Alternative valuation methods are harmful to one's pocket

Ben Graham taught us to look for discounts to net current asset value in order to protect against large declines in stock prices. Net current assets are current assets (cash and equivalents) minus current liabilities (all debts to be paid within a year).

But despite this method being proven to provide good results with minimal downside, people still choose to dream up their own convoluted valuation methods for investment.

Consider for example the use of the "eyeballs" metric at the peak of the dot-com bubble. Firms with no income were being appraised based on the number of people visiting these companies' web sites. That can barely show potential for future revenue, and it says nothing about real earning power nor what matters, profit-making.

While "eyeballs" seems ridiculous in hindsight, it wasn't questioned by many back then.

Other unproven valuation metrics are created all the time. Consider for example "economic goodwill". It states that the difference between market capitalization (share price times number of shares outstanding) and net tangible book value is the amount of "additional value that the market has assigned to a company, based on intangible assets, such as quality of management, growth prospects and efficiency of operations, that don't appear on a balance sheet".

The theory was that the lower this amount compared to the average of return on assets, return on equity, debt-to-equity ratio, and percentage growth of earnings divided by percentage growth of revenue, the cheaper a company would be.

This one study from 2000 thus picked the 10 most undervalued companies back then based on this metric, as shown below. The number in parenthesis is the return on their market price from 2000 until now.

American Power Conversion (-100% -- delisted)
Computer Associates (-74%)
Intel (-77%)
Microsoft (-58%)
Pomeroy (-81%)
Symantec (+63%)
Tellabs (-92%)
Verisign (-92%)
Viant (-100% -- delisted)
Xilinx (-78%)

To be sure, no valuation shortcut is infallible. Ben Graham never said the net current assets method can prevent loss. It can't, since the future is and will always be unknown. But if anything, it provides the best protection one can get short of clairvoyance.

People should be happy to buy dollar bills for fifty cents. Anything else is speculation.

No comments:

Post a Comment