In the case of Facebook and Twitter, since these companies are private, there are no publically available financial statements to peruse. Private investors are generally left in the dark, limited to public news related to what other early investors have paid for ownership stakes. For example, in July, a Russian internet company paid $100 million for a stake in Facebook, implying a $6.5 billion valuation for the total company.  Twitter recently obtained a $100 million investment from T. Rowe Price and Insight Venture Partners thereby valuing the total company at $1 billion.

Valuing growth companies is quite different than assessing traditional value companies. Because of the earnings and cash flow volatility in growth companies, the short-term financial results can be distorted. I choose to find market leading franchises that can sustain above average growth for longer periods of time (i.e., companies with “long runways”). For a minority of companies that can grow earnings and cash flows sustainably at above-average rates, I will take advantage of the perception surrounding current short-term “expensive” metrics, because eventually growth will convert valuation perception to “cheap.” Google Inc. (GOOG) is a perfect example – what many investors thought was ridiculously expensive, at the $85 per share Initial Public Offering (IPO) price, ended up skyrocketing to over $700 per share and continues to trade near a very respectable level of $500 per share.

The IPO market is heating up and A123 Systems Inc (AONE) is a fresh example. Often these companies are volatile growth companies that require a deep dive into the financial statements. There is no silver bullet, so different valuation metrics and techniques need to be reviewed in order to come up with more reasonable valuation estimates. Valuation measuring is no cakewalk, but I’ll take this challenge over estimating the number of ping pong balls I can fit in an airplane, any day. Valuing growth companies just requires an understanding of how the essential earnings and cash flow metrics integrate with the fundamental dynamics surrounding a particular company and industry. Now that you have graduated with a degree in Growth Company Valuation 101, you are ready to open your boutique investment bank and advise Facebook and Twitter on their IPO price (the fees can be lucrative if you are not under TARP regulations).

DISCLOSURE: Sidoxia Capital Management and client accounts do not have direct long positions AONE, however some Sidoxia client accounts do hold GOOG securities at the time this article was published. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

September 29, 2009 at 2:00 am 1 comment

Newer Posts


Receive Investing Caffeine blog posts by email.

Join 1,797 other followers

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services

Recognition

Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View | Kitces.com

Wade on Twitter…

Error: Twitter did not respond. Please wait a few minutes and refresh this page.

Share this blog

Bookmark and Share

Subscribe to Blog RSS

Monthly Archives