Book excerpt: Different approaches to quantitative value investing, and the influential thinkers behind them

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“Valuation approaches often begin and end with discounted cash flow models, which can be applied meaningfully to only a handful of companies that generate stable free cash flows.” (Representational image: Chris Briggs via Unsplash)

He was probably one of the first investors who wanted to democratize the art of stock picking. In his books Security Analysis, and The Intelligent Investor, he discusses how to analyse a company’s financials from a valuation point of view. I am a huge fan of Graham’s approach of comparing two companies coming one after another in a list of stocks arranged alphabetically. He talks about quantitative approaches like the requirement of dividend yield to be at least 2/3rd of AAA bond yield, and underutilised debt capacity where the value of an enterprise should be at least as much as the debt that it can comfortably support. He was trying to provide simple approaches that the individual investors could use. He was never very keen on meeting the company management as he believed that the management’s actions and the nature of the business reflect in the financial statements. One of the most famous formulas that Graham provided was the one to value growth stocks. He calculated the per-share  value of a growth stock as:

V=EPS x (8.5+2g)

He ascribed a zero growth PE ratio of 8.5 times. He added twice the expected growth over the next 7-10 years to this no-growth PE ratio to arrive at the value of the company. Interestingly, the formula does not consider the capital efficiency of the company.

Graham later added a multiplier – 4.4/Y to adjust for the interest rate cycle prevalent at the time of valuation. 4.4 was the average yield of AAA corporate bonds, and Y was the yield of bonds prevailing at the time. As the yield on risk-free assets increases, the equity value should decrease and vice versa. Graham was able to capture this aspect of valuation using this simple tweak.

Graham’s protégé Warren Buffett extended this approach. However, Buffett paid attention to capital efficiency and earnings quality. In the book The Warren Buffett Way, Robert G. Hagstrom provides insights into how Buffett would have probably approached some of his investments like Coca Cola, Washington Post, Wells Fargo, or Gillette. The approach was quite simple. Estimate the owner-earning of the company. Owner-earning is the earnings plus non-cash items like depreciation and amortization, less the capital expenditure required for maintaining the competitive advantage. Buffett prefers to use the risk-free rate for discounting and then buy with a margin of safety. Hagstrom calculates the value of the companies in which Buffett invested using a multistage DCF of owner earnings and estimates the implied growth required to justify the purchase.

Joel Greenblatt transformed Buffett’s tenet to buy stocks with a competitive advantage at a reasonable price into a simple formula. Greenblatt elaborates his technique in his book, The Little Book that Beats the Market. He took return on capital as a proxy for the quality of the business and earnings yield as a proxy for valuation. By the time Greenblatt’s approach came, stock screeners had become popular, and he converted the two factors into what he called the magic formula.

Bruce Greenwald popularized an approach called earnings power value which is explained in his book Value Investing: From Graham to Buffett and Beyond. In this approach, the reported earnings are adjusted for one-off items, normalized margins, normalized tax rate, and actual maintenance capital expenditures to arrive at the adjusted earnings. The adjusted earnings divided by the weighted average cost of capital gives the earnings power value of the business operations. Add the surplus net assets we get the earnings power value of the company. By subtracting the company’s borrowings, we get the value of the company’s equity. The approach can be modified to adjust for expected future growth.

Tobias Carlisle, in his book The Acquirer’s Multiple, emphasises the importance of mean reversion as the core tenet on which deep value investing works. Through back testing, he demonstrates that simply using the ratio of enterprise value to operating earnings to pick stocks could beat the returns of Magic Formula and S&P500. The approach is based on the principle that investors may not always be able to select companies where the high return on capital is sustainable. Human beings find the concept of extrapolation easier than mean reversion. So, buying based on the cheapness of earnings can ensure more margin of safety for the investors and a greater chance to benefit from the mean reversion of return on capital.

What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time by James O’Shaughnessy is also an interesting book in which the author evaluates the effectiveness of various quantitative approaches through back testing. It is a difficult read, and there is also some criticism that the approaches described in the book works only in back testing and not prospectively. However, it does give a lot of ideas for you to experiment with and shortlist companies for further research.

In the book Active Value Investing: Making Money in Range-Bound Markets, Vitaliy N. Katsenelson talks about the Quality Value Growth framework or the QVG framework to estimate what could be the right P/E that can be paid for a company. Katsenelson’s approach begins with a no-growth P/E multiple, which is adjusted for earnings growth, dividend yield, earnings visibility, financial risk, and business risk. Katsenelson suggests that the approach works well in range-bound markets. He also says that the P/E versus growth follows a non-linear relationship with the market willing to pay a much higher P/E for every incremental unit of growth.

If you are looking for academic rigour, then Valuation: Measuring and Managing the Value of Companies by McKinsey & Company and books by Aswath Damodaran can provide the theoretical foundation upon which most valuation techniques are built. However, this extent of academic rigour may not be warranted from a practitioner’s point of view.

Books that deal with the quantitative aspects of value investing often focus on back testing to analyse the effectiveness of various screens. Valuation approaches often begin and end with discounted cash flow models, which can be applied meaningfully to only a handful of companies that generate stable free cash flows. Many companies lie outside this universe of mature free cash flow generators. Are there approaches other than discounted free cash flow models or relative valuation multiples that can be applied to estimate the fair market value of stocks? While every investor who researches a company develops some understanding of the business fundamentals and forms expectations about the future outlook of the business, translating these expectations into numbers does not come naturally to most investors. Finally, the narratives should translate into mathematics.