How to Value a Business vs The S&P500

"The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn't look at a single valuation metric like relative P/E ratio. I don't think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it's not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics."

- Warren Buffett, 2002

Comparing a company to another company does not need to be made more complex than this statement.

• Free Cash Flow – projected out to forever and discounted at an appropriate rate
• Valuing the S&P 500 – understanding the equity risk premium and interest rates
• Return on Equity – a simple financial metric
• Return on Incremental invested capital – a financial and economic metric
• Evaluate a business's economic characteristics - microeconomics
  
  

If you speak to the best investors, who have outperformed the market for an extended period of time, they'll tell you that valuations math is fundamentally simple.

Indeed, valuation is a simple process. You just need to take the free cash flow of a business and project it to infinity and discount it back to the present at an appropriate discount rate. Using Excel, this would be represented by your XIRR calculation over your number of periods in time. Congratulations you're now an expert in valuation.

Well… mostly. There are more variables you need to consider and some of them are not things that can be nailed to a wall precisely.

Let's look at each of these components in depth:

Free Cash Flow

What Buffett points out is that there are limited financial inputs that you can use to determine a valuation or a company. The 1st and most obvious component is of course the discounted cash flow analysis. If you know what the future free cash flows of the business are going to be out into the future you can use a simple formula as defined by John Burr Williams in his famous work in the 30s “The Theory of Investment Value”. John Burr Williams formally defined the mathematical proof for how to arrive at the valuation of a business.

A business, as an investment, functions just like a bond, the cash you take out of it over time determines its value.

The question of discount rate is generally pretty simple. You want to use the same discount rate for all investments when you're comparing them against each other. Generally, Buffett and many other value investors use the 10 or 15-year Treasury rate as the risk-free rate when evaluating a business for purchase or retrospectively evaluate a deal to provide a historical perspective thereof.

Interest rates can do some interesting things to valuations. For example, in the late 80s interest rates were incredibly high. Making treasury bonds more attractive than stocks in many instances.

In periods of extremes, accurately but not precisely valuing an asset becomes more difficult.

As of the early 2020s, we are entering a period where assets may be very cheap depending on what interest rates do or maybe very expensive depending on what interest rates do.

In either event, using the same discount rate across all assets is like using the same yardstick. It makes them comparable. The only difference is the cash flows, the time they come out of the business, and how big they are at given periods.

Importantly, you should use the same discount rate when evaluating all assets within your portfolio. And you should use the same discount rate when revaluing assets within your portfolio.

To restate this a little more simply. When you look at the free cash flow component of a business, you want to be able to compare it to a bond. Ask yourself the following question, what is the money that I'm going to get out after I have put in pretax money; what is my real return?

Bonds and stocks are obviously different instruments. But if I know the future cash flows including the timing of those cash flows and the discount rate then I can make them equivalent in form and comparable. Bonds and stocks are, after all, alternatives for one another.

Valuing the SP500 or the total market

Rather than talk about the SP500, we will talk about the total market (think vanguard total market or Wilshire 5000). It's a little bit more accurate.

If you look at how GDP grows, which is rather steadily, you would expect the market value and the market capitalization of all combined public companies to grow at roughly the same rate as GDP.

GDP by itself is no perfect measure of the productive output of the economy, but it is a very good proximate measure and a yardstick is a helpful tool.

In some instances, the market capitalization of the total market grows much faster than GDP grows and in other years it grows much more slowly or declines.

This is a factor of recessions and people's optimism and pessimism towards future valuations.

Outside of periods of irrational exuberance, interest rates also play a role. Think of interest rates like gravity. They affect the available alternatives people have.

When you invest, stocks and bonds are some of the biggest available asset classes.

If interest rates are very high, bond yields may also be very high. If interest rates are very low by contrast, people may perceive that they have few alternatives and choose to invest in stocks, shunning bonds.

If everyone invests in stocks and interest rates stay low for an extended period of time, prices for stocks could be pushed up to a point where real future returns are necessarily very low.

If interest rates stay high for a very long period of time they could crowd out bond yields and make stocks much more attractive.

At the time of writing this, we may be entering a period of low interest rates. In the event we enter a world where interest rates stay low for an extended period of time, assets may be reasonably priced at the start of that journey.

Outside of these idiosyncratic times, the way to value the S&P 500 is by viewing it in its proximate history, as a function of market capitalization to GDP. There are a variety of ways to slice and dice this measure which we would recommend researching.

If the process of valuing the total market were to be turned into a formula the formula would look something like: growth + dividends + change in perceived valuations.

Looking at a company relative to the value of the market may help an investor understand where a set of given companies may be priced as a public entity versus private entities.

Keep in mind that the public market is sometimes wrong. This can occur in the short term but will correct in the long term. The short term can last a very long time, lending credence to the phrase:

“The market can stay irrational longer than you can stay solvent”

An analogy used regularly for the market is that a market is a voting machine but over the long haul it's a weighing machine. Voting machines being popularity driven and weighing machines being a measure of output, and productivity and therefore reflecting real value.

