Relative Value

Measuring quality

My post on Begbies Traynor last time raised a few interesting questions from a portfolio management point of view. As I was writing it, I couldn’t help but draw comparisons to RSM Tenon, the rather despised accountancy firm – both service firms trading on tiny multiples of last years profits after an acquisitive period and some extensive intangibles. Both have balance sheets tied up in illuiqid receivables, and both sets of management seem bearish even in the face of such market hammerings. Many things aren’t the same, of course – there are some rather big factors that separate the two companies. Regardless, the questions a comparison between the two companies raised left a few lingering doubts in my mind about my current method of comparatively valuing companies.

As readers of the blog will know, I rarely use any form of discounted cash flow analysis or any more ‘concrete’ method for assigning companies a present value. My long-standing reasoning is that they simply represent the biases we possess anyway – me being bullish on all the companies I am, for instance, will mean that I’ll obviously just come out with figures that’ll make them look like sound investments. Does assigning a number to my biases really help in any way if it does not fundamentally change my thought process? Instead of filling in a spreadsheet to which I know the answer anyway, I figured, I’d rather just move on and do more productive work.

With that, though, I raise a completely different set of problems. As I thought about the differences between Tenon and Begbies, I struggled with a way to attribute a value to the different problems they face. RSM Tenon faces a management that doesn’t seem to particularly care about shareholders. Begbies Traynor faces an uncertain market and may well have just enjoyed their best two years, with corporate insolvencies running way above a long-term average. Qualitatively, I feel I’ve determined the issues underlying the share price; it’s the quantitative bit that needs a little work.

The only solution, I think, is to bite the bullet and start putting cold, hard numbers on the factors that are affecting a company. Not only will it give me clarity and a better overview of all my investment decisions, setting up an approximate intrinsic value will both allow better comparison of investments and a better feedback mechanism for how they went, after I decide to sell. Part of the reason I didn’t do this in the first place, I think, is the comfort of woolly terminology. Making statements is the easy part. Determining their impact on the value of a business is a far harder prospect. But, since I started this blog to chart my development as an investor as well as open my decisions up to scrutiny, I reckon the next logical step is to take what I’ve learnt so far and apply it with some more methodical vigour.

Much like Valuhunteruk does, then, I plan to start outlining and appraising the business’s value under different scenarios. A straight discounted cash flow analysis presents, theoretically, a ‘mean average’ scenario – valuing the company under a set of assumptions for the next few years. My hunch, though, is that most analyst DCFs have a tendency towards presenting the most likely scenario, instead of the mean one; that is to say, they capture few of the outlying possibilities for the share price, and simply present an analysis based on things going hunky-dory and boringly unremarkable for the next few years. To counteract my tendency to do that, I plan to instead take 3 scenarios – a worse case, a most likely case, and a best case, and look at the value in each of the three scenarios.

That’s not as difficult as it sounds – the differences between the scenarios will probably be fairly easy to quantify factors; say, a few percentage points difference in revenue growth, or a reversion to mean margins vs. a continuation of high margins. With my three trajectories set out, I hope I’ll be able to better weigh up the share price prospects for a few years time. Since I think few probabilities of success will be measured on a bell curve, I’m not sure what I’ll do with my scenarios. Perhaps I’ll weight an average with some assigned probabilities.

For those of you who think this is too complicated, my gut agrees. I just think failing to express your preferences is simply making your assumptions implicit instead of explicit. So, with renewed vigour, I’ll be going back over my portfolio and thinking hard about how to quantify the factors that I spend so much time trying to identify. I’m not sure how I’ll be expressing my three scenarios in my posts – I’ll probably take another leaf out of Valuhunteruk’s book on that front, as I rather like his way of doing it.

Either way, stay tuned – for me, it’s back to the spreadsheets with number-filled eyes!

2 Replies to “Relative Value”

  1. Richard Beddard

    Blimey EV! Good luck with that. I tried to make my assumptions explicit using a residual income model. Great fun if you enjoy playing with spreadsheets but in the end I retreated because I didn’t think I was getting much benefit in terms of certainty around valuation but I was putting a hell of a lot more effort into it. Here’s the series of articles on it: Might go back to it one day.

  2. Lewis

    Cheers Richard!

    I do remember reading some of these actually – but I’ll take a further look as I ponder my own questions. I’m not sure how far I’ll get to be honest; I do like spreadsheets, but with no practical experience in this I may find I’ve bitten off more than I can chew. We’ll see!

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