It’s easy to find good listed businesses; the ASX is full of them. The challenge is buying them at the right time. And I’m not talking about trying to time the market – that is a fool’s game. But buying these excellent companies when their valuation is favourable is the key to good investing.
There are two main methods we use at Farnam to value a business: by building a discounted cash flow (DCF) and using a price to earnings (PE) multiple. A detailed explanation of each is beyond the scope of this article, but briefly, a DCF values the business based on future expected earnings discounted to the net present value, and the PE takes the current multiple the stock trades on and compares it to a group of industry peers.
Buying a business is not dissimilar to other purchases you might make. Warren Buffet noted in the Berkshire Hathaway 2008 Shareholder Letter that he likes to buy quality merchandise when it is marked down; the same goes for buying stocks. He says:
“Price is what you pay, value is what you get”.
The inverse of the above is also true; something can still be overpriced and poor value, even if that thing is high quality. The only difference is, with buying companies, the price that is determined by markets may not necessarily match the underlying valuation as determined by a DCF or PE.
For example, if the market expects strong comparative earnings to flow, the share price will inflate as more people want a piece of the action. This might push the valuation of the company higher than its intrinsic calculated value. This will not only give a higher PE valuation and a lower earnings yield, but will also increase the risk of investing in this stock, because in the event that earnings do not flow, the market will de-rate the company’s PE ratio back to something more reasonable.
And the higher the valuation is relative to the projected earnings profile, the harder the share price will fall.
Take Aconex (ASX: ACX) for example. In late January Aconex was trading at $5.44 on a 2018 forward PE of 35x (according to Morgan Stanley). To be trading on this multiple 1 year out is huge, even when you take into account the 2018 forecast earnings of 50% (10cps to 15cps).
What eventuated was that the company announced future earnings would be lower than estimates, which sparked a savage sell off down to $3.10. Interestingly, with the new 2018 consensus forecast of 8 cps the multiple is still high at 39x!
Another example is Dominos (ASX: DMP), whose price peaked at $80 per share in August 2016, when it’s 2016 results were released. This gave the company an astonishing 75x PE multiple. Since this excitement, and despite generally positive news flow, the price has gently drifted down to around $57 (in mid Feb 2016). The market realised that the valuation was too high and has steadily de-rated it. Interestingly, even at $57 per share, our DCF still only values the company at ~$30.
Without a doubt these companies are both high quality. But the share price was bid up based on sentiment and future expectations. High quality and strong forecasts increase demand for the stock and naturally increase the share price and valuation. When the market realised these future expectations were unrealistic, the share price suffered.
Occasionally, an overvalued stock will continue growing its share price and significant value will continue to be created for shareholders. But it is worth bearing in mind that companies cannot continue growing at high rates forever, so at some point the PE will need to come down to sustainable levels. This will either be in the form of slowing EPS growth or share price stagnation while EPS catches up.
Obviously a lot more goes into stock picking than just valuation; you have to make sure that a lot of other fundamentals are in place as well, but when the fundamentals are good, the valuation just helps you know if now is the right time to buy.
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation and needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.