Foreword
This post discusses some common techniques on evaluating the fundamental value of a company by looking at its income statement, for those who are investing, as defined in Investing vs Speculating.
There are, of course, other ways of evaluating the value of a company, which we will cover in other posts. Other posts in this series:
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
How do companies work?
Before we tackle the topic du jour, let’s get down to brass tacks and consider what is even a company? What does a company do? How does it work?
Legally, a company is simply a legal structure where one or more people get together to perform some tasks, generally a business. The company provides a shell to ringfence the business, so that there is a clear separation of concerns between its individual owners, and the business itself. A company, then, can be thought of as a container of a business — though that business may itself be the acquisition of other companies and/or businesses. For example, Berkshire Hathaway, is a holding company, whose main business is to buy other businesses, such as See’s Candies, GEICO, etc. Another interesting example of a “container” company is the SPDR S&P 500 Trust ETF. It is an investment company structured as an exchange traded fund (ETF), with the ticker symbol SPY, and its main business is to buy and hold stocks to track the S&P500 index.
Regardless of the business(es) a company is in, there are a few common aspects shared by all of them:
- Companies typically seek commercial profit (we are excluding charities and non-profits in this discussion).
- Companies generally have one or more products. Products may be be tangible, like a watch, a machine, etc., or they may be intangible, like a website, an online service, movie rights, etc.
- Companies start by taking money from investors (also called shareholders) to invest in producing the product(s).
- Note that this refers only to the initial investors, generally before the company starts trading on the markets.
- If you buy shares of a company with a broker, the company does not generally see a single cent of that money — instead, that money goes to pay off earlier investors, who sold you their shares.
- They may also sell bonds or otherwise acquire debt to raise cash to invest in producing the product(s).
- Finally, they sell the product(s), ideally at a price higher than the cost of manufacturing the product(s). If they manage to do so, they make a profit.
- Profits can then be retained by the company to invest in producing future product(s), or they can be used to pay down debt, or returned to investors via dividends, or to reduce the number of investors/outstanding shares by buying back shares.
Common accounting terms
Even in our simple model of a company above, a lot of interesting terms pop up. Understanding how to read a company’s income statement will require some basic understanding of these terms.
| Revenue Gross sales | The total amount of money the company generates from the sales of its product(s). This is almost always the first line of a company’s income statement, so literally the “top line”. Example: A company that sells 1,000 wooden figurine for $20 each, will have revenue of $20,000. |
| Operating expenses | The expenses that the company incurs through its day to day business operations. These can include costs of customer acquisitions, payroll for its workers (not directly producing the product(s)), research and development, etc. In economics terms, it is essentially the equivalent of “fixed costs”. Example: Our wooden figuring company may have to rent some factory space for its woodcarvers, at, say $6,000, which is its operating expenses. Note that regardless of how many wooden figurines are made or sold, the rent remains at $6,000. For now, we assume the factory is large enough to accommodate any amount of production. |
| Cost of goods sold | The expenses that the company incurs directly in the production of its product(s). For example, the costs of the materials used to produce the product(s), the payroll for factory workers, etc. In economics terms, it is essentially the equivalent of “marginal costs”. Example: Let’s say that to produce a single figurine, the company has to buy a block of wood for $5, and pay a woodcarver $4 to carve the wood into a figurine. So the cost to produce each figurine is $9. With our sales of 1,000 figurines, our cost of goods sold is $9,000. Note that cost of goods sold is directly proportional to the amount of wooden figurines sold. The more figurines sold, the more our cost of goods will rise. |
