I’m an analyst at heart, so I love metrics and ratios and data visualizations that show how one investment will work and another will not. When I scour Google finance for the next big idea, I look for low price/book ratios, or low P/E ratios, or high dividend yields.
But before you get caught up in all the numbers, think about this from an article on BBC News: “The average lifespan of a company listed in the S&P 500 index of leading US companies has decreased by more than 50 years in the last century, from 67 years in the 1920s to just 15 years today, according to Professor Richard Foster from Yale University.”
This information should terrify you, or at least make you think twice about stocks you think of as being “value” investments. It means that our conception of value isn’t just looking for “cheap” but rather do as Warren Buffett does: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
What does this mean? Let’s take two companies: Intel (INTC) & Coca Cola (KO). Which is more over (under) valued? Based purely on an analysis of the most-used ratios:
- Forward P/E ratio: INTC: 13.5 KO: 19.6
- Price to cash flow: INTC: 9.0 KO: 17.9
- Price to book: INTC: 3.1 KO: 5.7
By every valuation metric, Intel is cheaper than Coca Cola. If you treated each stock as a bond, you’d earn 11% in cash on Intel vs. only 5.6% on Coca Cola. Plus, Intel is a tech stock (ignore recent problems in personal computers). Technology has higher growth rates, so that 11% will likely be far more than Coca Cola’s 5.6% in 10 years, right?
Of course I primed you, so you know that logic is faulty. If I imagine a world 20 or 30 years from now, I can still see myself sipping a Coke Zero (or Coke 100 or some Coke brand). There’s not much that can replace my physical and mental relationship with the Coca Cola brand. Could someone come up with a better formula? Maybe. Could they market it better? Perhaps. Could they secure my loyalty. Could happen. What about incorporating an addictive drug in their drink? Yeah, sure. What about all of the above? Not bloody likely.
Because of the amount of change in the technology landscape within my lifetime, I can easily imagine a world without Intel in 20 years (maybe even 10). That doesn’t mean Intel will go away. In fact, Intel may be a good buy, but there’s an added risk. I don’t have the same relationship with my computer chips that I have with Coke. If the processing is fast, and I can do it anywhere, and it’s not crazy expensive, I don’t care if it’s Intel or AMD or the next new thing.
Project this outward. If I want to know the total value/price of Coca Cola vs. the total value/price of Intel, I should take the current market cap of each, the return in cash flow on each compared with the total future cash flows due to me as an owner over the lifetime of the company (discounted by inflation year over year).
- $176.2 billion market cap
- $10 billion free cash flow
- Expected lifetime? 15 years (this is a wild guess, by the way)
- $189.7 billion market cap
- $8 billion free cash flow
- Expected lifetime? 50 years (again, a wild guess)
Ignoring the discount rate (because cash flows will likely grow), we get a rough return from Intel of -15% vs. a rough return of 111% for Coca Cola. Notice how the least knowable bit of information becomes the most important. This is the essence of Buffett’s philosophy for not getting stuck in value traps.
As an analyst, I like to have perfect data. I’m tempted to ignore imperfect data because they’re based on a hunch or a guess or something completely unknowable. But a stock investment is a bet on the future. You cannot ignore the most important piece of information just because it’s imperfect. It’s better to conduct a valid analysis on imperfect data than an irrelevant analysis on perfect data. So if you buy a company based on a ratio, take a little time to think about whether that company would have existed 50 years ago, and will still exist 50 years from today.