Graham - Appraisal method

[luutzu]

Ok Thanks.


You know I have seen this so often, people dangerously half armed with a little knowledge, not least around the Roger Montgomery valuation formula saga, that it’s quite heart breaking but seemingly inevitable. Reality will mug you at some stage – I hope learning the hard way doesn’t cost you too much. (Actually I don’t care if it costs you heaps – It’s more a hope that people starting out don’t come under the misconception that you have a clue and get harmed by it)

Why is Fundamental Analysis always hijacked by Fundamentalists?

I'm considering this exercise in futility finished.

If you think investing is about precise valuation, you might be focusing on the wrong thing.

Might want to delegate the pricing power, product innovation and business development to management who live and breathe their business.

You're buying a living business, run and directed by living and thinking people; interacting and strategizing to gain market share and grow sales and profit...

You are not buying a piece of paper or a bond or a work of art or a bank deposit.

Yet somehow you think it'll be fixed and on top of that, priced it as fixed and to a degree that any slight changes in any one of the many variables will affect and made obsolete all that hard work.

If that make sense to you... sure, why not.

---

Man... appreciate your concern and all. But if I lose money on my decisions, I'll know exactly why and how it goes wrong. I doubt very much you'll know how or why you were wrong. Why? Because there's a bunch of variables that could each individually or all or some or most work together to make it wrong - and given the timeframe factor to the mix, you'll be a genius to pin point where and how and what goes wrong.

Equally important, you won't know why you got it right either.

Take a look at your past mistakes or successes. I bet you cannot be sure why you were wrong or right.

 

[craft]

If you think investing is about precise valuation, you might be focusing on the wrong thing.

Your continuous misrepresentation of what is said is infuriating.

Acknowledging the limitations of DCF is smart - throwing it out because of the limitation is dumb - DCF more than any other approach forces you to think about the valuation drivers. Your assumptions on these drivers is the grounding for ongoing monitoring of how reality unfolds against your assumptions (against your story).

If you haven't got a 'full' story you haven't got a robust basis for trade management and if you haven't got trade management your down to relying on luck or prescient prediction. Luck and prediction are not my strong suits (actually I think they are a stupid basis for risking money) but I manage to scrap through with trade management.

Anyrate, no doubt you will impute some other crap to me and continue an argument of your own imagination, but I'm done, I won't respond further because I won't see it.

 

[luutzu]

Your continuous misrepresentation of what is said is infuriating.



Anyrate, no doubt you will impute some other crap to me and continue an argument of your own imagination, but I'm done, I won't respond further because I won't see it.

I know you think DCF allow you to monitor valuation driver and all that; I just don't see it. Don't take it personally.

Why don't you pick a company you have analysed in the past and tell us what drove its value since?

I hold a few stocks and I could never work out how long term bond rates, risk free and risk premium and all that affect its earnings. I'm pretty sure they do, to some extend... quantifying it is another matter...So I let the company's financial managers take care of that since I have no clue.

Anyway, I could understand where Graham is coming from, I could look at historical examples and could figured out if it'll work or not. I'm happy with it and so let's do what we're each comfortable with.

 

[Klogg]

That is much more valuable than doing DCF where you just look really smart doing it, but won't have a clue as to what went right or what went wrong to repeat the right and avoid the wrongs.

This may sound odd, but the value I get out of thinking (and I mean really thinking properly, including the reading required) for DCF inputs is far greater than the value it spits out. Generally, if I know the inputs to the DCF well (within reason), then I get a good feel for the margin of safety involved.

For example: If you were to use the very simple approach to mining services companies about 3 years ago, you'd get some wonderful valuations popping out the other end - and the earnings of these complied with all accounting measures. On the other hand, the DCF would have uncovered negative free cash flow as a result of huge amounts of capex... a huge risk.

It's about identification of risks/problems associated with free cash flow, not about a precise valuation.

 

[luutzu]

This may sound odd, but the value I get out of thinking (and I mean really thinking properly, including the reading required) for DCF inputs is far greater than the value it spits out. Generally, if I know the inputs to the DCF well (within reason), then I get a good feel for the margin of safety involved.

For example: If you were to use the very simple approach to mining services companies about 3 years ago, you'd get some wonderful valuations popping out the other end - and the earnings of these complied with all accounting measures. On the other hand, the DCF would have uncovered negative free cash flow as a result of huge amounts of capex... a huge risk.

It's about identification of risks/problems associated with free cash flow, not about a precise valuation.

There's no reason why you can't work out capex and identify earning power and cash flow without using DCF modelling.

To me, I spend most or all of the time understanding the business and its financials. Once I'm happy with the position and the quality, valuation is very simple.