| Gross income Gross margin Gross profit | This is the the difference between “revenue” and “cost of goods sold”. Gross income tells you how much money the company generates simply from producing and selling its product(s). Example: In our example, our company will have gross income = revenue ($20,000) – cost of goods sold ($9,000) = $11,000. Notice that gross income relates directly to our marginal profitability — if gross income is negative, no amount of additional sales will save our company from eventual bankruptcy! In fact, if gross income is negative, then the company must be selling each unit of product at a loss. So the more units the company sells, the more money the company loses! Imagine a business that sells $1 notes for 50cents. That company has negative gross income and will go bankrupt eventually — the more “products” it sells, the faster it goes bankrupt! |
| Operating income Operating profit | This is the difference between “gross income” and “operating expenses”. Operating income tells you how much money the company generates from its operations. Example: Continuing with our wooden figurine company, its operating income = gross income ($11,000) – operating expenses ($6,000) = $5,000. Since operating expenses are (mostly) independent of how many product(s) we sell, operating income is basically just what’s left over, after our gross income is used to pay for “overheads” like rent, utilities, legal fees, administrative fees, etc. Note how a company that has negative operating income, but very high gross income, may actually be in good shape! It may simply be a new company, that needs to ramp up sales. With more sales, gross income will quickly overtake operating expenses and thus lead to high, positive operating income. |
| Non-operating income | Any income that the company receives that is not due to its primary business. Example: Our company has a interest-bearing savings account which paid the company interest, for a total non-operating income of $1,000. Note that for some investment companies, some types of interests and dividends from its assets may be considered revenue! |
| Non-operating expenses | Any expense that the company incurs that is not due to its primary business. Example: Our company once sold a defective wooden figurine to a customer, who sued and won a judgement of $2,000, which would fall under non-operating expenses. |
| Income before tax | This is the total amount of profit the company makes before paying its taxes. This is simply “operating income” + “non-operating income” – “non-operating expenses”. Example: Our company has an income before tax = operating income ($5,000) + non-operating income ($1,000) – non-operating expenses ($2,000) = $4,000. |
| Net income | This is the income of the company, after paying (or setting aside money for) any taxes it may owe. Example: Our company has a tax rate of 20%, which works out to total taxes = income ($4,000) * 20% = $800. Therefore, its net income = income ($4,000) – taxes ($800) = $3,200. |
| Normalized income before tax | Normalized income tries to remove the “noise” of regular income by removing one off expenses or gains. The goal here is to smooth out fluctuations of our income statements, so that long term performance of the business(es) can be easier to discern. Example: Our company has some non-operating expenses and income: Interest from its savings account of $1,000 Payment for a lawsuit it lost for $2,000 Since our company will likely continue maintaining its savings account, but will (hopefully) not be sued (and lose!) on a regular basis, the $1,000 can be considered recurring income, while the $2,000 payout can be considered a one off expense. Therefore, our normalized income before tax = income before tax ($4,000) + one off expenses ($2,000) – one off income ($0) = $6,000. Warning: Be careful about how companies classify “one off” expenses and income. It is easy to make the income statement look better than it is, if we classify every expense as “one off” and every source of income as “recurring”! The astute investor should recognize if the level of “one off” expenses remains stubbornly high over long periods of time. Such persistently high “one off” expenses, may really just be a real cost of business that management is misclassifying. Similarly, if certain sources of income fluctuate greatly over time, then maybe those incomes are really one off! |
| Normalized income after tax | This is just normalized income before tax, with the taxes due removed. For example: In our example, normalized income after tax = normalized income before tax ($6,000) – taxes ($800) = $5,200. Notice how the tax rate is based on actual income before tax, and not normalized income before tax! This is another reason why one should be really careful about how some incomes and expenses should or should be classified as “one off”. |
