How Not To Do Valuation

Valuation / Sunday, April 9th, 2017

Valuation is an estimation of how much a business is worth to a sensible buyer and there are many ways to value a business or stock by looking at its assets, liabilities, how much cash flow can be generated from those assets, industry dynamic, competition and so on.

Instead of writing about how to do valuation, I will do the opposite – How not to do valuation. Just as we can earn outsized return without any superior insight simply by reducing mistakes; we can benefit from learning the wrong way of doing valuation so we can avoid making them. The benefits are twofold. One, you will avoid making those mistakes. Second, when you notice someone doing these stuff in their write up, it raises your skepticism.


“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” -Charlie Munger


Earning Per Share x Price Earnings Ratio

The most common way people value a business is using the estimated eps times the P/E ratio. I’m not sure where to begin to explain what’s wrong with this equation but it is the most abused formula. This is not valuation. It is fooling yourself. This is using hammer to type on a keyboard.


2016 2017 2016 2017
EPS $0.50 $0.90 $0.50 $0.60
P/E Ratio 12x 10x
Fair Value $12.90 $10.60


Here are 2 stocks. Stock A grown its EPS by 80% while stock B only grows by 20%. Which is better? Many investors would prefer A over B since it has higher growth rate, therefore it justify a higher PE ratio of 12. Many would call it conservative and prudent and start finding peers that sells at higher PE to justify the purchase.

But if you ask me, I’ll need more information. What is the return?


2016 2017 2016 2017
Equity Per Share $5.00 $10.00 $4.00 $4.60
EPS $0.50 $0.90 $0.50 $0.60
ROE 10.0% 9.0% 12.5% 13.0%


Now we have the total equity, this will give us a clearer picture. It seems that stock A doubled their investments into the business, which explains why EPS has gone up by 80%. Whereas stock B only invested 15% more and generated an extra 10 cents EPS. Look it this way, stock A ROE actually dropped while stock B has done the opposite. Put it in plain English, every dollar spent on stock A will return 9 cents while for B that’s 13 cents. Worse, you are paying a higher P/E for stock A. Now, is paying a higher PE for a stock with lower ROE conservative? We don’t need to go further to see how absurd is this.

Have you ever get excited because your savings account grows every year without putting any extra money into it? I don’t, because the return is always 3%. It can go from $100 to $1 mil given long enough time but I won’t be too excited to add more money in because I know the return is low.


Ignoring return & cost

Growth rate, like the example above, is the most beloved terms. There’s a lust for it. But that’s not the be all end all thing in valuation. Just like you need more calories to grow your body by eating more, same applies to business. If a business is growing, you have to ask – What is required to achieve that? Return on equity, or return on invested capital is the key driver that connects the whole thing.

A business can grow to the sky and back but if it requires the same amount of extra investment to match those growth, it is no more valuable than before the growth. If you don’t get this sentence, you should read it again. And don’t take my word for it. Real cases are everywhere. You can find many stocks that beats Public Bank and LPI Capital in term of growth rate. Public Bank, which is at best growing at 6-7% a year, but why is it constantly selling at PE 15-17 whereas those high growth small caps sell below PE of 10? Because Public Bank is overvalued and the rest are hidden gem? No. That’s because Public Bank can generate a consistent high ROE for a long long time. Wellcall is another. It doesn’t need to grow a lot to justify a high valuation because it can generate a high return for every dollar invested. Maxis, Digi, Dutch Lady, the list goes on and on, they are all laggards in growth compared to small mid cap stocks but persistently selling at higher valuation.

What do we mean by high ROE? What is high and what’s low? That’s where you have to look at the cost side or opportunity cost. Cost of capital is the cost of forgoing other investment opportunities that can earn a similar return. If a business borrows from banks to grow their business, there’s the cost of interest they have to pay to the banks; if they ‘borrows’ from the market in the form of equities, the cost comes from shareholders committing to this investment and not able to invest their money elsewhere.

Growth is only valuable if it is above the cost of capital. If cost of capital is 10%, a same amount of return will not generate any value and one below that will destroy value. Now, there will be people saying this is too academic, too accountant, lack of business sense, or “you can’t measure cost of capital so why bother”. Well, if today you going to go out there and invest $10,000 to open a sugarcane stall and earn $300 every year for the next 3 years while the Public Bank banner across the street offer 3% fixed deposit p.a, and yet you are happy to stick to your business – you should start questioning your business sense. You can ignore something but that doesn’t mean it is not there.

