Good reads from around the Web.

The further removed we are from the financial implosion of 2007 and 2008, the more you hear people downplaying the whole crisis.

Everyone, it now seems, knew something would go wrong. We all understood – newspaper columnists imply – how it would pan out. And as for investors, well it was obviously a buying opportunity!

Rubbish. Rubbish. Rubbish.

From our earliest days as toddlers reading about Hungry Caterpillars, we learn to parcel events into neat narratives where everything happens for a reason, and proceeds the only way it possibly could do.

But reality is not like that, and we’d do well to remember it.

A nice reminder was served up this week by the release of the 2007 minutes of the US Federal Reserve.

They reveal that the U.S. Central Bank was complacent about the tsunami heading towards its shores, even as the first sandcastles were crumbling:

According to the transcripts, the word “recession” wasn’t spoken until the summer.

A staff presentation described a highly unlikely, worst-case scenario that included a 10 percent drop in the stock market.

That still would not be enough to force the economy to contract, the staff assured senior Fed officials.

Er, not so much.

Lots of critics of Central Banks will use these minutes as ammunition against their influence on the economy. But that’s not my purpose here.

It’s more just interesting to remember that some of the best economic minds in the largest, most capitalist economy in the world – who even had confidential data that the rest of us don’t have access to – just didn’t see it coming.

These were human beings, being overconfident as all human beings are.

And funny, too:

Richard Fisher, the president of the Dallas Fed, expressed confidence during the October 30/31, 2007 meeting that investors were waking up to problems in the subprime market.

“Investors are coming home from lala land. To be sure, we’re not out of the woods quite yet, as President Plosser and President Rosengren mentioned. The situation remains real, but we’ve gone beyond suspended reality.

If you will forgive me, you might say we have gone from the ridiculous to the subprime.”

Boom boom!

[continue reading…]

All too often, dividend investors base their investment decisions on yield alone, with little regard for the price they paid for the share.

As long as the dividend keeps rolling in, the thinking goes, I don’t have to worry about the share price.

Ignoring the capital is nice in theory, but difficult in practice. It’s rather challenging, for instance, to stay focused on a share’s 4% yield when the price has fallen 25%. And if you end up selling the share for a loss, that’s less capital that you can then reinvest elsewhere to generate the income you desire.

It’s a given that share prices are volatile, but I believe we can reduce the probability of permanent losses of capital by paying more attention to valuation when making buying and selling decisions.

Ideally, we want to purchase shares for less than their ‘intrinsic value’.

Put another way, we want to pick up £1 coins for less than £1. Investors might see that £1 coin as being worth 90p one day or £1.10 the next, but at the end of the day, it’s still worth £1. The market might make mistakes in the short-run, but in the longer-run it is a highly-efficient machine that more accurately prices a company’s true worth.

Valuation is an extremely broad topic and we won’t be able to cover it all here, but we will address the two major schools of valuation – relative and absolute valuation – and provide some methods you can put to practice straight away.

Relative valuation

By far the most common valuation method is relative valuation. With relative valuation, the investor compares the subject company’s multiples – price-to-earnings, price-to-book, et cetera – with those of comparable companies.

The underlying principle is that the market should price similar companies in the same industry the same way. If the subject company is trading with lower multiples than its peers, for instance, then it is said to be relatively undervalued.

To illustrate, an investor interested in grocery shares might put together a table like this:

Note: The data in this table is for illustrative purposes only.

From such a comparison, we might deduce that the market is undervaluing Tesco1 and Wm. Morrison relative to Sainsbury and Marks & Spencer on a price-to-earnings basis.

You can probably see why most equity research reports and investment decisions are based on relative valuation methods – it’s quick, simple, and market-based.

But whilst relative valuation is helpful, it does have some drawbacks.

First, we need to understand what goes into each multiple. For example, the price-to-earnings ratio is a function of earnings growth and the required rate of return. All else being equal, a share with a lower price-to-earnings ratio might have lower growth expectations and/or higher risk than its comparables, and this could make its lower multiple justified.

