Quality at a reasonable price

Having explored the idea of a quality company in my previous article, I wanted to follow up with an important caveat: price matters and my own approach is now more focussed on investing quality at a reasonable price than simply buying cheap companies. Without working to determine a fair valuation for an asset, an investor runs the risk of the age old saying “any investment is a bad investment at the wrong price”. In this article, I’m going to explore this saying in more detail and unpack the different valuation methods for buying quality at a reasonable price.

If the first goal of a solid investment strategy is to invest in high quality businesses with strong free cash flows, profit margins, and a good potential for future success, then the second goal must surely be to acquire that investment at a price equal to, or preferably less than it’s value. But how does an investor go about determining that value?

Company valuation

A company can be valued in different ways. The first aspect to consider is the market capitalisation, or market cap for short. This is the current value of all the shares in existence and is a reflection of the company’s size. Generally speaking, the more a company sells and the more profit it makes, the  bigger the market cap, as the shares are worth more money and the company has generally issued more equity.

Unfortunately, the market cap isn’t a particularly accurate measure of value, as it fails to account for the fundamental performance of the company and is simply a reflection of how much it would cost to buy all of a company’s shares. A more accurate valuation method for buying quality at a reasonable price is the enterprise value, which includes the cost of debt liabilities and cash on the balance sheet.

In addition to the market cap, the enterprise value also includes the value of long-term and short-term debt, pension liabilities, minority interests in subsidiaries, and cash balances. As such, it is a much more accurate representation of what an acquirer would have to pay to purchase the business.

An investor can use the enterprise value in a number of ways, but is most commonly used to compare the value of the company with others in its sector. By looking at the valuation of the company and its earnings, an investor can make a determination as to how much the market is willing to pay for similar businesses and whether or not the business they are considering investing in is in-line or not with these valuations.

Similar to this, we have a basic measurement of value called the Price to Earnings ratio, or “P/E” for short. This compares the price of a share to it’s earnings per share. This is usually a fundamental starting point for investors, with a low P/E value being considered “cheap” and a high value being considered “expensive”.

With these measurements, however, the investor is taking a very basic assessment of price and assuming that the assets are equal, whereas even the most basic assessment will inform them that this is rarely the case. This is because of the quality of the companies, which we covered in our last article, which can vary wildly from business to business. If half of the strategy to buy quality at a reasonable price is to value accurately, surely the other half is to ensure that they are actually quality investments.

When we take the quality of the asset into account, we quickly see that a great number of “cheap” companies are cheap for a reason. Low levels of growth, high levels of debt, slim profit margins, asset write-downs, declining market share – the list goes on and on. Investing in these businesses is backing a second or third-rate horse in many cases. There is a chance they will come good, but the odds are definitely not in their favour.

Sum of the parts analysis

In addition to valuation of a company’s earnings, an investor can also undertake Sum of the Parts (SOTP) analysis, which attempts to assign a value to individual operating entities in an organisation. The most basic type of SOTP analysis is the Net Asset Value (or NAV), which is the net value of a company’s assets minus liabilities, divided by the total number of shares. In theory, this is an approximate value that could be achieved if the company was liquidated, its assets sold, and the proceeds used to repay liabilities with the remainder returned to shareholders.

In theory, a company’s shares should trade at a value equal to it’s NAV, but this is almost never the case in practice and the price often reflects either a discount or a premium to NAV. If a company has £1 of NAV but the shares trade at 80p, this reflects a 20% discount to NAV, and likewise, if that same company trades at £1.20, then the price reflects a 20% premium.

For a Real Estate Investment Trust, or REIT, the NAV is one of the primary determinants of value. The REIT raises capital by issuing shares and borrowing money. They use this money to purchase properties. The properties are rented out and the money used to service the debt and provide an income to the fund, part of which is used to maintain the properties, and part of which is returned to shareholders in the form of dividends.

In these types of businesses, an independent surveyor provides a determination of the value of each property, based on the rental income, condition, and sales values of similar types of property. The valuation methodology takes into account the credit worthiness of the tenants, the condition of the building, and the expected demand moving forward. The stronger each of these qualities is, the more likely a property is to be worth more money each year, and vice versa.

As such, if an investor can purchase the REIT at a discount to NAV, they are effectively buying the underlying properties at a discount to their true value. By waiting for the discount to close, they can generate a positive return on their investment, in addition to receiving an uplift from capital gains in the underlying assets.

In reality, however, many discounts are present for a reason – perhaps demand is weak and expected to fall, the REIT could be having difficulties in getting the rent paid on time, or properties in the portfolio could facing significant renovation costs that exceed expected income. By comparison, sometimes premiums to NAV are well-justified, in instances where the assets are in particularly high demand with limited supply. It falls to you as an investor to make a determination on the NAV and decide whether buying at a discount, premium or equal value is the best strategy (or when to apply this from case to case).

