Value in the eye of the storm: Why you should welcome uncertainty!

One of the responses to my last post on valuing young companies was that even if you can value companies early in the life cycle, you cannot do so with any degree of confidence. I concede that point, but that is exactly why I would try to value them! I know that statement makes little sense, but to solidify my argument, take a look at the following list of five assets/entities and rank them on the basis of the confidence you will feel in valuing each one (I have provided my rankings and the reasons in the table).

Valuation Setting	Your precision ranking	My precision ranking	My reasons
$20 in an envelope		(1) Absolute	Nothing to forecast & no risk to adjust for.
A mature, money making company in a stable macroeconomic environment		(2) Very high	You can use both company & macroeconomic history in making forecasts.
A mature, money making company in an unpredictable macroeconomic environment		(3) Average	While company is stable, macroeconomic shifts can cause earnings/cash flows to change.
A young, money losing company in a stable macroeconomic environment		(4) Low	You have no history and know little about market. Lots of unknowns, at least at the company level.
A young, money losing company in an unpredictable macroeconomic environment		(5) Very little	The uncertainties you face at the company level are multiplied by uncertainties about interest rates and economic growth.

My guess is that your rankings will match closely to mine. Cash in an envelope is easier to value than an ongoing business, an ongoing stable business is easier to value than a young, growing business and valuations in general are easier when interest rates and economic growth are stable/predictable than when they are not.

Now that we have dispensed with that formality, I think it is worth asking a more complex question. If valuation is designed to find investment bargains, what is the payoff to doing valuation in each of these settings? Note that the game is now different, since your advantage does not come from the precision of your valuation but in its relative precision: How much more precise is your estimate of value for a given asset is than the estimates of others valuing exactly the same asset? Here is my attempt to look at my potential differential advantages (and I would encourage you to do the same).

Valuation Setting	Differential Precision
$20 in an envelope	(5) None.
A mature, money making company in a stable macroeconomic environment	(4) Very little (unless I cheat and use inside information, which would of course bring the SEC's wrath to bear on me). The estimates come from historical data and are unlikely to shift very much, since the macroeconomic setting is stable. Valuation modeling is trivial and you can use historical PE ratios or stable growth cash flow discount models to value the company.
A mature, money making company in an unpredictable macroeconomic environment	(3) Your differential advantages can come from being able to incorporate the macroeconomic uncertainty into company forecasts and valuing the company. If the macroeconomic uncertainty is large enough (say, at crisis levels), other investors may stop trying to value even mature companies (remember late 2008), essentially conceding the game to you.
A young, money losing company in a stable macroeconomic environment	(2) Your differential advantage comes from researching the business the company is in, understanding the company's products and being willing to make forecasts (knowing that you are going to be wrong). Again, with enough uncertainty, other investors will not even try to value these companies , focusing instead on rules of thumb, unusual value metrics (value per user) or short term numbers (earnings next quarter).
A young, money losing company in an unpredictable macroeconomic environment	(1) Your differential advantage will come from just trying to make estimates, in the face of immense uncertainty, when everyone else has long since given up any attempt to estimate value.

My motto is that you don’t have to be right to make money, but just less wrong than everyone else in the market. That makes my odds best in exactly those environments where I am uncomfortable and uncertainty is overwhelming.

Wielding Ben Graham’s tome on security analysis as a weapon, old-time value investors will probably take issue with this argument, pointing to the efficacy of the time-tested value investing conventions, where you are told to stay focused on companies with solid earnings and cash flows, with superior management. I would be inclined to concede the argument, if active value investing, as practiced today, actually worked, but there is little evidence that it does, at least in the aggregate, as I argued in this paper. In fact, there is evidence, albeit weak, that the average active growth investor beats a growth index more frequently and by more than the average active value investors beats a value index. That does not surprise me in the least, since it is in keeping with my thesis that the best investment opportunities are in the volatile, growth sectors.

I think that Ben Graham, if he were writing his book today, would be much less rigid in his view of value than the classicists. The real lesson that I get from reading Graham’s writings is that value is determined by fundamentals and that markets sometimes misread or ignore those fundamentals. My addendum is that investors are more likely to misread and/or ignore fundamentals, when they are faced with large uncertainties than with small ones.

In closing, there are three general propositions about valuation that flow from my view of uncertainty.

1. The more comfortable you are in valuing a company, the less point there is to doing that valuation. After all, the factors that comfort you are just as likely to comfort others valuing that company.
2. If you wait for the uncertainties to resolve themselves before you value a company, it is too late for a valuation. In the midst of crises or uncertainty, it is human nature to want to wait, until there is resolution, before committing to valuation or investing. It is precisely at the moment of crisis, though, that your valuation skill set will provide the biggest payoff, if employed. So, you should have been valuing banks in November 2008, Greek companies in 2009 and 2010 and emerging market companies earlier this year. Using a specific example, many global investors are holding back on investing in India, waiting for the election that is scheduled next year, making me more interested in valuing Indian companies today, and especially those that are more likely to be affected by the election results.
3. If most investors contend that something cannot be valued, you should try to value it. As I noted in my last post, I think that the status quo (where young companies are not valued) suits both investors and traders, the former, because they can stay above the fray, attributing any profits to be made in in these companies to gambling, and the latter, because they feel no obligation to even pay lip service to fundamentals.

If you have found conventional valuation to be an extension of accounting and therefore boring (I am sorry! My biases are showing!), you should try valuing young, growth companies instead, to see how much fun it can be to connect stories to numbers and narratives to value. So, rather than value 3M or Coca Cola for the hundredth time, why not try valuing Tesla, Yelp or Pandora? And if in the process, you make some money, that is just icing on the cake, right?