| Weighted average shares outstanding | Over the course of a reporting period, a company may issue shares to its employees, executives or board members as a form of compensation for their services. At the same time, a company may choose to buy back some of its outstanding shares on the open market with excess cash it may generate. Because of these, the number of shares outstanding of a company is rarely static — it typically changes slightly over time. The weighted average shares is just the sum of number of shares outstanding over the reporting period, weighted by the fraction of the period those shares are actually outstanding. Example: At the start of a reporting period, our company has 1,000 shares outstanding. One-quarter of the way through the reporting period, our company buys back 200 shares. Half way through the same reporting period, our company issues 400 shares to its employees. So, for the first quarter of the period, there are 1,000 shares outstanding. For the next quarter, there are 800 shares outstanding. And for the remaining half, 1,200 shares outstanding. Weighted average shares outstanding = 1,000 * 0.25 + 800 * 0.25 + 1,200 * 0.5 = 1,050 shares. |
| Diluted weighted average shares outstanding | In addition to issuing new shares, a company may also issue warrants (or options) on its shares. These directly issued warrants/options give the bearer the right, but not the obligation, to buy more shares directly from the company at a certain price — the strike price. If and when the bearer exercises these warrants/options, the company is obligated to create new shares out of thin air, and sell them to the bearer at that strike price. Once these warrants/options are issued, the company has no control on when the bearer may decide to exercise them. However, until the bearer actually exercises them, these warrants/options are not actual shares — they have no voting rights and they do not partake in any financial gains of the company. In order to show the potential effects of these warrants/options on the number of shares outstanding, we can look at diluted weighted average shares outstanding. This is simply the weighted average shares outstanding, increased by the number of shares that the company would be obligated to issue if all outstanding warrants/options directly issued by the company are exercised. Example: In addition to the outstanding shares, our company has issued 2 warrants, each for the purchase of 100 shares (200 shares total), to the CEO. Diluted weighted average shares outstanding = 1,050 + 2 * 100 = 1,250 shares. |
| Basic earnings per share Primary earnings per share | “Basic” and “Primary” means non-diluted in this case, so basic earnings per share simply refers to the ratio of net income, over the weighted average shares outstanding. Example: For our company, we have net income of $3,200, and weighted average shares outstanding of 1,050. Therefore, the basic earnings per share = $3,200 / 1,050 = ~$3.05 / share. |
| Diluted earnings per share | We can also look at earnings per share on a fully diluted basis, in which case, we’ll use the diluted weighted average shares outstanding as the denominator of the ratio. Example: For our company, we have net income of $3,200, and diluted weighted average shares outstanding of 1,250. Therefore, the basic earnings per share = $3,200 / 1,250 = $2.56 / share. Notice how the dilutive effects of the 2 warrants issued to the CEO dramatically reduced our earnings per share! While directly issued warrants/options don’t represent actual shares until they are exercised, they still represent potential claims on the future profits of the company and should not be overlooked. |
| Basic normalized earnings per share | We can also consider earnings per share on normalized earnings to smooth out one off expenses and income. Example: For our company, we have normalized income after tax of $5,200, and weighted average shares outstanding of 1,050. Therefore, the basic earnings per share = $5,200 / 1,050 = ~$4.95 / share. |
| Diluted normalized earnings per share | Finally, we can consider earnings per share with normalized earnings, on a fully diluted basis. Example: For our company, we have normalized income after tax of $5,200, and diluted weighted average shares outstanding of 1,250. Therefore, the basic earnings per share = $5,200 / 1,250 = $4.16 / share. |
Valuation models
When considering the income statement, there are a few natural ratios, or valuation models, that we can use. Here we discuss the more common ones, using our example company above. For reference, we’ll assume that each share of our example company is selling for $100 right now.
