Monday, 25 February 2013

Barry Schwartz on Valuing a Business

Baskin Financial Services is one of the finer investment outfits in Canada.  Both David Baskin, the company's namesake, and colleague Barry Schwartz have much to offer knowledge-hungry investors.  The two make regular appearances on BNN Market Call and Market Call Tonight, and correctly emphasize the competitive strengths of businesses, and important metrics such as return on capital.  In addition, both men contribute regular articles on the firm's blog, where they've had wise things to say about ignoring headline news, being patient, the perils of over-diversification, and much else.

A recent article by Barry Schwartz considers an important question: How do shareholders decide whether management ought to pay a dividend or repurchase shares?  If they pay a dividend, he points out, shareholders must pay tax, but are given control of the investment decision.  They have the option of buying more shares of the dividend paying firm, but if they believe that the newfound dollar in their pocket is better invested elsewhere, they can do exactly that.  A share repurchase saves owners the tax, but robs them of the alternative of investing elsewhere.  His narrowly framed question can stand in for a broader one: How should investors determine if a company is undervalued, regardless of whether management returns money to shareholders (via dividend or buyback) or if they retain all earnings to reinvest.

The formula he offers to resolve this question, unfortunately, is unsound.  Schwartz argues that a company ought to repurchase shares only if the P/E ratio is lower than its return on equity.  As he knows, P/E measures how expensive a stock is, and ROE gauges the profitability of the underlying business.  Though both are critically important, the two metrics are not on the same plane, the way, say, P/E and earnings growth are combined to form the PEG ratio.

To illustrate, in 2011 IBM posted adjusted earnings of $16.3 billion, on an equity base of $20.1 billion, for an ROE of 81%.  By Schwartz's logic - he prefers to pay no more than 75 cents for each percentage of ROE - management is wise to pay up to 60 times earnings to buy back shares of IBM.  That's $1000 per share, for a company now trading at $200, with a P/E ratio of 12x earnings.  A little rich, I think.

In fairness, I've used an extreme example, since IBM's ROE is radically high.  And, in practice, an investor that purchased only stocks with, say, an ROE of 20% and a P/E of 15 would likely do well over time.  In fact, the three companies that he cites as passing his test - CSX, Viacom, and Tim Horton's - are all superb companies, and probably undervalued, too.  Schwartz is profoundly right to covet companies offering both a high ROE and low P/E ratio.  Still, the formula he has concocted is flawed.

Disclosure: At the time this article was published, the author was long IBM stock.

Here is an article on how Mason Hawkins values a business.

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