Which valuation matters?

I was working through lists of companies other people had valued for a presentation I gave about the JSE-listed holding company (HoldCo) sector, and realised that perhaps this article needed to be written.

There are lots of different ways to value the same listed share, but which one is the correct one?

As a ‘rule of thumb’, the best approach to valuing a business, group or listed share is to use the key metric that you expect to generate future return.

This is important, so I will say it again:

The best valuation approach to valuing equity is to use the attribute that you believe will drive future returns.

In most normal situations in stock markets, this would be a company’s profits (also known as ‘cash flows’ or ‘free cash flows’). Sometimes the emphasis here is on historic profits and sometimes on future profits – but generally profits are key in driving shareholder returns.

Thus, using an ­earnings-based valuation approach would be most appropriate.

Luckily there are plenty of them to choose from.

Earnings-based valuations

For historic profits, the price-earnings (PE) ratio and the enterprise value to earnings before interest, tax, depreciation and amortisation (EV/Ebitda) ratio are good measures.

For future profits the discounted cash flow (DCF) approach, where the value of the investment is estimated using its expected future cash flows, works well.

The key caveats here are that the historic earnings may be a poor indicator of future earnings, and future earnings are only ever an educated guess of what things may look like.

But what if a company is not trading and is being liquidated? Or its earnings are heavily distorted by International Financial Reporting Standards (IFRS) requirements and a ‘cleaner’ metric needs to be selected?

Or if the company does not earn profits but investment returns from a portfolio of other companies (in other words, what if it is a HoldCo)?

Well, then future profits will be driven by the stock’s net asset value (NAV) and a valuation metric tracking this should be selected. For example, a price-to-book (PB) or price-to-tangible-book (PTB) ratio may be relevant. In the insurance space, this would be the price-to-embedded-value (PEV) ratio.

Read:

The key caveats here are that the book value of a company may be overstated (due to fraud, negligence or the nuances of IFRS), and even if book value is accurate, a suboptimal return on these assets will be accurately reflected in the market as a discount to this book value.

What about dividends?

Investing in normal equities for ‘yield’ is a lot like picking up pennies in front of a steamroller – you are taking excessive risk for an underwhelming return.

That said, some people, and more importantly some parts of the market such as the property sector, are actually yield-oriented.

In this case, by all means, use dividend-based valuations like dividend yield (DY) or the dividend discount model (DDM, also known as the Gordon Growth Model).

There are two key caveats here …

Firstly, management can decide what they pay out as dividends; thus, to some degree, dividends over short periods of time are not always reflective of economics.

Secondly, and over long periods of time, dividends are dictated by profits – so are you not just measuring a weak, lagging and somewhat manipulated version of profits here?

Take a look at Moneyweb’s Dividend Watch calendar here.

Many reasons to choose a stock

There are other reasons to buy stocks – from merger arbitrage or diversification to negative beta (such as gold miners) – but these are more exotic and not worth delving into with the limited space available here.

Overall, the best valuation approach to valuing equity is to use the attribute that you believe will drive future returns.

If you are buying for earnings, value the earnings.

Likewise with book and dividends. Though, in all cases, understand the caveats in these valuation metrics.

No approach is perfect, the future is always uncertain, and all we can do is shift the odds in our favour and diversify.

Listen to Simon Brown’s interview with Keith McLachlan about the layers of costs in holding companies (or read the transcript here):