Seeking True Value

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Valuation is too often associated with a price multiple that signifies how much an investor will pay for each dollar of earnings generated by a company. In a price multiple framework such as P/E, an investor decides what the earnings of a company will be and then places a multiple on those earnings depending upon how confident they are about the earnings. As discussed in our explanation of why earnings fall short, the problematic nature of a price multiple is the noise in the underlying E of the equation.

Aside from the issues with earnings only representing 50% of the company's cash earnings, the price multiple also fails to link the investment the company has to make in order to generate a $1 of earnings, thereby missing half the financial picture.

Investors that use a P/E also treat companies that have high proportion of expense from research and development (R&D) expense exactly the same as companies with relatively little R&D expense the same even though companies with high R&D expense are investing for the future while the others are not. 

Another problem with the P/E framework is that it assumes that earnings are into perpetuity with no systematic process of building in the concept of competition. Investors deal with it by giving different multiples depending upon the confidence investors have in a company's earnings growth and stability. However there is no systematic way of dealing with the concept on a company by company basis.

AFG’s Valuation model addresses these issues by providing a systematic valuation framework which links the earnings power of a company to its invested capital, converting the company’s earnings into cash flow measure and systematically modeling in the effects of competition through a company specific decay.

As seen in the analysis below, evaluating a firm based on AFG’s valuation model helps one to find winners and avoid possible torpedoes while a P/E analysis provides no insight into intrinsic value.
 

By assessing intrinsic value through AFG’s valuation model broken out by sector, it becomes apparent that investing in the best vs. the worst among sector peers, investors can gain a significant advantage when selecting potential portfolio holdings.

A P/E on the other hand provides no insight into intrinsic value distorting investment opportunities providing little or no insight into the true value of a company.

AFG’s Valuation Model systematically picks winners and losers in each economic sector despite market cap. By comparing companies on a peer basis, a portfolio manager gains significant insight into those companies that are overvalued vs. those companies that are inexpensive.

Percent to target is just one of several variables AFG analysts use to identify investment opportunities. They also look to identify those firms that are expected to improve their Economic Margin, follow a wealth creating strategy, have relatively low expectations embedded in current market price, and avoid companies with poor Earnings Quality. By looking at the spreads below, you can understand why AFG’s valuation model is an integral part of the investment process of some of the most respected investment firms in the U.S. and abroad. If you are ready to take advantage of AFG’s research, simply click here for a complimentary trial.