Value Investing

[alex123711]

hey Alex, I've logged back on after a long hiatus. I've actually mostly given up on active investing, I do just enough to keep me entertained and even then it is very small. I tried to focus on companies within my industry but even then I quickly got over my head. At the end of the day it is just easier to put the money into index funds and spend your precious time on things that are more enjoyable, such as going outdoors on an adventure.

You didn't enjoy it?

[Dave]

...spend your precious time on things that are more enjoyable, such as going outdoors on an adventure.

Why not both?

I've read 10Ks at the beach, in the woods, in the mountains...

Jokes aside yeah, it's not something everyone enjoys. But I do like that it's physically portable and that I can do it in a variety of nice places!

[ertyu]

Why not both?

I've read 10Ks at the beach, in the woods, in the mountains...

Jokes aside yeah, it's not something everyone enjoys. But I do like that it's physically portable and that I can do it in a variety of nice places!

What's your process after you read the 10k

[Dave]

@ertyu

My process is not formulaic, but for stocks I buy I generally perform most of the following: read the most recent 10K & 10Q, read the earliest 10K and initial public filings if available, scan all of the interim years 10Ks (particularly for notable changes in the business model or large transactions), in many cases build a spreadsheet of all the summary financials and a lot of calculations of ratios and various things for all available years to observe ST & LT trends, read the company's entire website, read all available earnings call transcripts, review the proxy statement and dig into the background of the top management, the board, and active large investors, read other investor relations materials, study any industry information I can find, read customer reviews if available, read employee reviews if available, look for any other sources of information on the company that may be applicable or available, study all competitor businesses and materials (much of the above but less focus on certain aspects), study around the company's value chain to see how they fit into the broader ecosystem (customers & suppliers, etc.) read all investment write-ups I can find on the company, try to reach out to large vocal investors to discuss, sometimes ask clarifying questions to management/investor relations, sometimes reach out to people who are experts on part of the situation I can't get a grasp one, perform valuation, and complete a self-created checklist to fill gaps in my review prior to purchase.

In reality most companies I disqualify quickly from consideration and do nowhere near all of that, but by the time I buy stock in a company I've generally done most of that, and often more depending on the situation. The process is basically to try to rule out situations fairly quickly as it's a low return on time to do all that work for a company there is no chance I'm interested in based off initial negative factors, but at the start of the process I often look at summary financials (from a website like QuickFS) to get a feel of the general situation (but I am VERY skeptical of these kinds of sites, they very often get things wrong, this is just a starting point), I study the business model, and I do a really rough valuation. This tells me of this is the kind of business both numbers-wise and qualitatively that I'm interested in and whose price may be worth looking into more. And then I proceed through the steps in the prior paragraph to whittle the situation down to one I feel I grasp adequately to value, double check myself, and then if it is sufficiently attractive to warrant investment in rather than an existing holding, I buy.

To be clear though, of every 50 companies I come across I may only do all of that for 1. I consider intellectual honesty/circle of competence to be the prime meta skill of investing, and I just can't get confident on the vast majority of situations.

[FrugalPatat]

I'm considering some form of value investing. I recently analyzed my first real company (that I selected somewhat arbitrarily, just for practice). It took a lot of time. Now I'm attempting a second company in a totally different sector. One problem is the time it takes to understand the company and the industry of which it is a part. Is this even realistic to do for every type of industry there is? Different industries also have different capital structures, margins,... that are typical. I'm not sure how to use a stock screener while remaining industry agnostic because 'it depends'.

[Dave]

It's common across many endeavors that it takes a really long time the first time you do something, and analyzing and valuing companies is no different. You learn what to look for, how to do so faster, and there is the accumulation of knowledge as you look at more and more companies where you can just pick things up much faster. This applies to very tiny details like how there is massive duplication and boilerplate language in 10-Ks down to seeing how certain business models/industries have certain characteristics that you pick up on quicker. Additionally, you will just naturally be able to learn about specific companies faster than others based on your own life experience.

