Valuations Have Limits: Think Of The Bankruptcy Pecking Order

Valuations Have Limits by David Merkel, CFA of Aleph Blog

Every now and then, some will argue that there are no limits on valuations.  This tends to happen in bull markets.  We are getting that now.

This sentiment is sometimes due to ignorance, because bull markets encourage cheerleaders.  There are few who will oppose a bull market, though many who will talk about it after the bear market emerges, as if they had predicted it.

But there are limits on valuations.  Think of the bankruptcy pecking order.

• Government and lawyers get paid
• General creditors get paid
• Banks and secured bondholders get paid
• Unsecured bondholders get paid
• Preferred stockholders get paid
• Common stockholders get paid

That is the way you should think about risk.  What are the odds that you do not get paid?  The higher the odds that you don’t get paid, the higher the yield you must receive.  Don’t own a stock unless you are likely to be earning significantly more then the preferred stock, much less debt instruments on the same company.

That is why I look at the value of various claims on a company.  It gives me data on where the stock should be valued.

I encourage all readers to think like businessmen about investments, because it leads to the best results.  Analyze where valuations are cheap, and where free cash flow is being productively deployed.

That is the way to think about investing.  Think like an intelligent businessman, and only buy companies that you would like to run.