16. Limitations of Market-Based Valuation

 
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Overview

Market-based valuation has many limitations. Awareness of these limitations can protect you from losses and help you spot mis-priced assets.

Lesson Notes

Limitations of market-based valuation

1 Multiples do not account for market cycles
2 Multiples can be easily manipulated in the short-term
3 Asset-specific details are ignored

Transcript

As we saw on the previous lesson, multiples are very easy to calculate and exist for almost all types of assets.

However, multiples have many limitations, which in this lesson we'll examine in detail.

Understanding these limitations will help you find mispriced assets and attractive investment opportunities in the market.

The first limitation of multiples is that they do not account for market cycles.

Let's say we buy a house at $300 per square foot.

This price might appear a good value at a point in time, compared to similar properties on the market.

However, if you bought the property at the height of the property bubble, say in early 2007, then it could still turn into a sizable loss, even if it appeared good value compared to other properties at that point in time.

When using multiples, always be aware of the current economic environment.

Property prices in particular, tend to be very cyclical and investing at the top of the market can result in big losses.

As we saw in our previous lesson, these risks are multiplied if you buy a property with a loan.

The next big limitation of multiples is that they can be easily manipulated in the short term.

Take for example an airline called Zippy Airways, which appoints a new CEO in December 2013.

Investors demand a sharp increase in profits for the coming year, and the CEO is incentivized accordingly.

He prioritizes cost cutting as the fastest way to grow profits for the coming year.

In 2013, the market value for airlines tends to be a price earnings multiple of 12.

The net profits in 2013 for Zippy was $20,000,000, and so the market value is $240,000,000.

Next year the CEO achieves $7,000,000 in cuts, which are primarily labor costs, without any impact on revenue in that year.

However, the cuts do begin to have an impact later in the year with decreased moral among staff who begin to leave at an accelerated rate in November and December.

Although the staff cuts are bound to affect the company in the long term, in the short term profits increase to $27,000,000, and the market value of the company rockets to $324,000,000, giving both the CEO and investors a short term boost in value.

In this example, multiples do not spot the long term implications of a short term profit boost, because they are not forward looking.

An income based approach in this example has a better chance of identifying the long term implication of large cuts and labor costs.

The next limitation of multiples is that they don't allow for asset specifics details that can distort a comparable multiple.

Let's say we have two commercial properties of similar size that are for sale on the same street.

The first property is for sale for $1,000,000 and has an annual rent of $50,000, providing a rental yield of 5%.

The second property is for sale for $900,000, has an annual rent of $40,000, with a resulting rental yield of 4.44%.

On a quick multiples basis, the first property appears better value due to the higher rental yield, however there’s some additional detail we need to consider for both properties.

In the first property, the anchor tenant is leaving next year, which means that $30,000 of rent still needs to be replaced.

This would represent a significant risk for any investor.

On the other hand, in the second property, all three tenants are still tied into long term leases for the next five years, and there’s also the potential to increase the square foot area by 20% due to a recent planning decision.

This would serve to increase the earnings potential for that building.

However, looking purely at the rental yield multiple, none of these additional details are captured, and we would probably view property one as the better value.

These limitations are not to say that multiples should not be used.

They should always be calculated, as they offer some clues as to how the market is valuing an asset.

Knowing the limitations of multiples can help you spot mispriced assets.

And mispriced assets lead to higher investment returns.

In the next lesson, I'll give you a couple of more tips on calculating asset multiples.