So for sure it takes a serious effort to understand a company, and I think you recognizing that is really important - a lot of people seem to think that an hour or two of research and a podcast by an "investing expert" is enough to have an accurate, variant view on a security. Knowing what you know and what you don't/can't know about a company is critical as intellectual honesty is absolutely foundational to value investing (circle of competence - because there are "no called strikes", there is no good reason to invest unless you're extremely confident about the attractiveness of a situation). I always like to keep it top of mind that for any securities past a certain market cap, there are numerous CFAs paid $250K/year with access to the best resources on the other side of the trade. Not literally true in many cases, but it helps calibrate the degree of seriousness you need to take your research. Which suggests seeking out securities that have less institutional investor eyeballs on them for various reasons. This doesn't necessarily mean they are more likely to be undervalued, just that they are more likely to be mispriced/mispriced to a greater degree in either direction.

Regarding your question of is it realistic to do it for everyone type of industry, practically speaking no, unless you dedicate most of your time and many years to this, and even Buffett claims that he doesn't truly understand/grasp most companies well enough to invest in. I think he's being humble here, but still. Professional investors often focus on certain industries, so thinking that you can ever have a deep understanding of all of them is unrealistic.

Still, you don't really need to study all industries, just enough to meet your own diversification goals. And as I noted above, you'll find over time that you get faster, and that your knowledge accumulates. For example, if you study car dealerships, it isn't such a big jump to auto parts suppliers, car service companies, ridesharing, and OEMS. And so on.

I don't completely follow your last comment about not knowing how to use a stock screener, would you mind expanding?

[FrugalPatat]

Regarding your question of is it realistic to do it for everyone type of industry, practically speaking no, unless you dedicate most of your time and many years to this, and even Buffett claims that he doesn't truly understand/grasp most companies well enough to invest in. I think he's being humble here, but still. Professional investors often focus on certain industries, so thinking that you can ever have a deep understanding of all of them is unrealistic.

Still, you don't really need to study all industries, just enough to meet your own diversification goals.

But then how to choose what industries to focus on? Some industries or companies are boring to me, and anothers sound interesting to read about. But that hardly seems like a good criteria. Also, the macro environments matters and changes, so I’m not sure focusing on just a few industries is a good idea. The macro environment could be bad for some of them.

I don't completely follow your last comment about not knowing how to use a stock screener, would you mind expanding?

I meant to say that I’m not sure how to use a stock screener because different industries come with different ratios, margins etc that are typical. For example: a low P/E or a low debt/equity ratio is not necessarily a good sign. It depends on the industry, and also on the values of other ratios.

[Dave]

You're going to have a hard time studying industries/companies that are boring to you, so I'd rule those out. I think following your interest is a good starting place because you'll actually be willing to dig deep enough to learn something useful. Since the knowledge is cumulative, it's not a waste of time to study a company/industry and conclude there are no (currently) actionable ideas. Once you've studied a company, you can put its stock on a watchlist and follow it for years. Performing "maintenance research" is much easier than studying a situation the first time, and so with minimal effort as the years go by you made find the price/value gap becomes more favorable down the road and you can take action then. Many of my best investments have been like this, situations I studied years ago and then either the value rose while the price lagged, or the price fell and I believed value was stable. Interest isn't the only criteria, but it is certainly one I use.

Regarding macro environments changing, sure, but this gets to your style of investing. Just because the macro environment is poor for an industry doesn't mean the stocks (or 1 stock within the group) will necessarily do poorly - it's all about what's priced into the stock and what is reality. It's fine to do a top-down approach with broad tailwinds, but it's not at all necessary. I've made a lot of money in stocks of hated situations/industries.

I'm with you that I don't just focus on a few industries because that feels limiting, but I'm not sure it's such a bad idea. I know investors who have specialized and done extremely well. The risk is as you suggest that the cheapest stock in an overvalued group is still a bad investment. So I wouldn't encourage doing that, but I think you are getting ahead of yourself here. As you start your journey your circle of competence is pretty small so you just start where you are and build up knowledge in an industry, and then you can move to another, and so on. But you have to start somewhere.

To be honest, I think choosing how to source ideas is very personal. You hear successful investors do the whole gamut. Screen off narrow criteria, screen off broad criteria, clone super successful investors via 13-Fs (dataroma)/fund letters, mine podcasts/blogs (Value Investors Club), follow interests, study all companies A-Z. I don't think there is a singular right approach, I'd just try different methods and see what works for you. This article summarizes some of this:

https://microcapclub.com/finding-ideas-before-others/

I 100% agree with you about the limitations of using a stock screener for exactly the reasons you say. Certain kinds of situations just pop up more because of industry characteristics. Further, given the prevalence of so many sophisticated quantitative-driven investors, how likely is something to show up in this sort of screen really to be so undervalued? Normally these situations have lots of hair to them, which gets to the same questions that face any stock - how well do you understand the drivers at play? Undervalued securities don't have to screen cheap, they just need to be (unfavorably) misunderstood, which comes about in all kinds of situations.

