As do most value investors, I look at buying a stock in the same way as I’d look at buying an interest in a private business. To realize an outstanding return, I’m looking to buy an interest in the business at a large discount to the discounted cash flows that will accrue to me as the owner. This means completely ignoring price momentum, liquidity, moving averages, macroeconomic forecasts and other items that are of interest to short-term traders and most financial media.
There are two main ways in which a stock can trade at a discount to its true value: on the basis of its assets or its earnings.
1) Asset Basis
In this category, a stock may be trading at a discount to the value of some asset(s) the company owns, less its liabilities. These assets could include hard assets such as the company’s cash holdings, its receivables and its inventory, or even intangible assets such as wireless spectrum and patents.
It’s important to recognize assets and liabilities that aren’t on the balance sheet as well. For example, a piece of real estate purchased years ago will still be carried at its historical cost on the balance sheet, while some obligations (such as operating leases and the outcome of uncertain legal disputes) aren’t included at all.
2) Earnings Basis
A stock may also trade at a discount to the company’s earnings power. A P/E in the single digits combined with low net debt levels make for a good candidate for this category.
What’s important here is that the investor not assume that current earnings are indefinitely repeatable. The investor must have a good understanding of the business, in order to be able to determine whether earnings are sustainable. Without this understanding, figuring out whether a stock trades at a discount to its earnings power is impossible!
In both asset and earnings cases, however, one has to be on the lookout for potential value erosion. For example, while a stock may trade for substantially less than the value of its assets, if the company is cash flow negative it may incur debts against that asset, reducing cash that could otherwise accrue to shareholders. At the same time, if cash flow from operations is diverted to low-return investments (e.g. a high-priced acquisition), even a stock that appears to trade at a discount to earnings power could make for a poor investment.
To avoid falling into such traps, investors should study management’s track record and incentives. Does management have a history of making poor acquisitions or does it return excess cash to shareholders? Does management receive bonuses based on revenue growth or based on returns on capital? For public companies, all of this information is in the public domain.
Here are some suggestions. Happy investing!