| Price / Earnings (P/E) ratio | The most popular ratio, the P/E ratio is available on almost every major financial research platform and provides a quick and easy reference number that is reasonably comparable across multiple industries. The P/E ratio can be computed as: Price per share / Earnings per share. In general, “P/E ratio” refers to “basic P/E ratio”, that is, price per share divided by basic earnings per share. Be very careful though! Just as there are 4 common variations of “earnings per share”, there are also 4 common variations of P/E ratios. Even though most sources quote “basic P/E ratio”, that is not true of every source! More egregiously, some sources quote different flavors of P/E ratios across different companies they report on, taking the confusion to a whole new level. To make things even more confusing, some sources make a distinction between “forward P/E ratio” and “trailing P/E ratio”. The former is computed using earnings projection for the future, while the latter is computed using realized, historical earnings. Looking at the P/E ratio is simply answering the question “how much do I pay, for $1 of net income?” — A P/E ratio of 30, means you pay $30 for every $1 of net income the company generates. Example: For our company, the P/E ratio is simply 100 / 3.05 = ~32.8. The diluted P/E ratio is 100 / 2.56 =~ 39.1. The normalized P/E ratio is 100 / 4.95 = ~20.2. The diluted normalized P/E ratio is 100 / 4.16 = ~24.0. Notice how dilution and normalization of earnings dramatically changes our computed “P/E ratio”. When to use P/E ratio: P/E ratio is generally comparable across companies in the same sector/industry. For example, comparing the P/E ratios of 2 companies manufacturing the same (or similar) Widget can give you an idea of which one may be a better value to invest in. Be careful when comparing P/E ratios of an established company and a startup! As discussed above, net income is affected more by sales and less by fixed costs when a company is more mature, while net income is affected more by fixed costs and less by sales when a company is young. At the same time, gross income tends to improve as companies ramp up their sales, due to economies of scale, which further exacerbates this issue. When comparing across sectors/industries, caution also needs to be exercised. Due to the rules of accounting, and the nature of different businesses, P/E ratios don’t tend to be comparable across sectors/industries. For example, a high growth industry may naturally support higher P/E ratios, because investors are looking towards the future, where higher income will naturally deflate the P/E ratio. However, a low growth industry will likely have lower P/E ratios, because the future is likely very similar to the recent past. The most egregious examples where P/E ratios don’t even work are generally due to accounting rules — Consider a real estate investment trust (REIT) that owns commercial buildings and rents them out. A cost of business would be the cost of the buildings themselves — buildings age with time and eventually need to be rebuilt/replaced. However, the lifespan of a building depends on the weather, the type of building, seismic activities in the region, whether maintenance is properly done on the building, and a myriad of other issues. Clearly there is no easy way to quantify all of these to arrive at a reasonable “expense” line item. Yet REITs need a way to be able to deduct this very real cost from their income — no company wants to pay taxes on “profits” that it did not really earn, because that “profit” is really just a deferred “cost of goods sold”. The accounting rules that are used to allow REITs to recognize the very real cost of building depreciation tends to be overly generous when buildings are properly taken care of — in general, buildings last longer than the rules assume, so actual amortized cost is usually lower than what the accounting rules assume. This results in income statements that look worse than they really are, because the “operating expense” of “depreciation” distorts the picture significantly. In situations like this, another measure other than the P/E ratio can be used to evaluate the company’s worth — REITs tend to be valued using their cash flow statements instead of their income statements, a topic we’ll discuss in a future post. For now, it is important to note that almost all major companies have some amount of factory equipment, buildings and/or other assets that depreciate over time. The accounting rules clearly is not able to quantify the actual depreciation rates in all cases. Therefore, the take away is this — the higher the “depreciation and amortization” line items on a company’s income statement are, the more likely they are distorting the income (and thus P/E ratio) of the company. |