For these reasons, I don't personally like screens. But like the article above suggests, screens could be useful to winnow the field just a little bit based on certain criteria you value (perhaps smaller companies that are cash-flow positive).

It might be an unsatisfying answer, but I* don't really think at the beginning it's that important to have an optimized sourcing funnel to find undervalued stocks. Learning about businesses that seem interesting that you have reason to think are perhaps cheap, understanding financial statements/financial statement analysis/valuation, and getting comfortable with the mechanics of buying stocks and building a portfolio are probably enough to fill your time and a better focus. As you do these things, you'll probably discover how you want to source ideas.

*admittedly this may be my bias, because I've never had a systematic approach to sourcing ideas, but rather just meander around based on interest, companies in the value chain of those I'm looking at/own, and following a number of investing letters/blogs

[frommi]

But then how to choose what industries to focus on? Some industries or companies are boring to me, and anothers sound interesting to read about. But that hardly seems like a good criteria. Also, the macro environments matters and changes, so I’m not sure focusing on just a few industries is a good idea. The macro environment could be bad for some of them.


I meant to say that I’m not sure how to use a stock screener because different industries come with different ratios, margins etc that are typical. For example: a low P/E or a low debt/equity ratio is not necessarily a good sign. It depends on the industry, and also on the values of other ratios.

Start with the companies where you know and use the products. For me it was always interesting to go into the supermarket and see who produces what. While reading 10k's maybe fun to some, its also not really enjoyable to me. So i just open a 10K if i know what info i am looking for. Most of the time i look how the numbers have evolved over time to get a feel for how the business behaves in a recession or when interest rates go up/down etc. Thats something a lot of websites provide for the past 5-20 years, so just chose one and you don't have to read 10K's at all.

For deep value investing i do it mechanically without reading or emotions, because most of the time you will just lower the returns that way. Stocks are that cheap for a reason, and its better to not get involved with the reasons. Just have the faith that on average you will do very well with a diversified portfolio of deep value stocks (stocks trading far below liquidation value (NCAV) ).

[FrugalPatat]

How do you guys determine your discount rate? Certain sources recommend using the WACC but this seems wrong to me. I don't understand why I should care about a company's cost of debt and equity, rather than considering my own opportunity cost + probably an addition for stock riskiness. I’m also discouraged by the sensitivity of the DCF-function to changes in discount rate (non-linearity). If discount rates matter this much, and we can't be sure which one to use, then what is the point of using this approach?

Start with the companies where you know and use the products. For me it was always interesting to go into the supermarket and see who produces what.

It’s a fun exercise sure and I made a list but it’s mostly large cap companies. And I'm therefore hesistant because as Dave said:

I always like to keep it top of mind that for any securities past a certain market cap, there are numerous CFAs paid $250K/year with access to the best resources on the other side of the trade. Not literally true in many cases, but it helps calibrate the degree of seriousness you need to take your research...

[jacob]

How do you guys determine your discount rate? Certain sources recommend using the WACC but this seems wrong to me. I don't understand why I should care about a company's cost of debt and equity, rather than considering my own opportunity cost + probably an addition for stock riskiness. I’m also discouraged by the sensitivity of the DCF-function to changes in discount rate (non-linearity). If discount rates matter this much, and we can't be sure which one to use, then what is the point of using this approach?

Think of any model as a function that translates something into something else that makes more sense. For example, Black Scholes is a model that translates market prices on bets on other market prices into something called implied volatility. Everybody knows BlackScholes, so in reality people aren't trading market prices, rather they are trading the volatility curve (aka "the smile"). The BS equation is just used to translate between what people in the market think about the smile and what kind of prices they quote.

DCF is pretty much the same thing. It takes an estimate of present and future cash flows---something that all freshman business students ALL know---and converts it into a single number. It reduces hundreds of estimated numbers for a given company to one single number, the discount rate or IRR, allowing you to compare them between companies. Others do the same! So people trade companies based on those discount rates only using the DCF formula to translate back and forth to real price quotes. It's the same with even simpler things like P/E ratios or CAPE.

