Investment textbooks taught us all about valuation and then a box from the 1980s was delivered and subsequently skewed all that learnedness into another direction. That new direction was to put valuation on a continuum — as it always is/was — and named the edges of the continuum value and growth. The box was meant to be educational and clarifying; it was but it also perverted the art of investing into thinking that value and growth were distinct things. They are not. It's time that we unpack that box.
Valuation is done based upon estimating the value of assets owned and adding the estimated future earnings in today's dollars. We could argue that estimating the value of assets owned is easier than estimating the unknown future of a company's earnings. And, estimating future earnings — always difficult — is even more so when a business is growing. Add the fact that growing businesses are often valued and priced higher than stable, slow growers and you can understand how the box was labeled. The box was trying to make sense of the range of prices, but prices by themselves don't indicate value. You can think of it as simply as this formula: Price=value +/- an error residual.
What's the error residual? It could be based upon a security's relative popularity or lack thereof (see the CFA Institute Research Foundation monograph "Popularity: A Bridge between Classical and Behavioral Finance"), a specific quantitative view or maybe even an AI that ran amok. The bottom line is we understand prices much more than we understand underlying value.
Let's rethink the continuum based upon something clearer and unchanging — time. After all, valuation requires cash flows and time, or the investment is tantamount to being a "collectible" (e.g., gold, not that there's anything wrong with collectibles.) On one end of the continuum we have value based upon owned assets, and where time is T and T=0. On the other end of the spectrum we have value based upon the present value of future earnings, T+1. A discount on either end of the spectrum is still a discount, good, but T=0 is more certain than T+1. All investors like discounts, some require less certainty, and nobody likes overpaying.
It's about valuation! The continuum ranges from what we think we know today to what we believe we know about some tomorrow. This approach also allows us to clearly differentiate between types of valuations and momentum, which is solely about price movements (the box included momentum managed funds under the growth label, huh?) We can now review real issues that exist today:
While this is part of the art in the business, everyone's an artist. It used to be common to use the 10-year U.S. Treasury bond rate plus a risk-premium margin in this calculation. However, the appropriateness of that approach given a 10-year U.S. Treasury yields below 1% is … not accepted by artists. Perhaps more acceptable during these unique times (will unique ever end?), would be to use a discount rate commensurate with the given businesses cost of capital as some artists already use. Keep in mind that for some businesses (i.e., Apple Inc.) you could still end up using what seems to be an insanely low discount number.
And, when discounting, try zeroing out the next 12 months of earnings. Notice the present valuation difference from of those near-term zero earnings. It's not so big. In fact, you could have seen price valuations higher than the market prices seen during March's bear visit.
The concept of valuing owned assets seems straightforward enough until you start to factor in the real movement toward asset-light business models. Moreover, intellectual property and brand value is very real in today's world. This implies that fewer securities will see T=0 as relevant and relatively easy to assess. The affinity group of investors that have historically required more certainty in their valuations seem to be shrinking as a result.
There are more issues that affect valuation, but this article is not meant to address all the issues as much as addressing the model itself. Both "value and growth" investors appreciate discounts and discounts represent value, so why are we still using growth as a descriptor? For example, a company growing at 20% a year selling at a 25 multiple — both of which seem to imply a "growth company" — is a value. Can we please begin to think outside of that box? We are all "value" investors; there is still art with this science and none of us willingly pay more than our measure of value.
Michael S. Falk is a partner at Focus Consulting Group, Chicago. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.
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