QUALIPORT
Useless Valuation Ratios

By Maynard Paton (TMFMayn)
September 15, 2003

There are many ways to value a share. But just like financial ratios, there are good ones and there are bad ones. As a collector of long-term quality companies, the Qualiport uses the free cash flow yield to define 'good value'. These three methods, however, do not get used by the portfolio.

1. Discounted Cash Flow

Within his 1992 Shareholder Letter, Warren Buffett wrote: "In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

While the theoretical intrinsic value of a business is indeed the net present value of its future cash flows, calculating such a value is fraught with trouble.

For starters, future growth projections often prompt investors to overpay -- and the textbooks require growth estimates to infinity! Furthermore, who can actually predict a company's profits say, ten years out, other than to suggest: "they'll be a little/quite/a lot higher or lower"? In addition, small adjustments to discount rates and other inputs frequently lead to large variations in the final value, such that virtually any figure can be achieved. Buffett may be a fan of discounted cash flows, but lesser mortals ought to look for more obvious and immediate value. Read more | more.

2. Enterprise Value

Enterprise value (EV) is defined as a company's market value plus its borrowings less its cash. In theory, EV measures what it would cost to purchase an entire business. Trouble is, private investors don't buy entire businesses.

Here's a good example of the EV problem.

Operating profit (£m)      100
Interest (£m)              (75)
Pre-tax profit (£m)         25
Earnings (£m)               17.5

Interest rate (%)          7.5
Tax rate (%)                30
Cash/(Debt) (£m)        (1,000)

Market value (£m)           105

With interest payments covered a wafer thin 1.33 times (£100m/£75m), this firm runs the real risk of bankruptcy. That possibility is reflected in the £105m market value, which equates to a price to earnings ratio (P/E) of 6.

But by valuing the firm at £1,105m (the extra £1b being used to pay off the company's debts), the EV investor would see this:

Operating profit (£m)      100
Interest (£m)                0
Pre-tax profit (£m)        100
Earnings (£m)               70

Interest rate (%)          7.5
Tax rate (%)                30
Cash/(Debt) (£m)             0

Market value (£m)        1,105

Taking the EV perspective, the company suddenly becomes healthy and reasonably valued (with an effective P/E of 16 (£1,105m/£70m)). In reality though, the company remains saddled with onerous debts and deserving of a low rating. The EV investor, unless he was to clear the borrowings personally, still risks seeing this particular share go broke. Jigging the accounts around and declaring an EV does not alter this fact. Read more.

3. Price To Book

A preponderance of cash-rich dotcoms has breathed new life into this archaic investment ratio. However, fans of price to book -- calculated by dividing a company's market value by its net asset value -- can't survive forever on the leftovers of yesterday's exuberance. You see, long-term investment is all about buying a regular stream of cash, not a lump sum.

Unless the assets under review are cash, then the price to book punter is gambling on how much could be raised from a fire sale. Fixed assets especially trap the unwary. If the company is struggling, fixed assets are more akin to liabilities. Cable & Wireless (LSE: CW.)(NYSE: CWP) for instance once had an attractive price to book, but its expensive telecom network didn't make money and chunky asset write-offs quickly caused C&W's book to evaporate.

In fact, book investors are more likely to come good hunting for balance sheets that undervalue the company's assets. Enterprise Capital (LSE: EPC) shares for example jumped 400% during a single August session after investors suddenly realised its £2m book investment in Wolfson Microelectronics could actually be worth over £20m.

More: Useless Financial Ratios | Discounted Cash Flow | Price To Book Is Dead