Intrinsic vs. Relative Value

Hahahahah - bet.

I didn’t realize you did a stint in corp dev. CvM. I really enjoyed my time in corp dev, and I’d like to get back into it eventually.

It can also depend if you’re a top-down or bottom-up investor. Generally, top-down guys lean towards relative and bottom-up like intrinsic. Makes sense given how they approach things.

^Respect. Though I’ve had more jobs than I care to admit. Finance is a true churn and burn field.

If all the calculations are done correctly, then both trading multiples and DCF will lead you to the same valuation. The problem is that a lot of times people use trading multiples incorrectly (for example, not normalizing for different capital structure or the sometimes obvious differences between one company and another within a peer group) and DCF calculations incorrectly (i.e. strange assumptions, wrong free cash flow formula, etc.) that will lead you down the wrong path. So, basically both valuation methods have their limitations but it’s worth going through the exercise of both in trying to arrive at a potential valuation.

The other thing you have to consider, as you said, is how companies trade. If a company and its peer group tends to trade on P/E, then either rightfully or wrongfully, it will continue to trade on P/E. The key is to exploit misunderstandings in the comp group – always question why comps are considered comps, both in terms of their operations as well as their capital structure. Where DCF is more useful – or other intrinsic valuation methods – is if you’re looking at a company that doesn’t have many public comparables. In such cases, you can occasionally find companies whose intrinsic value per share, even under conservative assumptions, deviates significantly from market price. It’s either because people haven’t gone through the trouble of performing this type of analysis, or investors are concerned about the absence of liquidity events that would cause the current trading price to converge with what you think the intrinsic value is. However, assuming your calculations are correct and there could be catalysts, then you can definitely make a killing on these. I’ve found a few stocks like this over the years, and I think bromion can comment on this more directly since he actually focuses on micro-cap stocks (whereas I generally look at mid-caps and occasionally large-caps).

Numi (and others), in your example of trading price converging to your calculated intrinsic value, what sort of catalyst(s) would you look for that would make a stock a buy? Anything that seems to be more common than others?

Div increase…share buyback…buyout…spinoff the usual really. It depends on the firm. If you’re investing in a net/net, you want to see a dividend. IF you’re investing in a mature firm, perhaps buybacks are a good idea…tiny biomedical device company? Probably buyout.

Regarding the OP, I think the answer really depends on *why* you’re doing the valuation. If you’re representing the firm in a transaction you don’t need to worry about intrinsic value, value is just as CFAvMBA noted, “what others will pay for it”, but if you’re investing in it, then you have to look at what return you’re getting (what Frank said), and at that point, how the stock “trades” is totally irrelevant. How much do you want to pay for this if you knew nothing about its market price? How do the firm’s cash flows compare to your hurdle rate? At that point you wouldn’t really care about comps…

I think it’s a good exercise to do blind valuations without knowing what a stock is trading for…

Steely Dan, that’s a good question. As it turns out, people have different opinions of what constitutes a catalyst. As well, it depends on the company and industry. In general, the way I think about catalysts is a sequence of meaningful events on a timeline that reflects my investment horizon. For example, if I have a 12-month price target on something, then what are some of the things that would move the stock in my contemplated direction? These things can range from anything to actual earnings calls (especially if key information about products/margins/etc.) are released, to updates on clinical trials (if we’re talking about healthcare sector), potential launch of a new game (if we’re talking about the gaming sector), monthly data on same store sales growth (if we’re talking about the retail sector), and so forth. If you’re talking about more event-driven catalysts, then you’d be looking at various regulatory clearances during an M&A approval process or bankruptcy resolution and other liquidity events in a restructuring process. I think you get the idea.

In the end, what’s considered a catalyst comes down to what YOU think matters about the company based on your investment thesis. A lot of people just a laundry list of things that could happen and call them all “catalysts,” but to the extent that you can map them out in some logical chronological progression, the more compelling your thesis will be in my view.

Also note that catalysts should be events that could move the stock more meaningfully than normal. In other words, the announcement of a new product with a $100 million peak market opportunity for a company that’s doing $20 billion in annual sales would not be a catalyst, and it would be a mistake to call it one.