| Price / Sales (P/S) ratio | Another common ratio used to evaluate companies, the P/S ratio is generally seen as “cleaner”, because it avoids completely the distorting effects of how accounting rules affect different sectors/industries. The P/S ratio can be computed as: Market capitalization / Revenue. Where “market capitalization” is just price per share multiplied by weighted average shares outstanding. Notice how this metric completely bypasses “normalization” of income, because we are not considering expenses. Also, this metric is almost always used in the basic form — P/S ratio is almost never computed with diluted weighted average shares outstanding. Looking at the P/S ratio allows us to answer the question, “how much am I paying, for each dollar of sales?” — A P/S ratio of 3, means that for every dollar of sales, the investor is paying $3. Example: For our company, the P/S ratio is simply (100 * 1,050) / 20,000 = 5.25. When to use P/S ratio: Remember our example above, about comparing a mature company’s P/E ratio against that of a startup? We said that this comparison doesn’t work, because the startup’s income is unfairly dominated by its fixed costs, which will become less of an issue once the company ramps up it sales. The P/S ratio does not have this issue! If we are confident that, at steady state, the startup will have a similar marginal gross income (that is, gross income per unit of product sold), and that the startup will have a similar operating expense as the mature company, then one easy way to compare the operating metrics of these 2 companies right now, would be to consider their P/S ratios. Next, let’s consider those sectors/industries that are highly cyclical, such as heavy industrial manufacturing. Companies in these sectors/industries tend to require high levels of investment in factories and equipment every few years. If you look at the net income of these companies, you’ll notice that they are highly cyclical — there will be long periods of low (or even negative) net income, which coincides with periods when the companies are building out new factories and equipment. These will then be followed by long periods of much higher net income, when the build out is at a lull. Due to this need for cyclical investment in their businesses, the P/E ratios of these companies tend to also fluctuate significantly over time, and thus are not reliable indicators of the companies’ health. Instead, the P/S ratio may be more suitable, because it takes away the distorting effects of the cyclical costs of investing in the business. There are some caveats to the P/S ratio, of course. Unlike the P/E ratio, P/S ratio does not take into account costs of business, which while liberating in some cases, can be highly misleading in others. For example, a software company may be able to earn a high operating margin (the ratio of its revenue that eventually translates into profits), but a retail store may not! In general, the same dollar of sales in different sectors/industries may not translate into the same profit, which dramatically curtails the use of P/S ratio comparisons across sectors/industries. Similarly, a company that is mostly funded by debt will have much higher debt servicing costs than another company that is mostly funded by equity. In the former case, after paying the interest on the debt, the company will likely have much less profits left for shareholders compared to the latter case. Finally, like the P/E ratio, the P/S ratio does not take into account growth of the company. A company that is rapidly growing, may command a higher P/S (and P/E) ratio, because investors are looking towards the future, where highly sales will naturally bring both ratios down. |
| Price / Earnings-to-Growth (PEG) ratio | To account for potential future growth, the P/E ratio is sometimes augmented by normalizing it against projected (or historical) earnings growth. This gives rise to the PEG ratio. The PEG ratio can be computed as: (Price per share / Earnings per share) / Earnings per share growth = P/E ratio / Earnings per share growth Where “earnings per share growth” can be either forward (i.e: projected) or trailing (i.e: from historical data), giving rise to “foward PEG ratio” and “trailing PEG ratio”. Note that in both cases, the basic (i.e: non-diluted) version of P/E and earnings per share are used. The PEG ratio does not conform to any reasonably English question that we can ask. Instead, it is a unitless value that just gives an indication of how expensive a stock is, with regards to both earnings and growth. Example: Recall that the basic P/E ratio of our company is ~32.8, and it has earnings per share of $3.05. Let’s assume that the previous year, the earnings per share of our company was $2.50, and that in the next year, the earnings per share of our company is projected to be $3.50. Trailing earnings per share growth = (3.05 / 2.50) – 1 = 22% Future earnings per share growth = (3.5 / 3.05) – 1 = ~15% Trailing PEG ratio = 32.8 / 22 = ~1.49 Future PEG ratio = 32.8 / 15 = ~2.19 Clearly, our company was a better value PEG ratio-wise, last year, than this year! When to use PEG ratio: The PEG ratio gives an idea of how expensive a stock is, compared to its rate of growth. This may be useful as a complement to any other valuation methods which did not take into account growth of the company, such as the P/E ratio, or the P/S ratio. The smaller the PEG ratio of a stock, the more attractive it is with regards to earnings growth. Therefore, when comparing two companies in the same sector/industry, but with dramatically different growth profiles, the PEG ratio may be a useful measure to take into consideration. |
