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.
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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.
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