Note: Ceteris paribus!

Second, we need to identify the differences between the businesses we’re comparing. For example, Tesco has a bank division whilst Marks & Spencer does not and that could account for the different multiples.

Finally, it’s possible that the market is wrong and the group could be over- or under-valued.

To illustrate, in the late 1990s, a dot-com share trading with a price-to-sales ratio of 100 might have been relatively undervalued versus other dot-com shares, but that doesn’t mean it was actually undervalued.

Once the dot-com bubble burst, it didn’t matter much that the share was relatively undervalued, as all of the shares in the industry collapsed.

Absolute valuation

The alternative method of valuing shares is absolute valuation, which as its name suggests seeks to determine the absolute – or ‘intrinsic’ – value of a given share, regardless of how it might stack up relative to its peers at a given point.

The underlying principle with absolute valuation is that, if you’re correct in your outlook (a big ‘if’), the market will eventually correct itself and the share price will move closer to your fair value estimate.

There are a number of absolute valuation methods, the most popular of which are the dividend discount model (DDM) and the free cash flow to firm (FCFF) or to equity (FCFE) models.

In each case, the investor estimates future cash flows, and discounts the expected cash flows to the present using an appropriate rate to arrive at a fair value estimate.

The simplest absolute valuation model is the Gordon Growth Model:

Fair value = Next year’s dividend per share / (required rate of return on equity – dividend growth rate)

To illustrate, let’s say we’re looking at a share that analysts expect will pay a 100p per share dividend next year. Let’s also assume that the required rate of return is 10% and that we expect the dividend to grow at 2% in perpetuity.

Fair value = 100p / (10% – 2%)

Fair value = 1,250p

If this particular share is trading for less than 1,250p in the market, then, we might conclude that it is undervalued and worth buying.

As with relative valuation, there are a few drawbacks to absolute valuation to keep in mind.

First and foremost, you’re making forward-looking estimates — often very far into the future — and those estimates may not reflect what actually happens. If you over-estimate the company’s prospects, for instance, you’ll over-value the share and may end up overpaying. As such, it’s critical to assume a number of possible scenarios when using absolute valuation.

Second, the absolute valuation method you choose needs to reflect the type of business you’re analysing. A company that doesn’t pay a dividend (and doesn’t expect to), probably shouldn’t be valued using a dividend-based valuation model. (Though, in theory, it can be done).

Finally, absolute valuation methods can require substantial spreadsheet work and thus have a steep learning curve and typically require more time than relative valuation methods.

Which valuation method is best?

Most research reports that you’ll read will use either relative or absolute valuation, but the best approach may be to use both. The two methods have their benefits and drawbacks, but when used together they can help identify miscalculations and establish a better range of valuation possibilities.

To illustrate, you might run a dividend-discount model only to find that your fair value estimate doesn’t make sense on a realistic price-to-earnings basis. Similarly, you may find a share to be relatively undervalued on a price-to-earnings basis, but when you run a FCFF model you find that the share is actually overvalued.

Whichever methods you employ, it’s important that dividend investors consider valuation and not simply purchase a share based on its yield. In the end, you still want to purchase a share for less than it’s worth and reduce your risk of losing capital.

For further reading

Realising that valuation is a massive topic, I’ve provided links to three resources that I consider to be quite valuable and helpful if you decide to learn more about valuation.

• Damodaran Online — The homepage of NYU finance professor, and arguably the world’s foremost valuation expert, Aswath Damodaran. Here you’ll find helpful data sets and valuation spreadsheet templates, as well as his finance class materials. Definitely one to bookmark!

• Value Investing: From Graham to Buffett and Beyond
  

• Valuation Calculator at Stockopedia

Have a great 2013!

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

1. Note: The Analyst owns shares in Tesco. [↩]

I love this article on The Register about a man who was found to have secretly outsourced his entire job to China:

A security audit of a US critical infrastructure company last year revealed that its star developer had outsourced his own job to a Chinese subcontractor and was spending all his work time playing around on the internet.

