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Author: howardroark Big red star, 1000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 72336  
Subject: Re: Valuation Question - Andrew and Others Date: 7/11/2002 5:21 PM
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I am really struggling with the valuation metrics in this economic time when:

1) Surprise down guidances are routine
2) No meaningful forcast is offered by many companies or timeline for recovery
3) Numbers themselves are in question related to uncertain accounting

Just curious how you are reconsiling these concerns and identifying meaningful valuation parameters that you would be willing to act on?


I don't think you thoroughly thought through this question before posing it (tho there). Are you sure it's in your best interests to give me what amounts to an open invitation to ramble incessantly? For future reference, I think your mistake might have been somewhere in the broad expanses of the "others" category in your saluation. Next time you might want to consider "Valuation Question - Andrew and Guest." For now, I'm sorry to say, it's too late.

I think your question is important, not so much because it addresses an issue that many investors are probably currently worried about, but rather because it goes to heart of many common misconceptions about valuation in the first place. It might be easier to address your concerns seriatim.

1) Surprise down guidances are routine

And not just your run of the mill surprising donward guidance either, but whipsawed, head-jerking, jaw-dropping ricochets from triple digit positive growth to double digit negative growth in many cases. How are valuation models such as DCF supposed to provide any value when a company can go from doubling the number of switches they sell every quarter to losing 3/4 of their revenue in a month? What about all those sky high price targets of yesteryear by the I-banks? I mean, sure they were a wee bit conflicted, but they still at least went through the motions of attaching fancy post hoc DCF rationalizations of their target prices that seemed consistent with the late 90s ebullient economic growth, right? How does this...

http://boards.fool.com/Message.asp?mid=12064562

turn into this...

http://www.forbes.com/newswire/2002/05/15/rtr603543.html

...and not leave valuation dead in its wake?

Because you're killing off the wrong villain. It isn't valuation that turned out to be problem here, but its twin nephews precision and certainty. That is, it was true in 2000 and it is true today that if I knew precisely and certainly what RBAK's future cash flows were going to be, I could easily use the template of valuation to determine buy and sell prices. Unfortunately, precision and certainty are more elusive than most people think.

This turns out to be especially true for companies experiencnig tremendous growth, companies in quickly growing industries and companies with large historical operating variances, but it's in fact true for all equities. We are simply not all that good at predicting the future, at least relative to how good we are at sounding prescient. Is it surprising the Tom Peters' Excellent Companies went on to substantially underperform the market or that growth stocks have traditionally and internationally underperformed more pessimistically priced stocks? Even the Nifty Fifty, which Jeremy Siegel noted as having gone on to beat the S&P (by the way, the Nifty Fifty wasn't nearly as expensive as some think, several of its components traded for less than 30X earnings), now looks as though it's underperformed the market since 1972 (Kmart, Xerox and Polaroid haven't helped).

Like the weather, we are only so good at predicting the future of firms' equity flows, something that's required to value a company today. Sunny days will shockingly turn into hurricanes and 100% growth will turn into -20% growth, but this doesn't mean we should throw away our satellites. That would only makes sense if we had absolutely zero ability to predict the future, and that's certainly not true. For example, I'd be happy bet you even odds that MRK will make more money than CMGI over the next twenty years. So rather than worry about valuation itself, it's probably a better idea to do what we normally do when we realize we're not as clarivoyant as we thought we were...hedge our bets and either seek relative certainty or make sure we get rewarded for the uncertainty we're embracing. More on that in a minute.

2) No meaningful forcast is offered by many companies or timeline for recovery

That's good, because in most cases, they don't know either, particularly as to what's in store outside of the next two quarters, and that latter period is where 99% of the value current shareholders are paying today for will be generated.

http://www.fool.com/portfolios/rulemaker/2000/rulemaker000510.htm

But the perceived lack of company guidance (you think there's a lack of company guidance now, there was a time when earnings guidance was about as common as press releases saying "Gap, Inc. (yet again) Reports Crappy Same Store Sales For June Despite Easy Comparisons and Heavy Promotion.") I think the lesson here is not only that company guidance makes up only a small piece of firm value, but also that you can't use a company's apparent confidence in its future numbers as a way to avoid the inherent uncertainty and imprecision of tomorrow. They are elusive for everyone, and maybe a little more so for David Wetherell.

