How the valuation spectrum can help us know when to hold, and when to fold
In our last article, we looked at how investors can use the valuation spectrum to make better decisions when managing their investments. In the article, we discussed base cases and low cases. Now we look at high cases.
Let’s start by noting that on an ‘almost sure’ basis (i.e. a probability of 100 per cent) a base case is going to be wrong. Forecasting the future is simply too much of an imprecise art. What we’re hoping for is a rough approximation such that our invested capital is not impaired (and preferably appreciates).
But clearly, there is a non-zero probability that the firm’s performance will exceed the base case – not just slightly but considerably.
So what does this look like? Going back to our original example, say we expect REA to achieve 10 per cent p.a. in terms of price increase in the base case. It’s clear that those price rises could be 15 per cent and this would translate into much higher earnings growth (operating leverage) and hence a higher valuation. Perhaps we also add in outperformance of some other business segments (for example, REA’s financing/utility leads business).
The probability of this is less than that of our original base case (since higher price increases are more likely to be met with resistance than lower price increases). That being said, the probability isn’t 0 nor close to 0 since REA has the industry position to pull it off.
Strictly as a hypothetical/illustrative scenario, if we were to assess the valuation of REA and it came to $100 then we would be less inclined to reduce the position at $65 all else being equal, since there’s a reasonable chance that higher prices may be attained on a reasonable basis.
If we had invested in another company which also had a valuation of $65 but a high case of $75, then this firm would be a candidate for liquidation quicker than REA assuming the prices were moving up in unison.
Across the valuation spectrum, management of an investment is an optimisation problem between price and the likelihood of a success. Whilst these two variables clearly have answers that are real numbers, they’re evaluated under uncertainty and hence form a range. Luckily, this range is an extremely useful tool for the rational investor.
Scott Shuttleworth is an analyst at Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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