I frequently – and humbly – say here that I am by no means the smartest man on the planet.
Despite never going to college, I’ve managed to do quite well for myself. I’ve cultivated some valuable skills over a storied, 30-year career in the investing business.
Of course, their research department usually consists of one analyst they follow at CNBC, but it’s often enough to delude them into thinking they can peddle their own bad investment ideas.
Do not listen to those clowns.
They’re using bad information and bad data – wrong, pointless metrics among them – and that can only lead to bad results. It will cost you.
One idea of this crowd, in particular, takes top prize in the “wrong and pointless” department…
Financial Pundits Love to Talk About This
I have reached the point where I want to smack anyone that even mentions the term price/earnings (P/E) ratio.
Ask any of those slightly above-average finance students what the P/E ratio is, and they will probably provide a one-sentence definition: “It’s a valuation metric,” is the most popular asinine answer that comes to mind.
If we learned anything from Enron, WorldCom, or more recently, Valeant (which by the way, just changed its name to Bausch Health in an effort to shed its scandal-ridden reputation), the denominator of the P/E equation can be… any number the firm’s accountants decide they like.
They can issue stock buybacks, fiddle with accrual or depreciation rates, or write the value of assets up and down to create, out of whole cloth, the number they want to show that quarter.
The ease with which earnings can be manipulated makes the P/E ratio all but meaningless.
The other major problem with P/E ratio is the way it can be quoted as based on trailing earnings, estimated earnings, this year’s earnings, last year’s earning, or even next year’s earnings.
If a company had a huge year and next year doesn’t look as good, its ostensibly desirable low P/E ratio could skyrocket pretty quickly.
You should never rely on the P/E ratio when assessing a company’s true value since the “valuation metric” doesn’t measure the true value at all.
It’s an indicator of the way the market inefficiently values a company and generally reflects how investors are inflating the company to loss-suitable levels.
In other words… leave P/E ratios to the talking heads.
I’ve got a real valuation yardstick to share with you.
It’s much more helpful when you’re endeavoring to accurately and appropriately value a company you want to own.
It tells you how well a company is operating, to boot.
But most importantly, this metric lets you gauge how much you stand to make in the not-too-distant future – a significant edge over some CNBC-addled schlub.
Cold, Hard Cash Is Still the King
It makes a lot more sense to focus on the cash flow that graces the company’s front door.
There are many ways you can use cash flow to spot the best companies that everyone seems to be overlooking.
Some of my friends have made a killing focusing on the price/free cash flow ratio.
Others use price/operating cash flow with decent results.
Me? I prefer using the enterprise value/earnings before interest and taxes (EV/EBIT) ratio for two simple reasons…
For one thing, both academic and school-of-hard-knocks studies prove it’s the best measure for identifying undervalued stocks with the potential for extraordinarily high returns.
What’s more, this metric is, quite simply, a gauge that big-money investors – you know, the folks who buy sports teams – use to spot that beautiful, vanishingly rare beast: a bargain opportunity.
When a money-management company evaluates potential candidates, it considers the enterprise multiple, not the price/(easily manipulated) generally accepted accounting practices (GAAP) number. So do the CEOs and CFOs of companies looking to grow by acquiring and building assets.
As a lifelong disciple of legends like Ben Graham, Peter Cundiff, and Marty Whitman, I really get frosted by folks who tell me a stock is a bargain based on the fact that it is trading below book value.
Here’s a Quick Real-World Example of a Fake Bargain
People define book value as the true net worth of a company. However, under GAAP accounting, a lot of intangible assets may be included in that number that may or may not have actual value.
I don’t like paying for the “maybe,” so price/book is not a great tool despite being thrown around all the time on TV.
Let’s look at News Corp. (Nasdaq: NWSA) as a great example of book value being a poor reflection of the real asset value of a company.
The company currently trades for 83% of book value. In theory, that means you can buy the stock for the value of the assets for less than they are worth. You pay nothing for the operating part of the business.
What a bargain! Well… that couldn’t be further from the truth.
Because, believe it or not, $16.4 billion worth of the company’s assets have no real value.
No kidding: They’re listed on the balance sheet as “intangible” and include things like goodwill from acquisitions, patents, copyrights, trademarks, and a bunch of other stuff that, frankly, doesn’t physically exist.
Those are worthless to me, so I adjust book value to tangible book value by removing all intangible assets from the equation.
Guess what happens when I do that.
When I do that, NWSA shares trade at more than five times tangible book value; they’re no longer the bargain everyone expects based on asset value.
The bottom line? It all boils down to selecting purchases based on the same criteria that the big-money guys use. Big-money methods can add up to big-money returns.
Taking control of your own portfolio and financial future means using the numbers that people who buy businesses use – not the stories the talking heads give you every day.
— Tim Melvin
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Source: Money Morning