3) Numbers themselves are in question related to uncertain accounting

This is a serious problem, no doubt. It's no good even trying to go about predicting the weather when you don't even know if your balloons are picking up actual atmospheric data or feeds from XM Satellite radio. Similarly, it's no good pricing plumbers if one of them is going to come in and steel your life sized Jack Grubman doll. Any reasonable valuation of most companies hinges in huge part on the veracity of the historical financial results, and I don't care how much you trust the CEO and CFO of your favorite firm, you can never really Know, in the capital K Platonic sense, that things are as they say they are. I couldn't have detected WCOM's line-shifting with six months and a magnifying glass.

And yet I still price shop when I hire plumbers. But ever since I lost that Henry Blodget figurine, I not only check references, but I have him come at the same time as the electrician and I won't pay as much for plumbing. It's impossible for me to precisely measure the precise risk of fraud that remains (nobody expects the Spanish Inquisition), but that's not going to stop me from price shopping for plumbers.

In this case, I would return to the critical point above, which is, are public firms financial statements so rife with fraud so as to render them wholly worthless, equivalent to the output of a random number generator? I would say no. Clearly no. I may again have my certainty dented a bit, which could require the aforementioned additional considerations, but importantly, it doesn't vitiate the underlying idea that the only way we know how much to pay for an asset besides guessing what someone else will pay tomorrow, is to estimate what that asset might be worth.

Just curious how you are reconsiling these concerns and identifying meaningful valuation parameters that you would be willing to act on?

I'm not doing anything different. There are, however, some things that I generally try to do to embrace the inherent imprecision and uncertainty in valuing companies that exists today, existed ten years ago, and will exist ten years from now.

For one, I only make bets where I believe I have an actual opinion. If you asked me, for example, what Juniper was worth, I would say "somewhere between a lot or a little," and that's about the best I could do. I probably couldn't distinguish between Sycamore at an Enterprise Value of zero (I believe that's its current EV give or take) and Sycamore with an EV of $40 billion. Maybe someone else can get comfortable with a smaller range, because they have a real opinion as to whether SYCM can grow at, say, 30% a year rather than 5% a year. For me and my ignorance, it would inevitably take a substantially negative EV to even consider the situation. So, unless and until a company comes outside of my ignorance range, I won't invest. And my ignorance range is usually pretty damn wide. The easiest way, I find, to determine exactly where my ignorance range lies is to run sensitivity analyses (vary my valuation assumptions, but this can be a mental step in many cases) and see if I really believe one scenario is more likely than another, or if I simply have no idea. This opinion-seeking generally leads me to industries I believe I know well and can understand, and even more commonly to companies whose prices don't require inordinate amounts of future growth to satisfy their implied valuation requirements, but that needn't be everyone's approach.

Second, even when I have an opinion on a company's value versus its market price, I try to consider how fragile that opinion is. That is, because I understand that being in the business of actively picking stocks as opposed to passively minimizing risk across thousands of baskets, I not only seek situations where I have an opinion, but those where I can have as much certainty and precision as possible. The less certainty and precision I felt I had, the greater return I would require and the smaller portion of my capital I'd be willing to commit to that investment. The more you choose to eschew certainty and seek return, the more important it is to diversify your bets. Even if you get someone to give you 40:1 odds at roulette wheel, you'd better be sure you're making a lot of bets. And even this basket-spreading is deadly if you've violated rule number one (above), which is to make sure you have a valuation opinion before you invest. So, while I generally don't take the venture capitalist approach to investing...

http://www.fool.com/portfolios/rulebreaker/1999/rulebreaker991215.htm

...if I did, I would make many diversified bets only in place where I had a valuation opinion. For me, that wouldn't be very many, which is why I'm glad that others feel different, since venture capital is an incredibly important part of our economy when it isn't creating bubbles.

Third, I respect the fact that, even in cases where I feel relatively certain, I still can't perfectly predict the weather. I can't know for sure if pipeline will run dry, or consumer tastes will abruptly shift, or a technological disruption will come out of nowhere, or if the company has for years been violating federal Medicare laws. So even after restricting myself to situations where I feel I have a valuation opinion and a higher than normal degree of certanity in my ability to see the future, I still try to avoid imprudent concentration of risks. I can't tell you where that line of imprudency is, or even if that's a word (though there are many who think they know for certain), but I can tell you where it isn't.

http://boards.fool.com/Message.asp?mid=12235218&sort=username

It is not easy to estimate an infinite set of anything let alone future cash flows. The key is to embrace your ignorance and consciously consider the bets and risks you implicitly take with each investment and with your portofolio overall. But valuation is still the same as it was in March, 2000 and in March, 1991. The question isn't whether you should keep calculating odds, because odds are all you've got, but which table you should play at and how much, if anything, you should bet.




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