Question: Is this stock “buy” or “sell”?

 

  • US Listed
  • Price: $138.97
  • EPS: $6.05
  • EBITDA/Share: $12.48
  • FCF/Share: $6.09
  • Dividend: $2.66
  • ROE 11% (10-14% Historically)
  • Capital Invested/Share: $82.31
  • EV/Share: $168.85
  • Revenue Growth Average: 3% last ten years & 5-7% in the next couple of years
  • NTM EPS Growth Forecast: 9-11% YoY
  • Business: Diversified Large Cap Conglomerate – Cyclical

 

 

How would you value this stock? Are you starting with standardized price multiples? Or would you start from applying a simple discount model with constant FCF growth assumptions?
Although it is stated that the company does diversified and somewhat cyclical business, some of you may want to know detailed information on their business. That is a fair question to determine the certainty equivalent free cash flow (or adjust discount rate instead).

 

 

 

 

As some of you might have noticed, this is not a real company that exists.

 

 

Yes, this is Russell 3000 Index which stands for US equity market itself.

You discuss the direction of US equity market – and the favorite and hot topic is Trump Administration momentum – but focusing on the valuation requires not only looking at price multiples but also taking the whole financial structure into consideration. Intrinsic value is driven by cash flows, growth, and risk, while the price is driven by momentum, liquidity and herd behavior. In other words, a trader uses pricing evaluation as a way to forecast the short-term pricing trend (buy low and sell high) and an investor plays the long-term value game (buy something when its price is reasonably and attractively less than your assessed value and then keep & wait for the asset to generate return to prove its higher price).

Remember that the price is used as an essential transactional tool to provide constant liquidity to both buyers and sellers in the exchange, not as a metric to value financial asset.

Discerning Value from Price

When you have clients and have products & service with the price that you have to sell to them, you would need to prepare the recommendations of buy or sell. If you are a real estate agent, you might need to drive to the recommended properties with buyers and tell them that the prices are reasonable referring to your rationales.

You even proceed to discuss the information that affects future price of the property as well as the pricing trend of that neighborhood in the past. Essentially, you are assuming a covariance matrix and risk premium in their mind – a real estate version of the exotic beta.

Gathering information that affects the price is not an act of valuation. It looks like that both share the same objective – to measure the room of future price move, but valuation just measures the reasonableness of acquisition price of securities against the discounted net cash return from it. Valuation is not a price forecast but a measurement tool for the investment decision.

Performance Report

Performance report and evaluation is a routine but imperative business practice in the asset management industry. Although it is useful in identifying the bad managers, business risk aversion makes performance control beyond the extent of valuation oriented approach can deliver.

At the end of the day, the more clients force the fund to get more oriented toward the market and forget about how different pricing and valuation are.

Risk of Investment and Trading

In the price-oriented approach, price volatility is dealt quantitatively and regarded as a proxy of risk. The expected return is discomposed into multiple factors and risk premiums, assuming that price volatility requires “premium” return accordingly. Pure value-driven investors do not see it that way but share the view that uncertainty of future cash flow needs to be discounted (i.e. trimmed). So from the two distinct roots with different nature, they both use the same words of “discount”.

Factor and Beta

As presented first in this article, monitoring the shape of the aggregated investment securities in the same way as individual securities are analyzed is not as popular. Ask an analyst about the valuation of the areas in which his/her covered companies are classified, instead of asking questions of whether the areas have positive/negative factor exposures against the industry/political or economic trend as a way to remain fundamental.

However, in the recent days of new or exotic betas, trading on ideas on factors is getting popular as ever. I have even seen a webcast in which some pros were asking a question if there is alpha on earth as all return will be attributed to some betas.

Because of the ease of its application as well as no pain from the valuation, it is becoming a trend. More and more new factors are invented.
(While it is statistically true that more independent variables (i.e. factors) increase R-squared, that would increase the risks of pitfalls such as hidden multicollinearity which leads to misleading models. I also believe many machine learning programming tools do not address this issue accurately.)

Valuation

I think it is time to revisit and rethink about the foundational distinction between pricing and valuation. It is a responsibility of investment professionals to ask questions about the valuation of FACTOR itself, as it can partially narrow the gap. If you assume that factor risk (via the compensation for price volatility) can fundamentally generate the return and the return is from future cash flows, the factors should have intrinsic value. Otherwise, you should ask variability of factor return can be attributed to price volatility itself or (cross-sectional or time varying) variability of factor valuation. Ask what are there between the price volatility and the return? Isn’t real risk (not price volatility) hiding there?

Like presented first in this article, country, and sector factors can be replaced with country and sector equity with all financial statements. Like individual securities, we can use them and get a sense of valuation. That is the missing area where experienced professional investors can add value.

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