I have been writing in this blog for about three years now. Looking back, I have learnt about stocks valuation and the different techniques. I felt that stock valuation is more of an art than science/math. It seems that the more experience I get, the more vague things become.
Stocks Valuation Too Precise and Arcane
I think I have a decent grasp on assessing business quality and competitive advantages. As long as it is within my circle of competence. When it comes to stocks valuation, most valuation techniques seem overly precise and arcane.
I honestly feel like if I valued a business 3 times using the Discounted Cashflow Method (DCF), I could have a huge valuation gap between the three of them all depending on my mood. The terminal value in a DCF just seems to have way too much weight in the model.
Recently, I try to think of stock valuation as a rough gauge, as it seems entirely too subjective at times. It’s useful to have a rough estimate of how much revenue growth the company needs each year and what type of profit margins they need to justify the current valuation.
However, It’s impossible to be completely accurate and confident in a specific valuation (you are attempting to forecast the future, after all), but it should definitely be objective and deterministic. If you’re pulling numbers out of thin air based on your mood, then you’re not really doing anything other than placing a random number on your feelings
My Approach to Stocks Valuation
Valuation is important but we need to distinguish between mindless analysis and work that actually increases your understanding of the stock. In the end, if your decision to buying/not buying depends on the result of a DCF then you will probably gonna find value traps. What matters most is knowing how a company’s financials actually work.
For example, my previous 2 investments into Aercap (NYSE:AER) and Oceanus (SGX:579) would have failed miserably if we rely on valuation techniques like DCF. Markets are complex systems. These 2 stocks were hated at the time and priced to bankruptcy. Turns out I’m right.
If you think you have a definitive formula that explains stock prices ceteris paribus, you will be fooled by randomness over and over. Efficient Market Hypothesis works well in theory until its first encounter with practice.
We see everyone looking for the next investment holy grail. Investment information is being touted everywhere and is much highly sought after in the market. The internet is heavily populated with investing videos of all kinds, while automated technologies have stripped much of the guesswork from the investment process. Still, that creates a few conundrums. Too much information will lead to analysis paralysis. 90% of the information is biased and unreliable in the first place.
The way to beat complexity is not to try and be a better stock picker. The way to beat complexity is to accept there will be a bunch of losers and deal with them. Before these 2 picks, I have discarded a bunch of stock ideas. Stock ideas that did not check all the boxes on my list.
Keep It Simple Stupid
This simple rule is quite powerful in cutting through a lot of noise. For example, earnings multiple of Covid plays has gone up significantly this cycle, but is there any way that their profit goes up 4x in the next five years ? I dont think so. I would guess a DCF would actually tell you the stock isn’t as expensive as it is (because of the rates cycle).
Investing is about buying a thing worth $1 at $0.50, it is simple but actually the guts to buy something worth $1 that falls to $0.50 is not easy.
Working on spreadsheets is simple, but resisting temptation to tweak your formulas to fit your version of reality is not easy.
Calculating book value of a company is simple, but understanding whether that book really has value or is a value trap, is not easy.
Calculating past growth and profitability ratios for a business and is simple, but actually trying to understand a business deeply enough to forecast its future growth is not easy.
Knowing that a business has moat as seen from its superior profitability and clean balance sheet is simple, but understanding whether this moat is sustainable or fleeting is not easy.
Knowing the results that numbers shout out of financial statements is simple, but knowing which of those results are signal and which are noise is not easy.
Understanding that money can multiply 10x in 20 years when you do DCA is simple, but sitting through these 20 years patiently when others are cashing in after having made 5x is not easy. I think you get my point.
(Taken from “Math is the Simple Part“)
Part of the challenge in investing is valuing companies, something that is only made more difficult by complexity.
Stocks valuation is a critical measure of calculating fair value. It allows investors to perform a comparative study of stocks to learn, which can grow in the long run. However, there are more than one ways to view stocks valuation and also to interpret it.
I think it is also important to have a feel of how the company runs its business operations. Assessing management quality is important as investing in a stock is essentially owning a piece of the business. I would prefer to have someone I could trust to hold the reins.
All in all, stock valuation has both art and science elements and we should not just depend on one technique to evaluate the stock’s potential.