In short, you can use the market, if it's rationally priced, to determine the approximate value of a public or comparable entity. This is by no means a perfect measure because value itself is actually a fuzzy thing. Unlike a bond, the cash flows of a business will have some degree of variability that can't be known precisely.

Return on Equity

Return on equity is a measure of the return that ultimately comes back to investors. By formal definition, it is the net income after tax less preferred dividends to common equity in the case for return on common equity. Return on Equity is the bread and butter answer to the question ‘if I buy a share of this company with my money? What is my return going to be?’

In normal times. The historical average for the S&P 500 is somewhere around 14% and can be used as a proxy. At least when comparing the company's return on equity to determine its valuation. Obviously, a higher return on equity implies a richer valuation or a near-term over-valuation by other market participants.

Looked at more carefully, the textbook definition of return on equity falls short. Return on equity can also be calculated as net income before dividends are paid to common shareholders and after dividends to preferred shareholders and interest paid to lenders divided by average shareholders’ equity. But in truth what investors really need to understand is the long-term view of free cash flow over average shareholders’ equity. Net income can easily be distorted. This is made apparent when looking at the next variable.

Return on Incremental Invested Capital

Every company, no matter how big, how small, how efficient, or how inefficient, will typically need to spend some CapEx in the future to grow or maintain its current market position. Net income does not include these CapEx expenditures because they necessarily come in the future.

If you really want to understand a business, you want to understand how efficient it is at using the money it uses internally to invest in new projects and how it will continue to grow using future money. An analogy would be something like this.

When you run a company as an owner, it's measure of efficiency to you is (A) is the money that you have left over after all expenses including taxes and (B) what future capital expenditures you will need to save some money for in the future and (C) how efficiently you can use leftover money towards those expenditures and any mistakes that may occur.

In the near future, you also might need to spend more on people and marketing and equipment to ward off competition. Additional capital expenditures in far-off future periods will likely play a role if you underinvest today.

The money left over after those things is what you can take out and buy fun things with.

Some companies need lots of incremental additional capital to grow. These businesses are like plants that always require you to add more water after each growing season. Some plants require so much water that you need to borrow from people that have a wellspring of it (banks). Other companies can grow with their own supply of water they produce after they've already reached a critical level of scale and simply plow the earnings that they generate back into the business.

The companies that can plow self-generated earnings back into their own business and continue to grow are often better businesses.

Once you understand how much capital is needed to grow the business in the future, then you can compare it to another business.

The math becomes simple, if one company needs a dollar to produce $1.25 and another company needs a dollar to produce $1.50, the company that can produce more money with each additional dollar invested is going to have a higher return on incremental invested capital. When considered along with its long term economic prospects and the price it can be purchased, the latter may be the better business to invest in.

The questions that need to be asked next is, how does the incremental invested capital tie to the underlying economics of the business.

Evaluate The Economic Characteristics of The Business

The most difficult part in valuing a business is making a determination about the economic characteristics of that business.

If you think about a business as an animal living in a niche, much like you are taught in high school and entry level college biology classes, determining the survivability of the animal and its hierarchy in the food chain comes down to survivorship and growth rates. Maslow’s hierarchy of needs might also come to mind.

How long can this animal continue to operate as it currently does until it becomes extinct? Even trees, as slow growing as they are, compete for resources in the forest. Biology is brutal. The competitive landscape of business world is even more so.

The questions you should ask are. How long is the business going to be able to invest its capital efficiently? How long will it be able to maintain its competitive position without being disrupted by either competition or a change in technology? Will, overtime, the company's competitive advantage be disrupted? or will the company cease to even exist? Is the value attributed to it by the market reflective of this?

Given the company's current return on capital how long is management going to be able to continue to efficiently allocate capital inside of the business or to shareholders? In some cases, this question is very clear, in other cases it's too complex to know.

Takeaways

The first important takeaway from this analysis should be that the mechanical elements of producing a valuation are very simple and formula driven.

The greatest difficulty in evaluating a business comes with understanding its underlying economic characteristics and projecting how those economic characteristics are likely to play out in the future.

Valuation necessarily includes a microeconomic perspective, rarely a macroeconomic perspective.

Perhaps the greatest takeaway should be for investors trying to expand their opportunity cost.

Investors should compare business opportunities against each other using return on incremental invested capital and return on equity paired with an valuation that uses the same yardstick for the discount rate.

As a mechanism for comparing all things against each other in the universe of companies, there are few better tools.

In theory, if you could understand the difference between these variables for every company public and private, you could very easily come up with a ranking for the most valuable company and each company thereafter.

And understanding these metrics and the economics underlying each asset, you may be able to determine if an individual company may be mispriced relative to another one. Or the general market.

Understanding a company’s intrinsic value allows an investor to make favorable investment decisions based on a how others in the market may be looking too short term.

The popularity contest that is the market allows rational capital allocators to advantage of opportunities that may arise.

The process for thinking about valuation is a process of thinking is also about opportunity cost.