Valuation Lecture

[Leda Billock]

Johngreat piece. Thanks for sharing it! We've been growing in our understanding of the power of low PE's over the long term. We think some of the energy names provide great examples on this potential today.

I recently had a chance to give a guest lecture at NC State University to the students who run Bell Tower Capital Management, a student-managed investment fund. I really enjoyed the meeting. There are some high-quality investment professionals in the making at NCSU.

The talk is called \\\"The Three Engines of Value\\\" (link below) \u2014 a topic I've touched on briefly in client letters over the years. It outline the 3 simple factors that drive each stock\u2019s price over time:

One of the things that is often overlooked in the stock market is how valuable it is to have a low valuation. If your company is self funding (meaning, it doesn\u2019t need to rely on a high stock price as currency to raise fresh funds to cover losses), then a low valuation is a blessing, not a curse. I see so many companies talking about their strategy to \u201Cget out multiple up\u201D, but this is not beneficial to long term owners. To better understand why this is, it\u2019s important to remember that there are three driver\u2019s of value for each and every stock: Growth, the change in the valuation, and the change in the shares outstanding. So many people focus on the multiple, and certainly a stock that goes from say 10 to 20 times earnings over a decade has a nice 7% annual tailwind from that multiple expansion. But what many management teams often forget is that a low multiple can create more value over the long run than a one time bump in valuation.

In 2020, an intern and I completed a study of the best performing stocks from 2005 to 2020, which encompassed the financial crisis, a deep recession, an expansion, and the early days of Covid. Many attributes of these winners are obvious (such as secular tailwinds that led to huge sales growth). But, a number of stocks on the list were merely moderate growers which had something that the high fliers didn\u2019t have: a cheap stock that persisted for many years. This gave the company the ability to consistently buy back shares at a high earnings yield. Basically, a stock that averaged 12 P/E for a long period of time is going to create far more long term value than if this same company traded at 30 P/E, because the market\u2019s lower valuation allows the company to reduce far more shares than they otherwise would have. Apple at 10 P/E was a stock in 2016 that was going to create enormous value given their FCF yield (which was all getting returned to owners) plus the growth (which even at a modest rate of 8% still meant an 18% intrinsic growth rate per share). Apple\u2019s P/E rose and pulled forward even more returns in the last 7 years, but some of the great all time winners were able to benefit from a multiple that didn\u2019t rise, meaning this 18% rate could continue as long as the company\u2019s modest sales growth rate of 8% lasted.

A number of winners on this list fit this general description: a modest but very consistent growth rate, a lot of free cash flow, and a persistently low to moderate P/E ratio. Some of the best stocks of the last quarter century including AutoZone, O'Reilly Auto Parts, and NVR never really have seen high multiples (part of the reason why their stocks continue to do so well even today). There are many others that are on this list, and there are a number of potential candidates that I believe will be the next decade\u2019s crop of stealth compounders (those that aren\u2019t growing at exciting rates but have strong moats, predictable businesses, free cash flow and shrinking share counts).

The lesson here, though, is to think about the three drivers and not get too focused on one at the expense of the other two. The best stocks over the very long term tend to have at least moderate growth (fast growth is nice but isn\u2019t necessary, and sometimes can lead to poor capital allocation). But the winners also tend to have the other two engines working in their favor as well. In the talk, I outlined a few examples, starting with a quiz that a friend of mine once gave me that highlights the value of these three engines:

John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber\u2019s strategy is to make very carefully selected investments in undervalued stocks of great businesses.

Description: This video lecture presents the definition of an asset as a sequence of current and future cash flows, and the implications of that definition. Valuation of cash flows is presented in the context of time, certainty, and the present value operator.

Description: This video lecture starts with a discussion of leverage ratio with an example from Lehman Brothers. The video lecture then continues to cover the last portion of present value relations, including inflation and how to calculate real and nominal rate of return.

This document contains my lecture notes on Valuation and Security Analysis developed over 25 years while teaching at Cornell, University of Chicago, and Northwestern University. There are twelve lecture notes in this document covering cash flows, valuation, cost of capital, and security analysis. Additional teaching material including EXCEL valuation templates are available for download at my personal website: www.sharingfin.com. All of these are provided as is for anyone to use. They could be useful for teaching Valuation, Security Analysis, and Financial Statement Analysis.

Accurate company valuation is the starting point of value investing and corporate decisions. This paper proposes a statistical factor model to generate company valuation across a large universe. The model scales the market value of a company by its book capital to generate a cross-sectionally comparable relative value target and constructs valuation factors by combining several descriptors from a similar category to increase coverage and reduce multicollinearity. Company relative value is mapped to industry classification and the valuation factors via a cross-sectional regression at each date. Historical analysis of U.S. publicly traded companies shows that the factor model explains a large proportion of the cross-sectional variation of company relative value and experiences little out-of-sample degeneration. The regression residual represents temporary company misvaluation, and can be exploited by both outside investors as attractive investment opportunities and internal management for market timing of corporate decisions.

Professor Liuren Wu is the Wollman Distinguished Professor of Finance at Zicklin School of Business, Baruch College, City University of New York. Professor Wu's research interests include option pricing, credit risk, and term structure modeling, market microstructure, and general asset pricing. Professor Wu has published over 50 articles, many of them in top finance journals such as the Journal of Finance, the Journal of Financial Economics, Review of Financial Studies, the Journal of Financial and Quantitative Analysis, Management Science, and Journal of Monetary Economics. Wu has worked extensively as a consultant in the finance industry, including data vendors, investment banks, and several fixed incomes, equity, and equity options hedge funds and market-making firms. As a consultant, he has developed statistical arbitrage strategies, risk management procedures, optimal trade execution and market-making strategies, and quantitative models for pricing fixed income and equity derivative securities.

Knowledge of fundamental analysis and security valuation is essential to assess the information content of financial statements, isolate the long-term value drivers of a business, and successfully implement trading strategies.

Investment bankers, asset managers, financial analysts, and private equity investors use fundamental analysis techniques to critically evaluate financial data and design complex valuation models to guide their strategic decisions.

Students are expected to develop security analysis and valuation skills to support the interpretation, evaluation, and use of financial information from the viewpoint of major users of financial statements (i.e. equity investors, corporate lenders, etc.). Ultimately, students will be able to analyse a wide variety of financial reporting issues and discuss their valuation implications drawing on cutting-edge academic research and real-world case studies, including Apple, Ferrari, Netflix, and Tesco.

Please note: Assessment is optional but may be required for credit by your home institution. Your home institution will be able to advise how you can meet their credit requirements. For more information on exams and credit, read Teaching and assessment

This course is aimed at students who, at some point in their careers, expect to use financial reporting information to evaluate past and current performance, assess future prospects, and estimate the intrinsic value of a business. The primary focus of the course is on the analysis of public corporations, but many tools and techniques that students will learn are also relevant to private company fundamental analysis.

This course will be particularly valuable to students who are contemplating careers in investment banking, security analysis, asset management, private equity, strategy consulting, and auditing. The course should also prove useful to those students currently undertaking interviews and assessments for careers in the finance, accounting, and consultancy sectors.

The Department offers an outstanding interdisciplinary research environment, retaining close ties with other departments and professional communities which ensures that our faculty work at the cutting edge of new developments in accounting practice. Students gain the knowledge, critical thinking and analytical skills to break down complex ideas and apply new concepts to real-world problems, preparing them with the necessary skills to thrive in various sectors, including corporate, government, non-profit and the public sector.

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