LIPSTICK ON A PIG DOES NOT MAKE IT A SUPERMODEL

PRICE IS WHAT YOU PAY; VALUE IS WHAT YOU GET

In 2002, Charles Schwab ran a commercial showcasing the sales manager of a rival brokerage firm urging the traders to push the sale of a stock with weak fundamentals to unsuspecting customers because the institution had been incentivized to do so. The winner, that is, the person who would sell the most shares, would be awarded courtside playoff tickets. He finished off by saying ‘Let’s put some lipstick on this pig!’ The stock in and of itself was a dud and needed sprucing up to make it more appealing to the firm’s customers.

This then begs the question: How does one assess a company’s fundamentals? A combination of three (3) factors can be used to analyze a company – the valuation factor, the quality factor and the momentum factor: –

1. The Valuation Factor – This is estimated using the Earnings Yield metric. Earnings Yield measures the utility derived from a public stock or private company. It is calculated by dividing Earnings Per Share by Price per Share for public companies and Operating Profit by Enterprise Value for private companies. It is used to identify undervalued companies where a high earnings yield is preferred. This is because when a firm’s stock price or its Enterprise Value falls but earnings or operating profit stays the same or rises, the earnings yield is shored up.
2. The Quality Factor – This is evaluated using Return on Invested Capital (ROIC). ROIC measures a company’s efficiency in allocating its capital profitably. It is calculated by dividing Net Operating Profit after Tax by Invested Capital where an ROIC that is greater than the Weighted Average Cost of Capital (WACC) is preferable.
3. The Momentum Factor – This is measured by looking at the stock’s price performance or earnings revisions over the past nine (9) months. These trailing metrics ought to be positive. This is done so as to avoid value traps – stocks that are cheap for a reason. These stocks trade at low valuation metrics for an extended period of time. They tend to be attractive to investors who are bargain hunting because they are inexpensive relative to historical valuation multiples of the stock or relative to those of industry peers or the prevailing market multiples. Despite the price being low, the value to be derived from the stock is, however, much lower.

Price and Value are terminologies that tend to be erroneously conflated. So, what is the difference between the two? Well, it depends on who you are asking.

Lord Darlington in Oscar Wilde’s play ‘Lady Windermere’s Fan’ referred to a cynic as a man who knows the price of everything and the value of nothing and a sentimentalist as a man who sees an absurd value in everything and does not know the market price of any single thing. Lord Darlington is essentially positing the fact that price and value are not mutually exclusive. They exist on the same continuum and cannot be divorced from each other. At any given time, one needs to define what is more important both in the short and long run. As such, it is imperative to undertake a due diligence to understand the idiosyncratic qualities of say, the company, that would make it either thrive or falter in the marketplace. For example, it is not uncommon for a company to be sold at a premium of, say 50%, of its intrinsic value because of the moat it has established over its competition. In this instance, by paying a premium, the acquirer is focused on the additional benefits to be begotten from the target company down the road due to its competitive advantage. It is also not uncommon for an investor to buy a value trap, a cheap stock only for its stock price to continue languishing or dip even further. One of Warren Buffett’s credo and ethos is ‘Price is what you pay and value is what you get’, a hill which my former boss would, quite frankly, die on. Pragmatism dictates that before a purchase is made, an analysis ought to be done to establish its worth, and in turn, the utility to be derived from it. Failure to do so could be tantamount to buying a pig with lipstick on thinking it is a supermodel.