So while the valuation looks simplistic, and it is just simple algebra, it's never done by simply plugging in the reported E with some rate of growth expected for the industry or economy.

But you know, to each his own as they say.

 

[Value Collector]

Are there any papers anyone knows of which
explores and tests this or any other F/A or
T/A method which has a quantified conclusion.

.

To me, F/A or value investing, is not about pinning a companies valuation down to an exact number, I think graham said something like "you don't need to know a mans exact weight to know he is obese and you don't need to know a woman's exact age to know if she is old enough to vote", and to be honest, without knowing exactly what the future holds any valuation is not going to be exact, because none of us know exactly what business conditions will be in the future.

Also, it's not all about formulas and ratios, you need to be a business man at heart, and understand the businesses and managements you are applying your formulas and ratios to.

Buffett references this in one of his letters saying something like, You have to be able to distinguish the characteristics that provide a company with longterm competitive strengths, eg applying the same formula to the earnings and assets of a single product toy company selling pet rocks or unbranded Hulu hoops as you do to a single product toy company that sells barbies or monopoly is not going to do you to good.

I believe it's the business acumen of the value investor that will lead him to the high quality companies, from there the earnings and asset formulas and ratios just provide him information about how much he can pay for these companies in order to make them good investments.

Anyone that takes formulas and starts applying them to random companies, ignoring the business side, is going to fall into lots of traps, and miss some holy grails.

 

[craft]

There's no reason why you can't work out capex and identify earning power and cash flow without using DCF modelling.

To me, I spend most or all of the time understanding the business and its financials. Once I'm happy with the position and the quality, valuation is very simple.

So while the valuation looks simplistic, and it is just simple algebra, it's never done by simply plugging in the reported E with some rate of growth expected for the industry or economy.

But you know, to each his own as they say.

Lutz

You are so contradictory it is unfathomable.

All anybody has said to you here is that you need to understand all the value drivers of a business to have a complete story.

You are correct that once you have the necessary assumptions of value drivers nailed it is incredibly simple to do a valuation of your story. [Even a DCF.]

Yet you continue to run this argument that a shortcut estimate that ignores important value drivers will suffice.

So without running off on some incompressible contradictory diatribe could you explain to me how the Graham method deals with different costs of growth? Or do you think the cost of growth is the same for all businesses or do you not think cost of growth is a valuation driver?

 

[luutzu]

Lutz

You are so contradictory it is unfathomable.

All anybody has said to you here is that you need to understand all the value drivers of a business to have a complete story.

You are correct that once you have the necessary assumptions of value drivers nailed it is incredibly simple to do a valuation of your story. [Even a DCF.]

Yet you continue to run this argument that a shortcut estimate that ignores important value drivers will suffice.

So without running off on some incompressible contradictory diatribe could you explain to me how the Graham method deals with different costs of growth? Or do you think the cost of growth is the same for all businesses or do you not think cost of growth is a valuation driver?

How was that contradictory?

How could I get any idea of the company's growth over next decade if I do not know its business and industry well enough?

How could I have a good idea of its earning power if I have not look at its books? It's implied that I'd have to do some averaging and read and try to guess the successes of its R&D efforts, its innovation etc?

To predict ten years into the future will take a Nostradamus... or takes an idiot like me simply "predicting" that a dominant player in an established industry will continue doing what it has done for the past few decades.

--
If you read towards the end of that section, Graham did mention that of course interest rate play an important role in valuation. And I am guessing he figured out how to work it into this model in 1975, but he said it right there that at the time no model really satisfactorily take that into account so this shorthand model of his, and he said if it's assumed to be true, does serve an important purpose in valuing growth stocks and know its price implication.


Anyway, I don't know how Graham does it, or how anyone does it. Simply take what I can understand from their books and apply it with my own "understanding" of business.

 

[craft]

Lutz
So without running off on some incompressible contradictory diatribe could you explain to me how the Graham method deals with different costs of growth? Or do you think the cost of growth is the same for all businesses or do you not think cost of growth is a valuation driver?

How was that contradictory?

How could I get any idea of the company's growth over next decade if I do not know its business and industry well enough?

How could I have a good idea of its earning power if I have not look at its books? It's implied that I'd have to do some averaging and read and try to guess the successes of its R&D efforts, its innovation etc?

To predict ten years into the future will take a Nostradamus... or takes an idiot like me simply "predicting" that a dominant player in an established industry will continue doing what it has done for the past few decades.

--
If you read towards the end of that section, Graham did mention that of course interest rate play an important role in valuation. And I am guessing he figured out how to work it into this model in 1975, but he said it right there that at the time no model really satisfactorily take that into account so this shorthand model of his, and he said if it's assumed to be true, does serve an important purpose in valuing growth stocks and know its price implication.