The point of using the modelling approach is that the market as a whole has a better understanding of what's actually going on as opposed to just investors making up their own stuff. It is essentially one level removed from individual opinions and gut-feelings.

Now, you might ask, suppose there was a model of the individual opinions. For example, suppose you had a model telling you which fraction of investors believed in the random walk hypothesis, how many did DCF, how many did asset allocation, ... If you had that, you'd see an even more stable and predictable number of curve or numbers and you could trade that.

Basically, the poker analogy holds strong. At the most rudimentary level, you play the hand, but if you understand probabilities of different hands, you play the probabilities. But if you know that and you know that the opponents also play probabilities, you play the players (like "tells", etc.). And if you know that, you might fake tells or play background information like whether someone is more desperate in terms of liquidity---closer to puking---than others.

A hard to accept lesson if this is that you quickly start playing the other players(*). In value-investing in particular, you're basically adopting a strategy of believing that you can find a model that can root out value before other people root out value. As such, you buy low ... and when others figure out what you know, they buy too thus driving the price up ... and at some point you sell, thus locking in a profit. However, if 80-90% of the other market agents either believe in momentum (buy something going up before other people get over their hang up and realize it's a trend too ... vis-a-vis .. sell before others realize the trend is ending) ... or the "stocks always go up in the long run, so buying whenever you have spare cash"-contingent, it dilutes the number of people who will adopt your strategy.---And so you might wait a long time before some other value-investor comes along to discover what you discovered and proceed to enter BUY orders which will lift the price and thus your potential profit.

(*) A perhaps even harder to accept lesson is that the mass of the market participants DO NOT think of this as turtles all the way down. For example, it's possible to use more complicated models than BS or DCF, but market agents have almost by convention decided that this is where they're at. Essentially, this sets the paradigm. As such, I think the modernistic pursuit of "the best model for the market" as misguided. The market is more of a sophisticated postmodern popularity contest where multiple opinions come together and the "early and eventually dominant"-opinion makes the most money.

It may be that the real secret to value-investing was that it basically become popular enough to make the initial promoters rich as others proceeded to do the same thing and boost the prices. Same as with any other strategy, really.

[suomalainen]

My understanding is that nobody actually uses DCF even though it's the "right" way to value a stream of cash flows. For one, the assumed IRR is just that - assumed, change it a little and the value changes a lot, and for two, predicting the future cash flows to discount is impossible. One year out? Sure, fine, close enough. Two? Ten? Twenty? In reality, at least in private markets where you remove that gamesmanship that Jacob talks about, valuations are almost always done on multiples (or PE ratio in public terms). This may stem in part from the debt markets basing their covenants off of EBITDA multiples (senior debt tends to be less than 4x or even 3 or 3.5x, mezzanine or high-yield or otherwise labelled junior debt may be 4-7x), so it's more natural to think of equity value as the cushion you have beyond the debt. Different industries and different size companies have different typical multiple ranges, but I'm not sure how those were developed. Some judgment on (that particular) market's risk/return is built into it, but I don't think it's reduced to a spot number like an IRR. So, like the public markets, whether a company is "fully valued" depends in some measure on how its multiple (PE ratio) relates to its industry peers and whether there are any reasons/factors for differences such as market share, customer concentration, innovation pipeline, etc.

I think you can be a "value investor", but you'll always be paying the current price of "market perception of value" which can have all of that psychological stuff Jacob talks about. So in that sense, I think of a "value investor" as almost buying without regard to future price movements. It's, as Buffett has said, a good business they want to buy at a reasonable price and they plan to hold it forever.

[Sclass]

I recall DCF examples in Buffetology used the fed funds rate. It seemed kind of arbitrary but their reasoning was your target stock was competing with bonds.

When Buffetology was published I got into DCF and made a bunch of screeners using DCF so I could rapidly find “value”. I fell for DCF. I’ve posted about this debacle before possibly in this thread. I was naive and young. And I lost a lot of money (well, a lot for me at the time).

