Don’t Be A One-Legged Person In An Asskicking Contest
My Answer To Why Valuation Is Important
Last week I asked your thoughts on valuation. If you think it’s important? Why or why not? I asked this because I’ve seen a lot of discussion on the topic in recent weeks. This post is my answer to that question.
Asking if valuation is important to deep value investors like us is like asking if we follow the teachings of Ben Graham and Warren Buffett. The answer of course is yes. But why is valuation important?
Once we understand how to do valuation most of us never think about this question again. And it’s important to understand why.
To show why valuation is important let’s continue with an example from the earlier post. Why The P/E Ratio Is Useless – And How To Calculate EV.
Why Valuation Is Important
Below is an example of two company’s made up for the example.
|Company 1||Company 2|
|P/E stays the same under the below scenario.|
|Cash and Cash equivalents||0||40|
|Company 2 is cheaper when considering EV|
P/E, EV/EBIT, and EV/FCF are all relative valuations. Companies that have lower relative valuation multiples are cheaper than others. And companies that are cheaper are better to buy. Why is this?
To find out why lets invert both EV/EBIT and EV/FCF to find each companies earnings yield. I explain earnings yield in the following section.
Earnings Yield Estimates Expected Rate Of Return
For those who don’t watch the short video above I’ll paraphrase. Earnings yield is the estimated return you should expect to earn in one year on an investment.
The higher this number is the better. This is because the higher this number is the more a company is undervalued.
Company 1 above has an earnings yield of only 7.1%. Not good enough. I look for earnings yields above 10%.
Company 2 above has an earnings yield of 16.7%. 2.35 times company ones earnings yield. And above the 10% I look for when considering an investment.
This means you should earn 2.35 times more if you invest in company two instead of company one. But this isn’t all…
By doing the work above with EV and earnings yield, not only do you see that company 2 will get you a higher return. But doing a bit more work allows you to see that company 2 is a less risky investment.
Company 2 is safer because it has no debt, while having a lot of cash. The saying that the more you risk the more you gain is a fallacy. This “advice” needs to die because it leads many investors into unnecessary danger.
But these aren’t the only concepts you need to consider when evaluating an opportunity.
EBay And Amazon Businesses
Many of you who’ve followed this blog for a while know that I also run an EBay and Amazon reselling business. The example below is something I found and sold last year.
I use the concepts talked about in this article every day. And you can use them whether you’re analyzing a stock. Or buying something to sell in your business.
Let’s say we have two of the same Giorgio Armani jeans. Same size, color, condition, everything. And both are real Giorgio Armani jeans.
Each pair of jeans looks brand new but does not have the tags on them still. These jeans sell for more than $100 brand new. But for this example let’s use $100 because it’s an even number.
So both pairs of jeans are the same and sell brand new for the same amount. But what if I said you could buy one of the pairs for $80 and the other pair for $2. Which would you buy?
The one that’s selling for $2 of course.
But if you had an EBay and Amazon business how would this change things? You would need to keep thinking…
One pair we bought for $80 and the other we bought for $2. We can resell both for $100. This means we have the potential to make $20 on one pair and $98 on the other.
The pair we bought for $80 and sold for $100 gives us a 20% return. Not bad. But the pair we bought for $2 gets us a return of 4900%. Or a 49 bagger in a short amount of time. We’ll get back to the time aspect later… This is a spectacular return. And is why valuation is so important.
All else remaining equal, the cheaper a company is the higher return you should expect in the long-term.
This is why it’s important to value businesses. Without doing valuation you can’t know if you’re getting a good deal. Or taking unnecessary risks with your capital.
In the above example is risking your $80 to make a $20 profit worth your time? Or would you rather buy the $2 pair of jeans and get a 4900% return on the same item while risking far less money on a safer investment?
But there’s still more…
You also need to think about the amount of time it will take for your investment thesis to play out. And consider what you can’t invest in while you invest in this opportunity.
This last concept is opportunity cost.
The Opportunity Cost of Investing
As investors we have to consider several choices every time we think about buying an investment.
- Is the investment safe?
- Am I getting a high enough return compared to the capital I’m risking?
- Am I getting a high enough return for the amount of time I expect to hold this investment?
- Do I already own another company that would be a better investment?
- If I invest in this company now, am I comfortable holding it for the long-term? Another – possibly better- company may come along and I need to be comfortable losing out on that opportunity.
These are just a few of the many things you need to consider when investing. But for now I want to concentrate on the last bullet point. It’s the concept called opportunity cost.
DEFINITION of ‘Opportunity Cost’
1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.
2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).
Below is a video from Study.com giving a real world example of opportunity cost.
The example of choosing between two jobs is too simple. But it’s a good starting point.
The thoughts I would’ve added to help me decide which is a better job would be: Which job would I be happier at? Which one has more room for advancement? How many hours do I have to work at each? Etc.
When considering an investment you need to consider more than just valuation.
For example: Which one is safer? Which one is offering a higher return? Which one do I have more capital tied up in and for how long? Which company has higher profits and cash flow compared to valuation? Am I willing to pay up for a better company? And much more.
This is how you begin to analyze the opportunity cost of an investment. And get closer to a decision.
But without valuation you’re only considering part of the equation. And without valuation you’ll have to rely on gut instinct and emotion. Two things that will kill you when making investment decisions.
Don’t Be A One-Legged Person In An Asskicking Contest
Yes I know when picking businesses and stocks to invest in not everything is equal like in the examples above. But this is why you need many tools in your mental toolbox while evaluating things.
And if you don’t consider valuation, opportunity cost, and the other concepts in this article, you’re missing some of the best mental investment tools. Or as Charlie Munger says:
“If you don’t have the proper mental tools then you go through a long life like a one-legged man in an asskicking contest.”
To learn more about mental models. And start adding tools to your mental tool box so you don’t go through life like a one-legged person in an asskicking contest, go to the earlier post. Car Wash Psychology, Mental Models, and The Power of Habit.
What do you think about valuation? And did I miss anything in my explanation? Let me know in the comments below.
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