Anyway, I don't know how Graham does it, or how anyone does it. Simply take what I can understand from their books and apply it with my own "understanding" of business.

.....

 

[luutzu]

.....

That's pretty clever.

Humour is your strongest point craft. Nuance and thinking might not be though.

 

[craft]

That's pretty clever.

Humour is your strongest point craft. Nuance and thinking might not be though.

Your right - I'm an idiot, only an idiot would try to help you.

 

[luutzu]

Your right - I'm an idiot, only an idiot would try to help you.

I like you craft. Serious. I know you want to help.

I thought I want to help too... But ey, some people just can't be help.

 

[craft]

I like you craft. Serious. I know you want to help.

I thought I want to help too... But ey, some people just can't be help.

Crickeys our motivations are the same and on an anonymous forum our credentials are for all intents and purposes the same. No wonder posting so often seems futile. Unless somebody already has the insight to judge our messages apart mine are as useful or not as yours.

O.K so you have helped me. Motivation to do something more useful with my spare time.

 

[Trembling Hand]

I like you craft. Serious. I know you want to help.

I thought I want to help too... But ey, some people just can't be help.

Dude you are leaving a **** trail wherever you go. Maybe it's time to sit back and re-asses your approach. If this was any other social setting other than the internet and everyone was throwing their hands up in the air and walking away from you would have to think one of two things,
1 You are surrounded by fools
2. There is one big fool, and you are it.


Just saying......

 

[luutzu]

Dude you are leaving a **** trail wherever you go. Maybe it's time to sit back and re-asses your approach. If this was any other social setting other than the internet and everyone was throwing their hands up in the air and walking away from you would have to think one of two things,
1 You are surrounded by fools
2. There is one big fool, and you are it.


Just saying......

Being socially inept is different from being a fool. Well, it is foolish to not get along and foolish to not know how to win friends and influence people... but you know, I actually do get along with people in real life - and we only rarely talks about the weather too.

Anyway, I guess the business I'm thinking of starting where I tell people they're wrong won't be a hit then.

 

[luutzu]

Crickeys our motivations are the same and on an anonymous forum our credentials are for all intents and purposes the same. No wonder posting so often seems futile. Unless somebody already has the insight to judge our messages apart mine are as useful or not as yours.

O.K so you have helped me. Motivation to do something more useful with my spare time.

what could be more useful than having your thinking challenged? Even by a fool?

Anyway, I too should stop procrastinating and get back to work. Those bills aren't going to pay themselves.

 

[goponcho]

Hi guys,

Thanks for the discussion. Not that i understand most of it, even if it is obvious, but it gives a beginner a chance to think about the basics, at the very least.

So from the banter i gather there are people that use the appraisal method, and others who use the DCF to come to a valuation?

Where is that page "security analysis for the lay investor" from? Couldn't find the passage in II.
- ie where is that formula from?

Regarding Graham's apprasial method in II - it was based on an estimate of future earning power x a capitalisation rate. I think a reasonable guess of earning power seems feasible from average past data. However, i think it would be difficult to transform an array of qualitative factors into one number for a capitalisation rate.

 

[Value Hunter]

I was just reading this thread and thought I would dig it up from the graveyard. I will make a few observations:

1) Graham tended to have a highly diversified portfolio and advised most others to do the same. With that context in mind his valuation approaches genreally only needed to be good enough on average across a basket of stocks rather than being highly accurtate in every individual case.

2) The risk premium implied in his formula was based on interest rates and market conditions at the time he published his formula. I am not sure he intended the formula to be permanently useful.

3) Buffet in one of his shareholder letters said that he uses the risk free rate to value all companies so that he is using an equal yardstick to measure all companies with. He would then consider risk separately by avoiding risky/inferior business and also by requiring varying discounts to intrinsic value for different kinds of businesses, rather than bake risk factors into his discount rate as many choose to do with DCF type models.

4) Professor Bruce Greenwald (who some would argue is the modern eras "Dean of Wall Street") in his seminal book "from Graham to Buffet and beyond" heavily criticizes DCF models because they are highly unstable and do not sufficiently segregate/quarantine more certain knowledge from highly speculative assumptions hence garbage in garbage out and he proposes various alternative and earnings based valuation models. His book is worth a read and highlights in the extreme instability of DCF models (small input changes lead to huge valuation changes, etc).

5) When you are buying stocks you should look for a level of undervaluation which is so glaringly obvious that it slaps you in the face and is visible instantly. If you even need to do a DCF to determine if the stock is undervalued its probably not undervalued enough.