Take the Road Less Travelled

Many investors use metrics such as earnings multiples when evaluating the value of an investment (or as may often be the truth, in order to explain to others what they have done, and seek reassurance for the risks taken by comparing their investments to others). Yet, there is an alternative, often dismissed, approach that may result in the best long-term outcome for investors: to pay a price for the business, which both the seller and the buyer find fair.

This behaviour is contrary to what most investors do, which is to exclusively analyze relative earnings multiples. This traditional behaviour is based on the importance placed on seeing out a “deal.” Investors typically seek the highest returns, and therefore the ‘best deal.’ A better investment in this context means paying a lower relative multiple to competitors or the industry. But is it ultimately the better deal?

There are several challenges with this approach that can be summarized by the following statement: common shares that are sold at cheaper prices, are usually sold at this price for a reason. Or how about this one: you get what you pay for.

Often this reason is not because the buyer is aware of some information that the seller is not; rather most information (especially if it is easily obtainable) is already factored into the price of the business being sold. This is not to say that it is impossible to make an investment profit in the short term by buying at cheap prices, but that the chances of this being repeated over and over again for an indefinite period where the buyer has proprietary information is low.

From the buyer’s perspective, having a mentality which seeks only to negotiate for the lowest price requires that they ignore information that may psychologically raise the value of the business to themselves. It is when this information is ignored that buyers miss opportunities to purchase stock in superior businesses.

As an example, Starbucks’ annual average P/E ratio has been relatively high over an extended period of time. A buyer seeking to pay relatively low multiples would screen out this stock because, by this measure, the price is not a discounted one. By eliminating this stock as an investment option, they have ignored the possibility that the business is selling at a higher relative price because it is simply a superior business.

The general solution to avoiding the limitations of valuation through earnings multiples is to have a wider view when determining value – a view that factors in all of the resources at the company’s disposal, including those that cannot be accounted for on a financial statement (i.e. qualitative measures). For example, Starbucks processes more payments on mobile devices than any other food retailer and has a loyalty program where customers pre-pay for food items. The quality of its store locations, customer service and brand loyalty are apparent to anyone walking the streets today. Comparing Starbucks to any other specialty food and beverage retailer makes these advantages obvious to anyone living in Western society. In other words, a lot of qualitative measures can be observed through common sense and outside the limited realm of financial statements.

Paying a fair price involves a mental exercise where one actually acknowledges the advantages that a company may have and calculates the appropriate value of these advantages. In some cases these advantages can be determining factors in valuing the business over and above its historical performance.

Paying a fair price has other advantages: if you buy great businesses that are conservatively financed, you will do well over time because your approach to developing your portfolio will inherently weed out the weaker business models, while accumulating the strong businesses. Secondly, if you are purchasing private businesses in negotiated sales, you will probably earn a reputation for treating the seller fairly, which may lead to more opportunities in the future.

In summary, adopting a practice of fair price negotiations removes the pitfalls of succumbing to the blind side of using accepted industry financial ratios as the best method for evaluating business value. As we have demonstrated, it’s about so much more – reputation, benefits, sustainability and an overall adherence to a set of core values, are all necessary for real long-term success.

Mill-Street-and-Co-Noah-Murad-Smart-Capital Take The Road Less Travelled