Today we take up the challenge of the art of stock valuation in a world of monetary madness. We're already a few years into what's probably going to be a prolonged bear market. As often happens in bear markets, the general consensus is that the 'rules have changed'. Long term investing - and value investing - apparently don't work any more. You need to be nimble and trade in and out of markets...ride the momentum...ride the Fed's liquidity wave.

Maybe that will work for some, but for the vast majority it will end in tears. Trying to second guess the short term moves in the market is a game for pros...and even then it reduces many of them to a nervous wreck after a few years. With increased central planning across the world's economy, second guessing the timing of the moves of power hungry central bankers and politicians is a tough ask.

Investing in the Value of a Business

The beauty of value investing lies in its simplicity. The basic premise starts with the fact that you're investing in a business...not a stock price. While the stock price responds to a hundred different things - both real and imagined - on a daily basis, the value of a business changes far less rapidly.

The value investor thinks in terms of an operating business, not a stock price.

The Financial and the Real Economy

Before we move on to the art of valuing a business, we want to address the connection between the financial and the real economy. The financial part of the economy, beginning with central banks and then commercial banks, creates money and credit, which flow like tentacles out through the real economy (operating businesses that employ people).

In a normal, functioning economy, newly created credit increases the money supply. If it flows smoothly, it increases (in aggregate) revenues, wages, profits, taxes etc. Companies, by offering products or services that people want, capture some of this newly created credit via increased revenues...and hopefully profits. The longer a credit boom lasts, the more a company benefits.

This is what happened in the lead up to the 2007 credit bust. Global credit growth was out of control. Many companies were making hay, and analysts thought the boom would go on forever. They believed credit would keep increasing and company profits would keep growing at healthy rates.

In 2007, the global credit bubble burst. Thanks to central banks, the supply of credit remains abundant. But demand, having been brought forward by prolonged low interest rates, is weak. No one wants more debt. Housing booms - and subsequent busts - all over the developed world helped to diminish demand for more household credit. And while banks still lend to the 'real economy' they do so at high rates.

So the flow of credit has slowed. This means revenues, wages, profits and taxes will not grow anywhere near the rates you were accustomed to in the credit boom era. And it means slower earnings growth for most companies...and lower profitability.

That explanation is all in the 'aggregate'. The 'aggregate' works for economists trying to fit a complex world into a model, but it masks reality. The reality is that there are winners and losers in credit booms and busts. And obviously in a credit depression there are many more losers.

So what does this mean for company valuation? In very basic terms it means you can expect the market to trade on a price to earnings ratio closer to 10 or 12 times rather than the often quoted 'normal' level of 14 to 15 times. In other words, for a given level of earnings the market will trade 20-30% lower than 'normal' because of low growth expectations. This is how a bear market works.

But when looking at individual securities, valuation is not as simple as picking stocks with low price-to-earnings ratios and high dividend yields...or stocks trading at a discount to book value. Many cheap stocks deserve to trade 'cheaply' because they are bad companies. And when you really look into it, they might not be cheap at all.

Value Investing the Warren Buffet Way

This is where Warren Buffett and Charlie Munger have probably made the greatest contribution to value investing since Ben Graham. Through the many years of writing annual letters to Berkshire Hathaway shareholders, they have provided value investors with a logical framework to calculate the intrinsic value of a business.

Armed with this knowledge and Ben Graham's concepts of Mr Market (the bloke who turns up every day and offers you a price - completely unrelated to the value of the company - for your shares) and a Margin of Safety, Buffett and Munger have compounded their way to astronomical wealth.

So how do they go about valuing a business? They look at just a few things. The return on equity (ROE) that the business generates, the equity value of the business, and the discount rate, or required rate of return. If you have these variables you can basically value a business.

Breaking Down Value Investing

Let's look at each of these things in turn. The equity value of a business is the capital injected into the business by its owners. You can find the equity amount of any listed company by looking at the bottom of a balance sheet. The equity is what's left over after you deduct liabilities from assets. This is also known as 'book value'.

Importantly, the equity is what you as a shareholder buy when you purchase a company's shares. You are buying a small portion of the company's equity - hence the term equity market.

Once you know the equity value of the business, you need to know how profitable it is. That is, you want to know what the return on that equity is. There are a few ways of calculating this, but to keep it simple it's just net profit divided by the equity value.

Now the discount rate or required rate of return comes into play. This might sound a bit arcane, but the discount rate underpins the whole discipline of corporate finance and company valuation. It's the interest rate used to 'discount' a company's future cashflows or profits back to a present value.

In practical terms, it's the interest rate you require to invest in a company or asset. If you demand a high rate of return, you must pay a very low price to achieve that return. If you're happy with a low rate of return you implicitly accept paying a higher price.

Most investors don't understand this relationship. That's why 'buying high' always generates a poor long term return. Buying low implicitly says you have a high required rate of return.

Now let's put it all together. If a company's ROE is 50% and your discount rate is 10%, you can pay up to five times the company's equity (or book) value to achieve your required rate of return (50/10).

So in this case the company's intrinsic value is 5x book value. If the market price is 10x book, then you're implicitly accepting a return of 5% from the investment. If the market value is 2.5x book, then you're implicitly accepting a 20% return on your investment. In the words of Ben Graham, at this price you'd be buying with a 'margin of safety'.

There are a few things to note though. This example assumes the company pays out all earnings as dividends. The calculation is a little different for companies that retain (and therefore compound) earnings. It also assumes the company can sustain a 50% ROE. Not many companies can do that.

That's why Buffett buys stocks that have extremely reliable earnings. It means that the ROE variable won't change too much and his estimate of intrinsic value will be sound. Changes in a company's ROE have a big impact on value.

The other thing to note is that the required rate of return has nothing to do with the stock market. It's the return the business will generate for you over the long term if you have correctly estimated its profitability. Over the long term the market should deliver the same return as the business. But in the short term - as you know - the market can do anything.

Regards,

Greg Canavan
for The Daily Reckoning Australia