| Enterprise value / Earnings before interest, taxes, depreciation and amortization (EV/EBITDA) ratio AKA Enterprise multiple | Now, let’s take a step back, and consider a company from another view point — that of a potential acquirer, say, a competitor. What would the competitor use to quickly evaluate whether our company is worth buying? First, let’s consider what the competitor would care about. The competitor likely wouldn’t care very much about the interest expense that the company pays — assuming the competitor has the deep pockets to buy out our company, it may very well also have the ability to pay off the company’s debts, which will nullify the interest fees. After all, how a company finances its operations (through debt or equity) is fungible as money is fungible. The competitor likely cares about taxes paid, but the consideration is more complex than just what our company pays in taxes. Remember that taxes is on profits, which is affected by expenses such as interest, which we’ve already discarded. Separately, combining two companies may reduce operating expense (remember that operating expenses are those expenses that tend not to scale with units of product sold — so some of these expenses can be removed when the companies merge), which then increases profits and taxes. In general, the final effect of taxes on the combined company is not as simple as just adding up their individual tax bills. So we can probably exclude taxes too, for now. The competitor also probably doesn’t care about our company’s accounting of depreciation and amortization effects either. Accounting rules tend to reset depreciation and amortization line items every time an asset changes ownership, which then changes the buyer’s accounting of depreciation and amortization. And finally, any cash that our company owns, is irrelevant — using cash to buy cash is just silly, so we should ignore them. If our company has $1,000 in cash, the competitor will have to pony up an additional $1,000 to buy our company, but this $1,000 on both sides of the ledger will cancel out. So, what is the actual cost to our competitor for acquiring our company? They’ll need to pay off all existing shareholders at the current share price (share price * outstanding shares = market capitalization), they’ll need to pay off all debts, and they can ignore the cash balance on our company, because cash is just fungible. This gives us a definition of enterprise value: Enterprise value (EV) = market capitalization + debt – cash and cash equivalents At the same time, by paying “enterprise value”, our competitor is getting a stream of earnings that ignores interest payments, taxes, depreciation and amortization, or “earnings before interest, taxes, depreciation and amortization” (EBITDA). So the ratio they care about is EV/EBITDA. Example: For our company, market capitalization = 100 * 1,050 = $105,000. We have no debt, and $1,000 in cash, so enterprise value = $105,000 + $0 – $1,000 = $104,000. $104,000 is how much it would cost, for a competitor to acquire our company outright. And by paying this $104,000, our competitor would get value in the form of EBITDA, equal to = net income ($3,200) + taxes ($800) + interest payment ($0) + depreciation/amortization ($0)= $4,000. And the enterprise multiple = 104,000 / 4,000 = 26. When to use enterprise multiple: Enterprise multiple is mostly only useful for considering the unlevered (i.e: no debt, fully equity funded) operations of a company, and without considering such costs as taxes, depreciation and amortization, which tend to change dramatically after a company is merged with a larger entity. After the merger, the combined company can then decide to re-lever (i.e: get into debt) its operations, but that is a future consideration. For the personal investor, enterprise multiple isn’t particularly interesting, except where the company may be a candidate for acquisition. For example, sectors/industries tend to consolidate as they mature, where larger companies buy out their smaller competitors. In these cases, it may be useful to consider how the larger companies may value their competitors. After all, if you can buy a company that is primed for acquisition at a good enterprise multiple, there is a good chance that one of its larger competitor will then buy the company from you in future at a higher enterprise multiple, ensuring a good profit! (1) |
How much is too much?
So, now that we have a “brief” overview of the different metrics that can be used to evaluate a company, based on its income statement, the next obvious question is, what yardstick do we use?
Is a P/E ratio of 10 good? How about 30? 100? Or may be a P/S ratio of 2? 3? 5?
The short answer, is that there is no real yardstick that works across all companies. As discussed above, P/E ratios tend to mellow (come down) as companies mature. They are also affected by various other issues like accounting and the cyclical nature of some sectors/industries. P/S ratio, PEG ratio and the enterprise multiple all have their own issues as well.
For simplicity, going forward, I’ll only consider the P/E ratio, with the assumption that somehow, all the distorting non-operations related issues are ironed out and accounted for. This argument then generalizes better across the different valuation metrics, and we are considering only the raw, operational characteristics of the company. (2)
How much do we want to pay?
So, given our new “perfect P/E ratio”, what yardstick should we use? This is where price discovery comes in.
Remember that the P/E ratio is simply how much we want to pay, for each dollar of earning. Clearly, that is a decision that is dependent on the individual.
For someone who has the option of investing either in a public company on the open market or investing in a private company at a fixed valuation, then the price they would be willing to pay for the public company would be dependent on the valuation of the private company — if the private company is selling for a P/E of 20, then it makes very little sense(3) to invest in the public company at a valuation much higher than a P/E of around 20.