Valuation Myths: Young companies cannot be valued

Twitter is now officially a publicly traded company, and I am glad that we no longer have to debate the IPO price and what will happen in the aftermath. While the opening may have veered a little off script, to the extent the price popped a little more than “desirable”, I am sure that the bankers, the preferred clients who were able to get the shares at $26/share and even the owners who left money on the table (just over a billion dollars) are all happy with the outcome, at least so far. While they may be tempted to claim “mission accomplished”, I think that there are a few more rounds to go before we make that judgment.

In an earlier post, I noted the divergence between investors, who trade based on value, and traders, who make judgments about price movements, and how they often talk past each other. If you have been following the conversation about Twitter online or in the financial media, the last week has also brought reminders about enduring myths about the valuing and pricing of young, growth companies that both sides seem to hold dear. At the risk of irking both groups, I would like to argue that they are holding on to preconceptions that are not only shaky and self serving, but also damaging to their portfolios.

Investor Myths

Let’s start with the three misconceptions that some “value” investors have about young, growth companies.

1. Young, growth companies cannot be valued: How often have you heard someone say that young companies cannot be valued because there is too much uncertainty about the future? This rationale is used by value investors not only to avoid entire segments of the market but as a shield against even discussing the value of young, growth companies. While it is true that there is more uncertainty about the future prospects of a young company than for a mature business, you can still make estimates of expected earnings and cash flows into the future and value the company, as I tried to do in these spreadsheets to value Tesla and Twitter. You can and should take issue with my assumptions and come up with your own values for both companies but you cannot argue that these companies cannot be valued.
2. Even if you can value companies, that value will change significantly over time (making it pointless): As you learn more about a new company, from its early operating successes and failures, you will reassess value and your estimates will change, often significantly over time.I know that bothers some value investors, because they have been taught (wrongly in my view) that intrinsic value is stable and should not change over time. I am not bothered by the volatility in my value estimate, since the information that causes my estimate of value to change will also cause the price to change, and generally by far more. As an illustration, let me point to Facebook, a company that I have valued a half dozen times since its initial public offering in March 2012. My initial estimate of value for the company on the day of the offering was $27.07, well below the offering price of $38. A few months later, after a disappointing earnings report that suggested that their mobile advertising revenues may be lagging, I re-estimated the value of Facebook to be $23.94, a drop of approximately 13%, but the stock was trading at just under $19 (a drop of 50%). In fact, my value for Facebook has ranged from $24 to $30, while the price has fluctuated from $18 to $51. If your payoff in value investing is in finding mispriced stocks, I think that your odds are much better with stocks like Facebook and Twitter, where both your estimates of value and the market prices are subject to change, than in mature companies like Exxon Mobil or Coca Cola, where there is more consensus about the future, and fewer uncertainties.
3. Young, growth companies are always over valued. This is an insidious myth that can be attributed to one of two forces. The first is that some value investors are born pessimists, who seem to believe that making bets on the future is a sign of weakness. The second is that some value investors rely on approaches for estimating value that are not only outdated, but simplistic. If your measure of value is to apply a constant PE (say 12) to next year’s earnings or to use a stable growth dividend discount model to value equity, you will never find a young, growth company to be a bargain. If you are creative in estimating value, willing to make assumptions about the future, persistent in tracking that value and patient in terms of timing (your buying and selling), there is no reason why you should not find growth companies to be bargains. I did not like Facebook at $38/share in March 2012 but I loved it at $18/share in September 2012, and while I would not touch Twitter today at $42/share, I would be interested at $15/share.

Trader Myths
On the trading side, there are two broad misconceptions about “value” that are just as misplaced and as dangerous as the three myths that value investors hold on to.

1. With young growth companies, value does not matter. This is, of course, the mirror image of the value investors’ lament that a young growth company cannot be valued. While value investors use it as a reason to not invest in the company, traders use it as a reason to ignore value, arguing that if no one can value a company, its price is entirely a function of what the market thinks it is, rather than fundamentals. Perception may be all that matters if you are pricing a piece of art (like this one that just sold for $142 million), but it cannot be with a share of a publicly traded business. After all, no matter what the promise or potential of a company, the stories eventually have to show up as numbers (revenues and earnings), and if perception is at odds with reality, it is perception (price) that will change, not reality.
2. Even if value does matter, it is best determined by focusing on the short term, where you have a chance of estimating numbers, rather than on the long term. With young, growth companies, analysts seem to prefer that the focus stay on the short term – next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the end game (the long term) that determines the value of young companies, rather than the near-term results. Put differently, it is not how Twitter does in 2014 that will be the arbiter of its value, but how the choices it makes in 2014 affect its long-term growth path. 

I know that you are probably still skeptical about whether you can value young, growth companies and I empathize. I have struggled with young company valuations both technically (in coming up with cash flows, growth rates and discount rate) and psychologically (in fighting the instinct to flee from uncertainty) and I know that I will never quite master the process. However, each time I value one of these companies, I learn something new that I can incorporate into my tool kit. I have taken some of these lessons and put them into this paper on dealing with uncertainty that you are welcome to read (or ignore). Better still, pick a company that you are convinced cannot be valued and try valuing it. You may find it difficult, the first time around, but I promise you that it will only get easier. And it is so much more fun that valuing a utility or a bank!

Paper on valuing companies in the face of uncertainty (Short paper)

My presentation on valuation in the face of noise (Slides)