The advantage of writing a blog for 10+ years is that I don’t have to go anywhere to find examples of mistakes. I can always find one I have committed and written about it.To see the example of a PE driven investment gone wrong, read the analysis of Facor alloys here. In a year’s time, I realized that I had made a mistake and exited this position with a 12% loss – you can read my analysis hereIf I had held on to the position, I would have lost close to 85% of my investment, even as the stock continued to sell at a very low valuation (current PE being 3)
Reasoning from first principles
Reasoning from first principles leads one to understand the fundamentals factors driving the issue in question. So how do we apply this concept to investing?
I wrote the following on it
Lets break the above point down into its key components
- Free cash flow
You can find multiple definitions of cash flow, but the one which I like to use is the cash you can receive from the asset, without impairing its long term earning capacity. Lets apply this to a simpler example than a company – A house or a flat where it is easier to analyze the cash flows.Free cash flow – Can be estimated as follows : Gross rent – taxes – maintenance expense – other overheads
Maintenance expense usually involves repairing the house, cleaning it after the tenant vacates it and any other expense incurred to keep it in a rentable conditions. Other overheads can be society & broker charges to let out a house etc. So after paying out all these costs, the cash left behind would be the recurring free cash flow to an owner.Lifetime - This is the period an asset can be expected to generate a cash flow. In case of a flat or house one can take as it as 30 years, before one has to permanently replace it with a new construction. In an extreme condition you can stretch it to 50 years, however try letting out a very old house and you may realize that the rentals are much below the market rates.
Discount - The definition of discounting can be found here. Usually this depends on the riskiness of an asset.So how would you value the house or flat now?
The gross rental yields these days are usually around 2-3%. At these yields , one is in effect paying 50 times pre-tax free cash flow. This of course assumes 100% occupancy and no taxes.
Over the long term these rentals usually follow the inflation rate. So over the life of a flat or a house, you will earn back around 60% of the cost in the form of rental. The value of land underlying a house or a flat has been known to appreciate at the nominal GDP rate (GDP growth + inflation rate).If you put all these cash flows together and discount it at around 10%, the final DCF value comes to about 1.5X purchase price. In other words, the asset is generating an IRR of 12%.
Is this cheap or expensive? It depends on what you believe the price of land will be 30 years from now and if 12% is good enough for the risk and effort of managing a rental property.The problem with PE ratios
As you can see from the above example, the PE ratio is dependent on several variables which we had to estimate upfront. In the case of some assets such as a rental property, it may be possible to estimate it with a certain level of confidence.
This is however not always the caseLet say, for the sake of example, that the house turns out to be on an old burial ground where there are ghosts and so one want to rent or buy that land J . What happens then? Well the entire investment goes to zero.
On the other hand, lets assume that the government announces a large IT park close to the property and the rental go up by 5X. Irrespective of the actual increase in the property price, the cash flow based valuation definitely goes up as the rentals have increased drastically. This is what has occurred in several cities across the country in the last 10 years.So the initial PE turns out to be cheap or expensive depending on the subsequent cash flows and terminal value of the asset
PE ratio in equities is even more misleadingIn the case of companies, the problem we face is that the cash flows are quite difficult to estimate, there is no fixed duration and the terminal value in the real long run for any business is usually 0.
In the example of Facor alloys, the PE appeared to be low based on the recent cash flow (as of 2010) which had been in excess of 30 Crs. As a result, if one assumed that these cash flows would persist, the company appeared cheap at 3-4 times cash flow.The above assumption turned out to be wrong. The cash flows were at a peak due to a cyclical high in demand from the steel industry. In addition to a crash in the demand, the management diverted the cash flows to another sister firm which demonstrated poor corporate governance.
In effect, the expected cash flow and duration turned out to be wrong. In such a scenario, the PE ratio was simply misleading.As a counter example, consider the case of CRISIL (a past holding) which has always appeared expensive based on the usual measures of valuation. However the company has delivered above average returns as it has generated the expected cash flows without much variability in a fairly predictable fashion. The competitive position continues to improve and the company is likely to keep growing with a high return on invested capital for the foreseeable future.
Understand the businessThe only way to evaluate if a company is over or underpriced is to be able to predict its cash flow. The higher the valuation, the longer the prediction period.
So if a company is selling for 2 times earning and you are fairly confident that the current cash flow will persist for 5 years, then you have a bargain. On the other hand if you are looking at a commodity company whose cash flows depend on the price of a volatile commodity, then making any prediction is usually a waste of time. You may be able to look at some long price charts of the underlying commodity and get lucky from time to time, but good luck with trying to make it keystone of your investing strategy.On the flip side, if you are looking at a company selling for 100 times earnings, one needs to have a high degree of confidence on the expected cash flow for 20+ years and beyond. Anyone claiming such clairvoyance is worth of worship !!
The sweet spot is usually when the valuations appear reasonable (in 15-25 range) and one can make a reasonable estimate of the cash flow based on an in-depth understanding of the company, its industry and the competitive situation.In summary, the best way to approach an investment candidate is to filter out the extreme cases and then dig into the business as much as possible. This should help one make a reasonable estimate of the cash flows and its duration. Once you have a reasonable fix on these key inputs, doing a valuation and comparing it with the market price is the easy part.
Homework: Is coal india Ltd a value stock?It is selling for 10 times earnings net of cash for sure. Personally I think the PE ratio here is meaningless. One is making a bet that Coal will continue to be a dominant fuel for us for the next 10-20 years in face of dropping cost of solar and other energy sources such as Natural gas. In addition there is also the headwind of climate change regulations and drop in prices globally. In short I don’t know enough to predict the cash flow and hence the idea is a pass for me. If you plan to buy or hold it, you need to answer the above questions with a high degree of confidence.
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.