However, for someone else who has only the option of investing in the same public company, or putting their money in a savings account earning 1% interest (i.e: paying $100 to earn $1, or “P/E ratio” of 100), then they may be willing to pay substantially more.
The final clearing price of the company’s stock, will then be a reflection of all opportunities available to all investors, such that all capital is properly deployed across all assets (in this case, the public company, the private company, and the savings account). The final result may very well be that the first investor deploys their capital entirely into the private company, while the second investor deploys their capital into the public company at a P/E ratio of 100.
Yes, this means that the private investor, at least nominally, stands a higher chance of coming out ahead in the long run, but that is not a consideration for price discovery, but a reflection of the intrinsic inefficiencies of the markets (both public and private).
So, to put it simply, for the rational, purely financial(4) investor, and assuming a “perfect P/E ratio” can be defined, then the highest P/E ratio they should pay, should be the P/E ratio of the next best investment available to them.
How certain are you?
In a perfect world, where you can be certain of your projections of a company’s growth, where you can define a “perfect P/E ratio”, etc., choosing the “next best” P/E ratio to pay is the rational thing to do. However, the world is hardly perfect, and uncertainty abounds.
For example, how confident are you in the projections that management makes for the company’s forward progress? Is management likely to overestimate? What are their incentives? Also, even if management is perfect at estimating their own company’s operations, how good are they are estimating the operations of competitors? What about future competitors that don’t even exist right now?
In reality, companies rarely perform according to their projections, and events in the future may dramatically diverge from our projections. Because of this, we need to build some amount of “margin of safety” into our assumptions.
For example, in the case of our public investor, choosing between investing in a public company and a savings account, they need to recognize 2 important facts:
- The savings account is guaranteed by the FDIC, so unless they have more than the FDIC insurance limits in the account, or the FDIC itself goes bankrupt, they are very unlikely to lose money. Therefore, the “capital” “invested” in a savings account is generally considered safe.
- Any capital invested in the public company has no such protections. An unforeseen event, say a once-in-a-hundred-years pandemic, may occur, causing irreparable harm to the company’s business and forcing it to shutdown, leaving shareholders with nothing.
So when choosing between investments, we also need to consider the potential risks in the investments, not just of the risk of returns (i.e: the probability that returns in future will match returns in the past), but also the risk of loss (i.e: the probability that we won’t even be able to recoup our initial investments).
It is with this in mind that we define a “margin of safety” — when considering between a “safe” “investment” like a 1% yielding savings account (implicit “P/E ratio” of 100), and a public company, we may very well decide that the public company should only command, at most, a P/E ratio of 17, because of all the inherent future unknowns that we need to account for. This gives our company a nominal yield of around 6% (1 / 17 = ~0.059 = 5.9%), for a “margin of safety” of 4.9% (5.9 – 1 = 4.9%).
This “margin of safety”, is sometimes also called the “equity risk premium”. It is, roughly speaking, the additional yield that investors demand from equity investments, over risk-free investments due to the inherent riskiness of equity investments.
Obviously, different investors have different appetites for risk — some investors may demand a 5% equity risk premium (i.e: stocks should yield at least 5% more than risk free investments), while others may demand much lower or higher premiums.
The combined preferences of all investors across the whole market, for all possible investment assets will interact to settle on a clearing price for all our investments.
Footnotes
- Note that this is delving into speculation territory, since we are depending on someone else valuing the company higher than we do, instead of just making a profit purely on the operations of the company.
- Obviously, this is a departure from reality — such a measure that properly takes into account all the myriad of issues is simply not possible. The assumption here is that the reader will consider all the relevant metrics (PEG ratio for growth companies, P/S ratio for startups, etc.), and come up with a personal composite that they believe in.
- This assumes our investor does not care for diversification, which is obviously not traditional and generally not advised.
- “Purely financial” here meaning that the only consideration is financial — the investor does not care about other things like sentimentality (I just like the stock), environmental concerns (I like green stocks), etc.
Janky Thoughts 