Intrinsic vs. Relative Value

While shooting the breeze at happy hour yesterday, some colleagues and I were discussing valuation. Personally, I’m a big believer in using comparables to find a relative value. It lines up closer to what my father always said which was, “It’s only worth what someone will pay for it.”

My colleague was big on intrinsic value via DCF. In my humble opinion, DCF models are inherently skewed and easily become GIGO though too much optimism.

What say you?

In a former life, I did equity analysis and found that higher ups appreciated DCF over comps. In a more recent life, I worked in a sell side capacity for a company evaluating offers for purchase. In that capacity I only used comps (ev/rev, ev/ebitda, etc.). So what’s the call? I’m looking at you Frank and Chad.

The key is to use both imo. If i had to choose, i pick DCF because when you buy a business that is ultimately what you get, cash. if someone approaches me and says, “i want to sell you this piece of business” i would calculate how much money i can make. if it meets my 15% hurdle, than its a deal. Any way the comps matches up just means i could have gotten a better deal but irrespective of anything else, I still make my 15% so I did my job and i can buy a classy babe some heels. making decisions on comps is relying on perceived valued changes (which can generate huge gains in a short time). SS likes to use comps because they get away with asking ppl to pay way too much but justifying it with “look, its cheap, the other guys are selling for way more”.

Comps are great for setting up pair trades but I would prefer to find an undervalued company that I feel comfortable owning before I find an overvalued company to short. I agree with Frank that cash is king so I prefer the DCF for finding absolute value before shorting based on relative value.

Intrinsic value only. I think relative value is meaningless, as I’m willing to wait and wait while the stock stays undervalued. But that’s just my style, and I suppose there is no right answer.

so I looked at SI during the weekend. I’m placing a HOLD on it for the moment. expected returns on this is in the order of roughly 10% by my guest. solid company with a decent balance sheet but earnings growth potential for this technology industrial will likely track world gdp growth. capital spending contraints of key purchasers and innovation oriented capex for the company are key constraints on cash flow growth in my view. still, an above average company selling at average european valuation.

I look for things with a 10% return and above. If price drops lower, will probably initiate a position in this.

have you got any thoughts on this? do you agree with my growth assessment? biggest problem with this investment is really not SI specific, but rather, I know throughout the year, I might have a chance to jump into something better.

I don’t disagree, the growth prospects are limited, at its core it’s a mature firm that’s overleveraged to GDP. The advantages is that it is globally diversified rather than tied to one nation. However, in my experience it’s very uncommon for stable large caps to sell at 10XFCF. Now there may be better places to invest your cash sure, but I think you’ll need to look into smaller caps for that. I haven’t found many small cap ideas yet.

All investment is forward-looking. You pay for an investment today based on what you expect it to earn over the investment’s horizon. Similarly, all value is subjective and merely informs the views you have about what you expect the performance of the investment to be in the future. In statistical terms, value is fundamentally about mean-reversion. For instance, people use P/E ratios to determine whether something is overvalued or undervalued, but statistically you can think about it with cointegration. If the price rises faster than earnings, then there will be pressure for it to moderate. This also has the effect of placing bounds on the tails. For instance, a very cheap stock on a P/E basis will likely mean-revert to higher levels, limiting downside risk in that event. Relative value is merely the extension of this approach to many many more assets or value indicators. I’m never been completely comfortable with the way DCF is presented with regards to equity investment. For instance, consider a Treasury bond. We know how much it is worth today through DCF. However, when we want to actually make an investment in Treasuries, we have to project interest rates the future and value the Treasury bond given the (forward/zero coupon) curve at the horizon. Similarly with stocks we know the price today. What you really need to value is the stock at your horizon. So you don’t just need the path of earnings, but the expected WACC in the future, not the current WACC. I would guess that simple statistical techniques are as effective without relying on the estimation risk from projecting earnings 5-20 years into the future.

^respect. Interesting enough, mean reversion seems to be one truth of capital markets. Time and time again empirical evidence has found it sound. Much like corks in a barrel of water, stocks tend to rise and fall together. Here is my random walk though my career as a financier. I started out in ER support role at a quasi bucket shop. This place picked kids fresh from the school of hard knocks versus kids who went to Ivys. I fit right in. I learned how to model, write a research report, and spin the facts. I got my CFA Charter as this was seen as instant credibility for this otherwise dump of a shop. In this shop, DCF trumped comps simply because DCF focused on that specific stock, not a correlated asset to base the value off. I helped construct BUY reports on stocks I would have felt very comfortable shorting. Eating your own cooking does not seem to be the norm in SS ER. Reverse DCF engineering was not uncommon (ie get this stock a 15% margin of safety, drop the WACC, increase the growth, revise the forecast, etc, etc.). I learned quickly that with a basic DCF model, it was not hard to make it spit out any value you wanted with minimal twist and distorting. Market Crisis – Most of this department cut. I get my MBA from another school of hard knocks (Feel free to hate, but not everybody can crack a 780 on the GMAT like everyone on AF and get in a Top 3 MBA). I also knocked out the CAIA and FRM. I then got into a corproate development role for a company and sorted out both potential acquistions and evaluated offers mergers/acquisitions. As a PE backed company, we only looked at comps (ev rev, ev ebitda, etc) for a band of similar companies in our location, market capitalization. There was some tap dancing and cherry picking when we sought out our ‘comps’ to counter offers. This role was fun, but eventually a great offer came in, which was accepted, and the PE firm cashed out leaving most of the non senior pepes without a job. After seeing what I’ve seen, I now just focus on portfoio allocation over stock picking. Perhaps I’m too dumb to find the sleeping giants, but I have not the time, interest, nor confidence to perform research and dump my own money in it. I’d be interested to hear if any SS ERers invest in their BUY stocks. #StraightTruff

Yo CFA hit me with an email - - I’ve got a question about the corp dev job and your thoughts on that type of gig.

In Canada, you can’t initiate on positions you cover…

i don’t get it, you have confidence to pull hot classy babes but not the confidence to invest your money? that’s like mike tyson being scared of fighting floyd…

Will do Jcole. Anything you can post publicly?

I was going to hit you up with some specifics on one along those lines I was looking at. What are general exits for those types of roles after a few years?

Like anything, the answer is both. No two companies, assets, etc are alike; therefore, no perfect comparison or conclusions can be made. I agree though, DCFs can be garbage. Projections reflect hubris and purpose, so it’s imperative to thoroughly vet anything provided by management. At the end of the day, a combination of (hopefully similar) results would be ideal.

I tend to work on a lot of highly leveraged deals where no amount of benchmarking against comps and calculating of various leverage and coverage ratios can ever fully substiture an accurate cash flow projection. Your ratios can look rosy and you can still find yourself insolvent next year after some large CAPEX spending, limited revolver capacity and penidng amortization payments.

In my view, the impression that DCF can be gamed to give any number comes from the fact that most people do extremely, extraordinarily poor job in understanding an industry and a company, and vetting throroughly every single line item in the projected financials, every single assumption in the forecast. Too often they’ll spend an unreasoanble amount of time cherry-picking comps and calculating a WACC with a level of precision that’s laughable, while missing the elephant in the room - their forecast is sh*t and they don’t understand it. In the leveraged space, having a lousy forecast is a luxury you can’t afford.


of course if you don’t have access to management or their full disclosure, I can see how your attempts at understanding the forecast can fail despite your best efforts. So I guess the choice ultimately depends on the space you work in…

Holla at me Jcole.