The idea is that you will find situations where a stock is trading below the value of its future income. And as @jacob says, any student can do this calculation and you hope to find the valuable ones before anyone else notices. That’s really naive. In other words, you’re going to find a bunch of numbers readily available to all and churn them up on your HP12C and you’ll get a thumbs up or down on the stock. If life were only that easy.

What I discovered the hard way is that every intern at the large banks is running the numbers on stocks that have coverage…and a number that don’t have coverage. If you find “cheap” stocks they are usually cheap because the market is not bidding their prices up. If you believe your naive DCF calculations have discovered something new you’re now the fish. Everyone has run the analysis and adjusted their future expectations around that and perhaps a dozen more factors you don’t yet know.

So while running my DCF finder I found dogs. Stocks that had low prices and great future cash flows. It was like I’d just found treasure. The problem was I’d found trash. And the real time experiment of buying the stocks and watching their earnings erode in the coming years schooled me hard. Mr. Market knew more about their potential earnings than I did and my assumptions about stable or increasing income were not only wrong, they were priced in. The value trap so to speak. I know this sounds really bad but I was really a young naive investor at the time (grad school gambling my stipend).

I used to also read a lot of annual reports 10Ks and such. Same problem. Every intern has read them and there’s nothing in there that hasn’t been priced in. It’s too easy. I guess my feeling about people who insist on this is “how has that worked out for you?” My late father used to scold me for not reading quarterly financials or attending earnings calls over the last twenty years. It was part of his “style”. I figured all that was already digested and priced in. I’d tell the old man that some wet nosed MBA has already read all them for me. He was horrified at my hubris.

The bottom line is if you really want alpha you need to know something others do not. There are a bunch of ways to do that but they are not “value investing” so they don’t really belong here.

[frommi]

If you are swimming in the pool of large caps, a DCF is pretty useless.
I typically dont do that, what i found works good is the Gordon Growth Model. It gives you an expected IRR for the next n years, where n is typically 5 years for the companies i look at, because that is my expected holding time. Your expected return is divided into 3 components, dividend+growth+valuation change. If you take growth as the median EPS growth estimation from a lot of analysts and valuation as the median valuation over the past 10-15 years, you take any guessing out of the equation. You get reasonable numbers you can compare between investments, because you can also do that exercise for real estate (rent yield+inflation estimations) or bonds (yield+0 growth+0 valuation change).
Of course that is not true "valuation", but it works, at least if your numbers are reasonable.

[FrugalPatat]

Some great content in these last few posts. I’m only a beginner in learning how to read and analyze financial statements (and annual reports / 10-K’s by extension). I have read a number of books in the past on investing but they were mostly boglehead type books.

I’m currently 100% in cash because of the elevated valuations in the market. It has been a few years that I no longer wanted to own the full market index through the usual etfs. Of course, my situation is different in that I'm not financing retirement with this money. But I’m influenced by John Hussman’s monthly market comments (even though I know about the lack of performance of his funds in the past decade). On the other hand I like the permanent portfolio and if I were in the US I’d probably be using that (although I’d still be scared of rising rates ). But I’m not convinced it works in Europe.

I was therefore hoping that being able to understand and analyze 10-K’s and the companies’ industries would open some doors. That maybe it would allow me to find a way of being in the current market that would let me sleep well.

[frommi]

I fully understand you, i have the same problems with investing in a market fund. The S&P500 is very expensive.
The way i can sleep at night is that i simply hedge with put options over the summer months and by only buying stocks that i know are very defensive in that a recession will not derail their earnings.

Buying them at historically cheap prices they behave like bonds, but with much highers coupons and some growth. Companies like tobacco stocks, MDLZ PEP or MCD don't fluctuate that much and their earnings/cashflows are pretty stable. Many people under-estimate what dividends can do over the long run. PM for example has outperformed the S&P500 on a total return basis over the past 5 years, and that business is boring af.

And by hedging you even make money when stocks go down. Funny side fact, on that crash day in August i was up like 4% on that day, even if my portfolio has since been giving back some gains. But on average i have made 14-15% annualy for the past several years with that approach.

[Dave]

@jacob’s post is very insightful and worth understanding for market participants of all strategies, because you can think of it as a sort of the substrate in which you operate. Many layers to the market, many strategies, and knowing of this informs whatever you are doing to a more intelligent degree. I don’t disagree with what he said.

