One very frustrating aspect of the global financial crisis of 2008-2009 was the awareness that the volatility was, in part, exacerbated by an accounting rule. During the late fall of 2008, the Financial Accounting Standards Board (FASB) finally took up discussion of FAS 157, Fair Value Measurements, and issued a recommendation to adopt certain modifications in the form of FAS 157-d, Determining the Fair Value of Financial Assets in a Market that is Not Active.
Determining Fair Value
The central issue that was reviewed: companies holding certain mortgage-backed securities had been required to "mark to market" the value of these investments. In a well-functioning securities market, marking to market is a reasonable way to determine fair value, in the same way that a comparable sales analysis - in a well-functioning real estate market - can offer clarity into the appropriate listing price for residential properties.
When capital markets become dislocated, forcing companies to mark their then-illiquid securities to an indeterminable market value creates a downward spiral of asset impairments, charges to earnings, and degraded capital positions. FAS 157-d recommended several remedies. One important and appropriate remedy is a greater reliance on discounting future cash flows to determine fair value in a distressed market. (For more, see Mark-To-Market Mayhem.)
The Price is Right
During periods of systemic stress, valuation in the public equity markets offers a similar challenge to investors. While one can find a readily available market quote for shares of most common stocks, how confident can investors be that they are paying the correct price? One of the most common valuation methods relies on the P/E ratio of companies. In well-functioning markets, P/E ratios provide a quick and easy assessment of comparable value.
But what happens when the "E" becomes entirely uncertain? And, considering the seismic risk-repricing feature common to distressed markets, how confident can we be that earnings multiples represent fair values? Those market environments demand that we shelve, at least temporarily, our reliance on certain relative value measures, like P/E. Yet, it's clear that during a market melt-down, accurate valuation is as critical as it ever is. (For more, read Is The P/E Ratio A Good Market-Timing Indicator?)
One way to compare value measurements is by assigning various alternatives to the quadrant below.
Economic measures describe an actual tangible value, while accounting measures approximate actual value and are impacted by GAAP accounting conventions. Absolute value measures describe value on a stand-alone basis. Relative measures are useful when comparing the same measure between two companies. To flesh this concept out a bit, we'll fill in the quadrants with example measures:
The discounted cash flow (DCF) method is economic in the sense that it relies on cash flow, an actual tangible benefit to equity holders. It is also absolute, as it relies on the company's own cost of capital, rather than a sense of where the rest of the industry or market is currently valued.
The Enterprise Ratio
A company's enterprise ratio (ER) is found by the following formula:
(market value of debt + market value of stock – cash / cash flow from operations)
Here, too, the components are all economic measures, but the resulting ratio is useful only in comparison to another company's Enterprise Ratio and thus, it is relative.
Return on Equity
Return on equity (ROE) can be estimated several ways, one of which is simply to divide the firm's net income by its shareholder equity. Net income and shareholder equity are GAAP measurements, thus ROE is an accounting function. But like DCF, ROE expresses a measure of return which holds meaning in absolute terms: a company which earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)
Finally, the P/E ratio relies on earnings, which is a GAAP concept and it is useful only when compared to the P/E ratio of industry peers or a market index.
In his book, "Active Value Investing" (2007), Vitaliy Katsenelson argues that one prominent feature of secular range-bound markets is P/E multiple contraction. A long period in which stock prices fluctuate but do not progress can tend to diminish investor confidence, which is reflected in the multiple investors are willing to pay for a claim on a company's earnings. A growing number of strategists now believe that 2008-2009 was a secular range-bound market.
Answering the Tough Question
The implication is this: what is a fair multiple to pay in a range-bound market, where multiples aren't likely to be stable? If you think it is a difficult question to answer, you are in good company. Many investment analysts ask the same question. Ultimately, a P/E ratio is never objectively high or low; it always must be compared to something else to have meaning. In a market where value is difficult to discern, relative measures, like P/E, render less meaning than they do in more stable, secular bull markets.
The P/E ratio's usefulness during periods of market stress is further limited by its denominator, which is an accounting measure. Earnings, while important, are subject to many aspects of management discretion such as changes to amortization and depreciation schedules.
Alternatively, DCF analysis offers an approach to valuation which stands alone and at the same time projects a truer estimate of economic benefit.
DCF takes projected future cash flows and discounts them back to the present. The theoretical justification for this method is the sense that the intrinsic value of a financial asset is the value of the future cash flows which that asset generates. Alfred Rappaport argues in "Creating Shareholder Value" (1997) that cash flows from operations are the relevant numerator, because they represent the cash available to equity holders, which results from the core operations of the business. Many industrial companies require that operating cash flows be adjusted for depreciation and high levels of maintenance capital expenditures. In these cases, free cash flow may be a better figure to discount. (For a background on DCF, see our DCF Analysis Tutorial.)
Deriving the appropriate discount rate - the weighted average cost of capital - is a bit more complex. The weighted average cost of capital is comprised of a proportional cost of debt, which is approximated by the yield on the firm's long-term bonds, and the cost of equity. The cost of equity is expressed formulaically below:
Ke = rf + (rm – rf) * β
- Ke = the required rate of return on equity
- rf = the risk free rate
- rm – rf = the market risk premium
- β = beta coefficient = unsystematic risk
The result of discounting future operating cash flows back to the present by the weighted average cost of capital is a clear, objective estimate of the real economic benefit of owning the company today. (To learn more, see The Capital Asset Pricing Model: An Overview.)
Limitations of DCF
Estimating future cash flows from operations requires a sales forecast, which may or may not be accurate; this possibility for error is compounded when forecasting over multiple periods. Moreover, since DCF relies on the above required return for equity formula, we note that the beta of a stock may overstate or understate the actual volatility of the security. Finally, the equity risk premium is not constant.
Likewise, we should point out that not all relative measures are inferior in distressed markets. As with P/E, the price / book ratio utilizes an accounting figure in its denominator. And though the appropriate multiple of price over book may be a relative measure, stocks which are trading below their book value (or, as is common during stressed markets, below tangible book value) offer a type of absolute value opportunity.
The Bottom Line
Intrinsic value and the degree it differs from market price are, ultimately, subjective matters. Severe market dislocations demand that we not only adjust valuations, but that we reassess the metrics by which we derive those valuations. Economic and absolute measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining intrinsic value. (For more on DCF, see our related article DCF Valuation: The Stock Market Sanity Check.)