Valuing earnings

In addition to Net Asset Value, an investor also needs to consider a company’s earnings – both their quantity and quality. For example, let us compare three different companies, as follows:

In the first of these examples, the P/E multiple of the company declines as investors realise that the profit margin is declining. The company is still profitable, and so still has a value, but as a result of the declining margins and decreasing P/E multiple, the share only increases 26% over five years, giving about 5% compound annual growth rate (CAGR), or a little over 6% if you include dividends.

Our second company, the one that manages to protect it’s margins, is valued consistently by the market over the five year period at a steady P/E of 10x. As a result, this company does better, returning 80% over the period, for a 16% CAGR, or 17% with dividends.

In our final example, the market rerates the company at a higher value in the third, fourth and fifth years, as investors notice that the company is increasing their profit margins and paying a rapidly increasing and well-covered dividend. As a result of this, the company’s shares increase in value by 320% over the period, for a CAGR of 64%, or 66% with dividends.

Although basic, this clearly shows the importance of focussing on the highest quality investments, but what about the valuation?

This is where your skill as an investor comes into play, as the price will not be at a single consistently point throughout the five year period. Let us say that in the first year, the price of each company’s shares fluctuate between 50p and £2. If we purchase the first company at 50p and held for the five year period, our return would increase to 250% – nearly ten times that of if we bought it for a pound a share.

Likewise, with our final example, if we purchase the shares at £2 and held for the five year period, our return would decrease to 60%, which is 12% a year, and less than 10% of the return if we had purchased at £1.

From this simple example, it becomes increasingly obvious that a key part of investing is valuation, and the need to remain disciplined about not just what you invest in but when. Purchasing companies at the wrong valuation can totally destroy your returns and at worst result in you constantly “buying high and selling low”.

In addition, it might be easy to assume from this example that high P/E ratios are a sign of a quality company but this isn’t always the case. Don’t forget that valuations are relative and subject to change. If investors believe that a company’s prospects are good, they are likely to bid the price of the company up in anticipation of this. As a result, it is easy to find company’s trading on valuations of 20, 40, 60, even 100s of times earnings. In some cases, this is justified, as the company grows earnings at such a tremendous rate that it “grows into” the valuation over time.

To me, this has always seemed a little risky, as the market has already priced the company for extremely strong growth and if this fails to materialise then the share price nearly always collapses along with the P/E multiple. In this scenario, the investor might see growth in the underlying company but not in the share value, as the company has to work harder and harder to maintain it’s current share price with slowing growth.

It’s also worth pointing out that there are no hard and fast rules here. Some investors swear by investing in only the lowest P/E shares – an approach associated with Value Investing – on the belief that this is the most common source of unloved companies. Others avoid these companies at all costs, believe their low valuation is an indication of a company in distress or with qualities that make them an undesirable investment.

Price to Earnings Growth

My own approach leans much close to Value Investing and I much prefer to buy companies at a discount to their intrinsic value but ensuring I am investing in quality at a reasonable price is an important part of this. A good middle ground between the two approaches is the Price to Earnings Growth ratio, or PEG, which is the P/E ratio divided by the annual growth rate in Earnings per Share. To save boring my readers to tears, I won’t go through the maths behind this, but will simply say that the PEG ratio attempts to account for the growth rate of a company’s earning as much as the value of them relative to the price of the shares.

As a general rule of thumb, buying companies on a PEG of less than 1 is the sweet spot, representing a company which has a suitably strong rate of growth relative to its P/E value.  A company with a high growth rate will have a lower PEG, whereas as a company with a low growth rate is likely to have a higher one (unless their P/E ratio is low in which case it will cancel out).

Relative Valuation

In addition to these approaches, which seek to value a company as an individual entity, an investor could also undertake a relative valuation approach, whereby thesy value a company or asset relative to others in the same sector or class. For example, if three companies sell plumbing suppplies in the UK, and all three produce approximately £50m in revenue with 10% profit margins, the cheapest of the three would arguably be the most attractive.

One of the most basic forms of relative valuation relies on the Price to Earnings ratio, which I wrote about at the beginning of this article. By comparing the P/E ratios of different companies in the market, an investor is able to make a very basic assessment of their relative value. For example, a company on a P/E of 8 might be more attractive (i.e cheaper) than a company with a P/E of 80.

The basic principle of relative valuations is that the investor is using multiples, averages, ratios, and benchmarks to determine a firm’s value. How the investor choosees those metrics is up them, but remember – just because something is cheap relative to competitors, it doesn’t have anything to do with it’s “quality”,

Of course, if investing was as simple as just buying companies with a PEG of less than one, or a P/E of less than 10, anyone with a computer could set up a screen to filter out these names, call it “investing in quality at a reasonable price” and become rich overnight. This, of course, is patent nonsense, but reflects just one part of a successful investor’s process.

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