The firm’s telecommunications supplier Verizon was called in after the company set up a basic VPN system with two-factor authentication so staff could work at home. The VPN traffic logs showed a regular series of logins to the company’s main server from Shenyang, China, using the credentials of the firm’s top programmer, “Bob”.

You have to admire the chutzpah of the guy. But the excellent part of the story is that his resultant work was not substandard.

In fact, Bob, the happy coders in China, and the employer would all seem to have benefited from the arrangement:

[Bob] was paying them a fifth of his six-figure salary to do the work and spent the rest of his time on other activities.

Bob is employing salary arbitrage, as made famous by Tim Ferris in his DIY freedom tome The 4-Hour Work Week.

Realising his company was grossly overpaying him for his skills on a global basis, Bob addressed the issue and pocketed the profits – both in terms of money and also in terms of time.

A drone’s life

That brings me to the first of two disappointing elements to this story.

Instead of using his time productively – maybe generating an ongoing passive income stream to pay his bills when he was eventually busted – it seems Bob spent most of his time goofing around on the Internet.

Here’s his typical day, according to the report:

9:00 a.m. – Arrive and surf Reddit for a couple of hours. Watch cat videos

11:30 a.m. – Take lunch

1:00 p.m. – Ebay time

2:00-ish p.m – Facebook updates, LinkedIn

4:30 p.m. – End-of-day update e-mail to management

5:00 p.m. – Go home

It’s a shame that once freed from the laborious constraints of typical hourly work, Bob choose to indulge in exactly the sort of Western slacking that’s giving the Chinese and others their opportunity. There’s only so many cat videos on YouTube that anyone needs to watch in a day.

Secondly, although it’s not explicitly stated in the article, it seems his company was concerned about Bob’s unorthodox approach to his job, given that it has had a report written up on him.

This despite the fact that it considered Bob one of its best employees:

In his performance assessments by the firm’s human resources department, he was the firm’s top coder for many quarters and was considered expert in C, C++, Perl, Java, Ruby, PHP, and Python.

Why didn’t the scheme ‘work very well’ for Bob’s employer, too?

Granted we’re told he was working on ‘critical infrastructure’, so perhaps there were security concerns. But in the terrorism-jumpy US that could mean a sewage farm in Indiana.

Apparently Bob had repeated the trick at other companies, too, so he was raking in thousands altogether. And that’s the crux of the issue.

The typical middle manager is far more concerned with what you are doing than with what you are producing. I personally find this attitude so galling and belittling that I’m pretty much unemployable. I can’t understand how anyone can not be at least mildly miffed by it, once you see what’s going on.

Bob’s deception was corporately untenable, even though he was achieving the work asked of him. Most companies can’t have workers questioning the system, any more than the machines can let humans run amok in The Matrix.

In a better reality, one of the companies scammed by Bob would promote him to head of Human Resources, and have him re-wire its entire operations.

The man is clearly an organisational genius in the tradition of Henry Ford.

Welcome to the real world

Bob’s achievements sum up why I am a freelance and I work for myself, from home, as much as I possibly can.

The time savings are extraordinary if you’re any good at your job, both in terms the productivity gains on the work you do, and the hours you save in schlepping back and forth to an office where most people spend half the day on Facebook.

But there’s a further benefit of not aligning yourself too closely to the fortunes of any one particular witless company or another.

Put your head down, strive hard, but unless you’re curing cancer, you’re doing the job of your childhood dreams, you have a one-in-a-million leader, or you always aspired to sit in meetings to have long discussions about superfluous projects and initiatives that will arrive stillborn and be dissected in tedious detail while your precious life-hours are drained away in company-branded coffee cups – sorry, did I say that out loud? – then remember you’re always working for yourself.

You might also ask yourself: “Could my job by outsourced to China?”

If yes, then it could be prudent to take defensive action and seek a new job before a corporate Bob does yours in for you.