Find The Growth Choke Point For Better Valuation

The growth of corporations is always constrained by something.  The trick is figuring out what the “something” is.  Tonight, I am here to simplify it for you.

Financial businesses that are regulated

We value these via book value or tangible book value.  Capital levels constrain business growth, so look at the return on equity to help modify what the proper valuation level should be.  Book value and return on equity are what govern.

Non-financial businesses that are regulated, such as utilities 

Look to the rate base that the regulators use.  Book value might be a good substitute, but look to see how companies might invest to increase their “rate base.”  Market Cap as a ratio to what the regulators allow profits on would be ideal.

Unregulated businesses that are mature

These are governed by sales per share, calculating the price-to-sales ratio.  In general, it is wise to buy these when the P/S ratios are low, and sell them when they are high.

Unregulated businesses that are not mature

This is the complex part of valuation, but in this case the PEG Ratio makes sense.  Companies that grow their earnings rapidly can justify high P/E multiples, but in general they need to grow earnings more rapidly than their P/E ratio expressed in percentage terms.

I don’t invest in many immature businesses, so this is not so relevant to me.  I look for places where businesses are neglected, and I buy, while selling businesses that are more then fully valued.

Summary

Think about compounding.   Ask what will best compound the growth of your capital.  I suspect that it will resemble what I have written here.  Focus on compounding and ignore Modern Portfolio Theory.  Compounding is real business.  MPT is fakery from men who could not build a business.

By David Merkel, CFA of alephblog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.