Does Valuation Matter in Equity Investment?
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Everyone who has the slightest interest in the world of investment has probably heard of the term valuation. But exactly how important is valuation?
We all know that the value of an asset should be nothing but the sum of its discounted future cash flow—sounds straightforward enough, right? The thing is, however, while everyone and their dogs can agree on this equation, it gets much more complicated when you ask how much cash flow we are expecting and what discount rate we should use—this is just like we can all agree that we should do good, but what exactly is good and what isn’t? Leaving that question up for discussion among the philosophers, let’s continue on equity valuation.
The method of directly calculating the value of an asset using cash flow and discount rate is called absolute valuation. Let’s attempt to value Pepsi (NASDAQ: PEP) using this method. Pepsi went public in 1967, which means we have access to decades of the firm’s historical cash flow figures, but what is the number for next year? And the year after? And to the future? Nobody knows. Sadly, though, we as equity investors, only care about what happens in the future, which means we can only guess.
After entering inputs into all sorts of sophisticated models incorporating macroeconomic data, financial ratios and scenario analysis, you finally reach a constant growth rate of cash flow. And just as you think you are done with guessing, you realise you also have to guess the discount rate. If you have some background in finance, you might say that is easy since you can just use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. To use CAPM to reach Pepsi’s cost of equity, we need the beta—Pepsi’s adjusted 5-year beta is 0.78, 2-yr beta is 0.65, and 1-yr beta is 0.56. Which one would you use? Plus, these numbers are based on regression against S&P 500 and weekly return data, and you will get different numbers depending on the index or frequency of return data.
That being said, how much trust would you have when you are told the “target price” of security the next time? You should realise that two drastically different target prices can be calculated by simply tweaking the inputs in the model—“garbage in, garbage out”. This is why equity valuation is more of an art than rocket science. An analyst enters his or her interpretation or opinion of a company into the models, like how an artist blends pure colours into paints and is eventually reflected on the calculated target price, which is the painting on canvas.
As a result, you might see some analysts issued a “buy” recommendation while others issued a “sell” on the same equity—as you won’t see two identical paintings. Pepsi currently has an average target price of $188.87 (Pepsi’s stock closed at $167.71 on Nov. 16, 2023, which means a “buy”) resulting from analysis performed by 26 professional analysts around the world, with the highest being $220 and the lowest being $151. The conclusion? Take those target prices as a grind of salt.
Going back to Warren Buffet’s quote, a good investor should base his or her analysis on the fundamentals of the company rather than simply trying to see whether the stock is traded at a “good” price.
In our next publication, we will try valuing AMD, my favourite company, using the relative valuation method (in contrast to the absolute valuation that we discussed today) and see if the stock is overvalued.