However, I do think there is a slight simplification he made to illustrate a point that many people do and I think it presents a slightly warped view of value investing:

In value-investing in particular, you're basically adopting a strategy of believing that you can find a model that can root out value before other people root out value. As such, you buy low ... and when others figure out what you know, they buy too thus driving the price up ... and at some point you sell, thus locking in a profit. However, if 80-90% of the other market agents either believe in momentum (buy something going up before other people get over their hang up and realize it's a trend too ... vis-a-vis .. sell before others realize the trend is ending) ... or the "stocks always go up in the long run, so buying whenever you have spare cash"-contingent, it dilutes the number of people who will adopt your strategy.---And so you might wait a long time before some other value-investor comes along to discover what you discovered and proceed to enter BUY orders which will lift the price and thus your potential profit.

(*) A perhaps even harder to accept lesson is that the mass of the market participants DO NOT think of this as turtles all the way down. For example, it's possible to use more complicated models than BS or DCF, but market agents have almost by convention decided that this is where they're at. Essentially, this sets the paradigm. As such, I think the modernistic pursuit of "the best model for the market" as misguided. The market is more of a sophisticated postmodern popularity contest where multiple opinions come together and the "early and eventually dominant"-opinion makes the most money.

It may be that the real secret to value-investing was that it basically become popular enough to make the initial promoters rich as others proceeded to do the same thing and boost the prices. Same as with any other strategy, really.

On a theoretical level, I take some issue with this. Value investing is not about buying an asset before other investors do to front run the price. Practically speaking, yes, this is generally how your return comes out, if you say do the stereotypical of buying an asset at a discount to intrinsic value before others, the price bids up close to value, and then you sell.

But at its core, the theory of value investing is to buy a business for less than it’s worth. And what it’s worth is the present value of cash flows from now to judgement day. This is not a small point, because the implication is that the price activity from date of purchase to final liquidation is meaningless to intrinsic value calculations (beyond the ability to repurchase or issue stock). So to @jacob’s example of a large % of the market running momentum or indexing and thus ignoring value stocks and keeping them perennially cheap, it really doesn’t matter in the longest run because eventually the cash will flow from dividends and liquidating payments and the value is preserved. The return will just be back-loaded, which obviously you’d prefer it front-loaded for higher IRRs!

So practically speaking @jacob is right that if few participants are using value, it can keep stocks mispriced for very long periods of time and really shift the price realization much longer, but if your valuation is right (a HUGE if, not a trivial thing), it actually does not impact intrinsic value at all. This is why you hear so many value investors talk about thinking like an owner buying for keeps and not just renting stocks.

Again, beating the dead horse, value investing works by definition. It’s not some woo woo idea, it’s just that if you buy a business for $100 and the discounted cash flows from now to bankruptcy are worth $150, then you are buying $150 of value and things work out OK (you earn the IRR from initial purchase price to equalize all dividends to that). It’s just that the IRR would be higher if the stock rerated to value much quicker, and historically it did rerate much quicker than we sometimes see today, going to @jacob’s last comment that those who first discovered it earned extremely high returns that likely are no longer replicable at scale and likely to generate the highest return – that is reserved for what @jacob noted as “the early and eventually dominant” current opinion makes the most money.

How do you guys determine your discount rate? Certain sources recommend using the WACC but this seems wrong to me. I don't understand why I should care about a company's cost of debt and equity, rather than considering my own opportunity cost + probably an addition for stock riskiness. I’m also discouraged by the sensitivity of the DCF-function to changes in discount rate (non-linearity). If discount rates matter this much, and we can't be sure which one to use, then what is the point of using this approach?

It’s tricky. You see a lot of different views on how to get to the discount rate (very academic, pick your own, ignore altogether, etc.) You use the WACC when you’re valuating a whole firm with debt because you’re thinking about the aggregated capital structure, not just equity. You can do just your discount rate and value the equity, but adjustments have to be made. Practically speaking, this gets to @suo’s comment about how finicky DCFs are and their limitations.

I’d argue you don’t have to use DCF’s to value stocks, but even if you do I think there’s a problem with conflating the difficulty of doing something with its theoretical accuracy. So if you a DCF for a company and lean towards conservatism across the board (lower end of revenue growth, margins, higher discount rate, etc.) and it still comes out as meaningfully above the share price, then you have an interesting situation. This is why it’s more helpful to think of a range of intrinsic value and focus on situations below the lower end of value, rather than value as some precise concept you have to pin down accurately. This is what Graham meant when he said you don’t need to know a man’s weight to know he’s fat. We don’t need perfect precision – “better to be approximately right than precisely wrong”.