Quick quiz. What is the reason that Pensonic trade at P/E 10 despite doubling revenue over the past 10 years? Because it earn crap return and destroying value. Your money is better invested elsewhere.

If you can throw away everything about investing and learn one thing – That will be thoroughly understand the return of every dollar of invested capital. A simple concept yet it is the cornerstone of investing.



Besides PE, other popular multiples we use to do valuation include EBIT, Cash Flow Multiple etc. There are nothing wrong with multiples. But multiples are meant for screening or as an crosscheck/triage, not valuation. Screening is what you do at the start, valuation is done at the end. So don’t mix those 2 things up. But the popularity of multiples is obvious. It is simple and easy to use. You can explain it to yourself and sell to others easily as a story. It is elegant enough for back of envelope calculation. And thus lending itself to be abused in a blanket fashion.


Short-term horizon

There’s a tendency to do valuation by looking into the next few quarters and estimate the EPS. The main reason investors refuse to do long term forecast is because no one can predict what will happen 5-10 years from now therefore it is a waste of time.

What is valuation? Can you value fine arts like an 18th century painting or how about a Ming dynasty bowl? You can’t. Their valuation will depends on how much the next buyer is willing to pay. It is speculative. However, stock is different. A business have cash flow generating assets, therefore we can value it from the cash flow those assets are expected to generate over its entire lifetime. Read this again if you don’t get it.

So if valuation is dependent on the sum of these cash flows generated over its entire lifetime, how is it possible for you to do valuation by looking at few quarters or a year? And again, because it is hard to predict what will happen 10 years from now doesn’t mean you can ignore it. Why is Amazon selling at such a hefty valuation despite reporting razor thin profit? Because the market is looking at its future potential. Market is forward looking not in term of quarters but years. Why is Grab valued at $3B? Are you able to give Grab a valuation by projecting its profit & loss statement next year?



If you can take one thing away from here, that is always ask “What is the cost?” What is the cost for growing? A company can grow its revenue 9x but if it requires 10x of extra investment to do that, it is a rubbish investment. 2nd level thinking is not some deep mysterious thinking ability, you simply have to be more curious and ask more. And when you do valuation, you need to separate speculating from investing. There’s nothing wrong with speculating, everyone does it including me although I don’t endorse it but at the same time, I know my bad track record of convincing people. So if you going to do it, make sure you keep both eyes wide open. The second you start mixing speculating with investing; the second you start believing you have your swimming pant on but in fact it is long gone, you are in a lot of trouble ahead.


“The first principle is that you must not fool yourself – and you are the easiest person to fool.” – Richard Feynman

3 Replies to “How Not To Do Valuation”

  1. With due respect, IMO valuation cannot be NOT done before investing, just that how to value high-quality business is another art.

    I recall your post about LPI’s 15-20% return p.a from 2006 even if we bought at 18x P/E. LPI fulfills your criteria of high ROE, does it mean we should ignore the valuation altogether? I think we shouldn’t. On perfect hindsight, it simply means we can even buy LPI at about 25x P/E to achieve KLCI-like returns of 10% p.a.. Buying LPI at 30x P/E still doesn’t make sense — however great the company is — if KLCI index fund is your alternative.

    I know you decry using back-of-envelope multiples to value businesses. Believe me, I’m at your side too to some extent, but I think that earnings yield is still the most commonsensical way of valuing business (Warren Buffett never did a DCF too for his buys). If I can’t derive my intrinsic value range of a company — a well researched and understood one — via a simple earnings-yield valuation within 5 minutes, I probably don’t understand the company enough to invest.

    1. I don’t quite get your first two paragraph, mind to explain more?

      On the back of envelope concept, it has it’s own validity, just what happens is people trying to force it to do things that it isn’t fit to do, EPS*PE is one. And there are several layers to view it. A valuation can be done using back of envelope if the misprice is so huge; if the analyst has high alpha; if the business model is so simple; or a combination of these.

      1. Maybe I misunderstood your post . It seemed to me that in your post you were implying “don’t bother doing valuation on sustainably-high-ROE companies (like LPI), just buy ’em even at high price and they will deliver over the long term”, which I disagree. However great a company is, there’s still a fair value on it against our opportunity costs; going beyond that fair valuation is not sensible.

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