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Author: FDWBaltimore Two stars, 250 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: Re: Today's rule-maker column Date: 6/2/2000 7:23 PM
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"If you can buy the best companies, over time the pricing takes care of itself." - Charlie Munger, Berkshire Hathaway (OID)

That doesn't mean you can't underperform for a number of decades by overpaying for something. I think Munger has given that caveat to the thought you're citing here. Over long periods of time, yes, a company's return on capital will convene with its return to shareholders...it's pure mathematics. But let's just look at the fact that much of Cisco's capital isn't even reflected on the balance sheet (because Cisco refuses to have it reflected through its selection of accounting methods that does not reflect the equity value they trade for acquired intellectual property and other assets). We don't really know what its return on capital is. Yahoo! does the same thing, although they've done fewer huge acquisitions, so it's easier to construct. How do you make a judgment about the long-term return on capital for a company, and thus your long term returns to investors, when you can't even tell what today's return to investors is?

I hereby encourage the valuation superstar out there who can use all the available data (there's tons of it) to show me the valuation methodology that:

- in 1980, proves Wal-Mart (NYSE: WMT) will be worth $260 billion today
- in 1990, proves Microsoft will be worth $350 billion today
- in 1994, proves Cisco will be worth $450 billion today.


What do you mean? Matt Richey knows how to do a discounted cash flows. Mechanically, it's quite simple. It's having the judgment ability to look forward and use the right inputs to say "Yes, I believe Wal-Mart can increase its fixed assets at 25% per year for 20 years, it can do 'X' working capital turns, it can achieve 'X' profit margins, and it can achieve 'X' return on capital." If you can answer those questions, then you'd feel confident in assessing the intrinsic value of Wal-Mart in 1970, Microsoft in 1990, or Cisco in 1994. "Valuation" as you have identified it, Tom, has very little to do with the current P/E or the current price/sales or price/book ratios. That stuff is quite basic and not highly predictive. On the other hand, if know some things about accounting and can make some basic forecasts about business, stating your assumptions explicitly rather than assuming a company makes a great investment at any price because it has made a great investment at a number of prices in the past, then you can start to use valuation as a tool to assess risk and reward.

The valuation tool has been invented. Buffett and many other very good value investors, some of whom you know personally, use it all the time. They talk about it all the time. It's called a cash flow assumption and its practical manifestation is a discounted cash flow calculation . In it, you explicitly state your premises rather than trusting that the premises embedded in the market price of an equity can be ignored since return on capital and return to investors converge at a point 30 years in the future.

By the way, there's no reason you can't pay 700 times earnings for a company or 30 times sales or whatever multiple to a static accounting factor and still buy something at a great discount to intrinsic value. The value investor would counter that this is entirely possible. But the value investor would also say that you have reduced your margin of safety in doing so. The intelligent value investor doesn't deny there are 30, 50, and 500 baggers out there. They are just a little less formulaic and a little more skeptical than the trusting approach of the Rule Maker.

Remember, Fools, earnings and earnings-per-share (EPS) accounting doesn't reflect the balance sheet, which is critical to the analysis of any business.

I agree wholeheartedly. But the Rule Maker only pays attention to part of the balance sheet. Great attention is paid to current assets, current liabilities, and long-term debt. You don't deal with long-term assets and the equity statement. I can understand why you don't deal with long-term assets, since one of your favorite companies, Cisco, refuses to show on its balance sheet tens of billions dollars of intellectual property it now acquires on a yearly basis to keep its cash flow growing. You don't have a business at Cisco without all the long-term assets it acquires and all the shares it issues to acquire these. But you all aren't analyzing this. Every time Cisco issues shares, it's trading away part of the company you guys love and hold up as one of the great companies of our time. I would think there would be more of an ongoing analysis of the rewards of trading away ownership stakes in the current, great company for rewards that are on the if-come.

If our Rule Maker companies are required to justify their valuations based on Wall Street earnings estimates, well, we're in trouble.

This is a straw man. Most great investors (heck, most good investors) don't rely on Wall Street estimates. Wall Street analysts are good for helping you to understand a business, which is the most important thing. They're not as good, on the whole, at helping you to make a good investing decision. But that doesn't mean they're imbeciles or the system is really screwed up. It just means you have to know how to use their work, which is in many cases very good to excellent. These aren't dumb people. I think you set them up as straw men and straw women much too often.

Foolish aside: Because of the relative weakness of "earnings" as a measure of corporate success, I think we should slap a $10 fine on any writer in this space who suggests that the P/E ratio is a useful tool for investors. In fact, I propose that, due to its irrelevance, it henceforth be referred to by the authors of this column as the P-Wee Ratio.

Earnings can serve as a fine proxy for cash flow in many cases. "Never" and "always" have many places in the vocabulary of intelligent, skeptical investors, but this is a little dogmatic. I think the Rule Maker approach should be more than commended, it should be celebrated across the universe, for bringing working capital issues to the process of learning about investing. Wall Street is in at least 90% of its research totally oblivious to working capital issues, at least until they show up as an earnings issue long after they've shown up as working capital issues. But this prohibition is a little dogmatic.

Not that I don't like your sense of humor.

Okay, I've gone on long enough. I'll conclude by saying that the market may still be overvalued.

I propose that the value of "the market" be discussed only under severe duress or in case of Martian invasion. Why waste your time on it? We're all business analysts -- let's focus on what we can control and not on what we can't.

Until then, I see nothing wrong with 1) continuing to enjoy 99% of what Bill Mann writes while 2) continuing to pursue the Rule Maker's labor-light, tax-deferred, commission-free growth -- whether that's 8%, 10%, 13%, or 15% a year. I think it'll beat the market's average return.

I don't think you have to imprison yourself to achieve returns that are far better over the long-term than the upper end of your estimate here. Buffett's not some awkwardly inward guy. He's a great Dad and citizen. While Munger may have worked hard as a younger man, I think you'll see in his upcoming biography that he lead a full life and is appreciated as a wonderful person by many people. But this is the point of value investing. To maximize the upside and reduce the probability of the downside. Going to the trouble to value something correctly increases the potential upside while decreasing the potential downside. I don't see anything wrong in the world with that.

Dale
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