My understanding is that nobody actually uses DCF even though it's the "right" way to value a stream of cash flows. For one, the assumed IRR is just that - assumed, change it a little and the value changes a lot, and for two, predicting the future cash flows to discount is impossible. One year out? Sure, fine, close enough. Two? Ten? Twenty? In reality, at least in private markets where you remove that gamesmanship that Jacob talks about, valuations are almost always done on multiples (or PE ratio in public terms). This may stem in part from the debt markets basing their covenants off of EBITDA multiples (senior debt tends to be less than 4x or even 3 or 3.5x, mezzanine or high-yield or otherwise labelled junior debt may be 4-7x), so it's more natural to think of equity value as the cushion you have beyond the debt. Different industries and different size companies have different typical multiple ranges, but I'm not sure how those were developed. Some judgment on (that particular) market's risk/return is built into it, but I don't think it's reduced to a spot number like an IRR. So, like the public markets, whether a company is "fully valued" depends in some measure on how its multiple (PE ratio) relates to its industry peers and whether there are any reasons/factors for differences such as market share, customer concentration, innovation pipeline, etc.

I think you can be a "value investor", but you'll always be paying the current price of "market perception of value" which can have all of that psychological stuff Jacob talks about. So in that sense, I think of a "value investor" as almost buying without regard to future price movements. It's, as Buffett has said, a good business they want to buy at a reasonable price and they plan to hold it forever.

@Suo’s second paragraph is exactly what I meant above. A true value investor, not just someone trading value factors, thinks of value with no regard to future price movement. The value is calculated from cash flows, not stock prices. It’s just stock prices often offer the opportunity for higher IRRs via early exit.

Only thing I’d comment on here is that while many people ignore doing DCFs and use multiples instead, it’s important to realize that multiples are essentially highly simplified DCFs with tons of embedded assumptions. There is no escaping the difficulty of valuation, and using multiples just either blindly ignores a lot of those underlying factors (like @suo said of market share, customer concentration, pipeline but also a million other things like ROIIC, margins, inventory turnover, whatever) or can be used intelligently and conservatively. I use multiples all the time, but you need to be honest about what you’re doing.

@Sclass, I know exactly what you’re getting at and tons of people fail here and I’ve done it myself many times. But I think you’re conflating a simplified version of what value investing is with what it actually is, because buying value traps is not skillful value investing. Running DCFs with inaccurate assumptions results in inaccurate values, and thus poor results. The ole garbage in garbage out.

You’re totally right that tons of people can and have run these DCFs…but the magic is not in the formula, it’s in having a more-refined view on the inputs. It is not trivial to accurately project sales, margins, cash flows, ROIIC, etc., and reading 10-Ks does not guarantee you get that right. The ability to run a DCF is just sort of the bare-bones analytical skill needed to estimate value, but the real challenge comes to getting those inputs MORE (not completely) correct, and is the whole crux of the matter, “expectations investing”. What is priced into the stock and are those expectations roughly right (stock trades near value), too conservative (stock is cheap), or too aggressive (stock is overpriced).

I agree with you that it is not easy at all, and would discourage anyone from thinking it’s as simple as reading some 10-Ks, plugging them into a calculator, and comparing value to price. I’d argue that isn’t at all what value investing done well is.

Your comments about reading 10-Ks are really interesting and worth potential value investors reflecting on. I do not agree with you that everything is priced in all the time, but I would agree that it’s not common that you find some gem in a 10-K that sheds a clear light on what intrinsic value is. By not reading 10-Ks you may expose yourself to some risk (off-balance sheet liabilities, customer concentration, debt repayment schedule, the degree of interest rate sensitivity, whatever), or you may miss some nugget that could be useful, but in general I agree that they aren’t at all a guarantee to great results. I look at reading 10-Ks as being a very basic step to gain a view, but again it just helps flesh out my understanding of a situation and it informs where further research into key variables should go.

