Value investing involves a lot more work than simply tracking down a list of the companies whose share prices have fallen most and taking that as a proxy for value
At its heart, value investing involves buying stocks that trade at a significant discount to their intrinsic worth and then selling them in the event the wider market catches up with your own assessment. As such, you would think a large fall in a company’s share price would be of great interest to us – but no, we source ideas from an academically proven value screen and here is why.
AO World is a UK-listed online white goods retailer and, shortly after it floated in February 2014, it saw its share price hit a high of 377p. By the start of this year, however, the share price stood at almost exactly half that – at 188p – since then it has dropped by around a third further to reach 125p. A green light for value investors then? Well, let’s see.
One key measure investors can – and, in our opinion, should – use to gauge whether a business is of potential interest is reached by dividing its enterprise value (EV) – essentially its total value, including debt and other adjustments – by its earnings, before interest and tax are taken into account (EBIT). AO World’s EV is currently £580m while the highest EBIT it has made in a single year is £8.5m. So that is an EV/EBIT figure of 70x.
Now, here on The Value Perspective, we would much rather use a company’s average annual figure to guide our view of normalised earnings rather than its peak earnings. In this instance, however, that is not possible as AO World averages a loss of £2m per year. We would then look to buy businesses at less than 10x their normalised EBIT and yet – despite its huge share price falls – this AO World ratio is seven times the multiple we would like to pay at 70x!
For value investors, that is extraordinarily, eye-wateringly, no-point-going-any-further expensive. A dead end. Even at today’s significantly reduced price, any investor who buys into AO World is relying on what is known as ‘Bigger Fool Theory’ – the idea there will be a bigger fool out there willing to buy the shares off them at a price that will enable them to make a profit.
Conversely, to be a proper value investor, you need to do a lot more work than simply tracking down a list of the companies whose share prices have fallen most and taking that as a proxy for value. The distinction – as is often the case in investment – is neatly captured by Warren Buffett, who famously observed: “Price is what you pay. Value is what you get.”