With all of that said, I agree with part of your last comment that the bottom line is alpha comes from knowing something others don’t. I see reading 10-Ks as helping gain a small piece of understanding of the situation, so when you go out and look at market price and read what others are saying, you can have an idea of how well calibrated other market participants have a view on the situation. I just don’t agree that knowing something others don’t is distinct from value investing, as I see the entire point of what I’m doing is to find situations where others are too conservative in their views of the future cash flows of a company.

@FrugalPatat,

The discussion of these things can get overcomplicated and go well beyond the core of value investing. I would argue that value investing is simply taking a businesslike approach to investing where you find businesses whose future you can model with some degree of accuracy, you value their securities, and if they are valued at much higher levels than the price, you buy. Said differently, you find a situation where you believe you will earn an attractive rate as a permanent owner of a stock – if you can buy a given company at a price where your earnings yield is 10% and it is likely to grow in line with inflation, that is attractive.

The rest is nuance and worth exploring, but people make lots of strawmans with value investing and miss what it really is. I own several businesses whose assets are worth multiples of their share price and who have profitable and growing earnings streams. Things are very likely to work out OK, even if I can’t model the future with precision and running DCFs is hard, because it is very clear that the market's expectations around the companies' futures are excessively pessimistic. It is very, very hard to beat the market (through any approach including value investing), but it can be done.

[jacob]

So practically speaking @jacob is right that if few participants are using value, it can keep stocks mispriced for very long periods of time and really shift the price realization much longer, but if your valuation is right (a HUGE if, not a trivial thing), it actually does not impact intrinsic value at all. This is why you hear so many value investors talk about thinking like an owner buying for keeps and not just renting stocks.

Something to keep in mind as a small investor, though, is that small investors are utterly dependent on either the price rising or a dividend payout which must be higher than the risk-free rate to realize an [acceptable] return. A small investor might think like an owner, but they'll never be an owner in the sense that they get get a board seat or even take over the entire company (like Buffett et al) and proceed to liquidate all those market-underpriced assets for money.

[Dave]

Something to keep in mind as a small investor, though, is that small investors are utterly dependent on either the price rising or a dividend payout which must be higher than the risk-free rate to realize an [acceptable] return. A small investor might think like an owner, but they'll never be an owner in the sense that they get get a board seat or even take over the entire company (like Buffett et al) and proceed to liquidate all those market-underpriced assets for money.

100% agree. This is why investing in companies whose shareholder base, board, and management have enough skin in the game (ideally through direct ownership of substantial stock purchased with their own money, or an incentive plan that is truly in line with minority investors) is critical. Thinking like an owner means you need to understand your partners and what direction the business and its cash flows are going to go in the future, not just blindly hoping they end up in a good place. Again, value investing is being being business-like in our security dealings. That means you don't do business with people you don't understand and trust.

This is one case of where people strawman value investing or get frustrated with it for reasons that have to do with an inadequate depth of research and nothing to do with "value investing". Buying a company at a very high earnings yield but whose earnings are being squandered on low ROI asset growth or egregious management comp is very likely to turn out poorly.

When we talk about valuing future cash flows, we're talking about actual cash flows to shareholders, not some financial data aggregator site's calculation of free cash flow. Part of the work of doing a DCF is figuring out where the actual cash is going to go over time, not just calculating recent FCF and growth rates and assuming it's automagically going to appear in your brokerage account.

These sorts of things must be factored into your investment analysis, which includes business and industry analysis, management and owner analysis, and security analysis. If you have concerns over capital allocation, either move on or demand a bigger discount to cushion in the event things develop unfavorably. We aren't helpless here and if we can't get comfortable with where the cash is going, just move on and find something where you can. Of course there are no guarantees, but there are certainly many situations where the owners and management have clear records and articulated approaches that mitigate the risks of poor capital allocation, thus attenuating the risks you're talking about.

[Dave]

A perhaps even harder to accept lesson is that the mass of the market participants DO NOT think of this as turtles all the way down. For example, it's possible to use more complicated models than BS or DCF, but market agents have almost by convention decided that this is where they're at. Essentially, this sets the paradigm. As such, I think the modernistic pursuit of "the best model for the market" as misguided. The market is more of a sophisticated postmodern popularity contest where multiple opinions come together and the "early and eventually dominant"-opinion makes the most money.

I think I understand what you're saying here, but I'm not 100% and would appreciate if you could expand on this.