Introduction to Structural Valuation Analysis

Solving the Investor’s Dilemma

When should I buy? When should I sell? What is good value and what is not? How can I avoid an investment which is going sour? Stocks seem to spend a good deal of their time going down; can I take advantage of declines by short selling—safely? When are other brokers giving me the straight goods and when are they just blowing smoke? I want to have, as a part of my portfolio, investment in companies whose shares trade on the public stock exchanges, but who do I trust to advise me? Where can I get the straight answers?

One of the first places to start is with a firm’s balance sheet, which contains a significant amount of information not appreciated by the market. This information can be used to earn excess profits over and above the market index returns. Indeed, for more than 25 years, Strategic Analysis Corporation has been using and refining a unique capital markets methodology called Structural Valuation Analysis® (SVA) that turns the wealth of information contained in a firm’s balance sheet into valuable knowledge.

Whether you use SVA to trade stocks on a daily bases or to construct a sound, long-term investment portfolio, the methodology provides valuable insight into a firm’s true value.

What is SVA?

SVA examines one of the most fundamental financial statements a firm produces – the balance sheet. The cornerstone of SVA is the theory of Accounting Dynamics, developed by Verne Atrill Ph.D. in his manuscript How ALL Economies Work. Unlike traditional quantatitative or fundamental analysis, SVA draws upon information from several areas such as accounting, statistics and even the physical sciences.

SVA provides a structure within which a stock’s valuation can be measured. This structure is defined by a series of ratios that create a systematic approach to equity valuation which has helped clients to consistently enhance stock timing and portfolio returns.

At the heart of the SVA approach are three unique and powerful numbers – Fair Market Value (FMV), Market Value (MV) and the Stability Ratio. Used in conjunction with other SVA metrics, these ratios allow the investor to recognize and capitalize on changes in a firm’s balance sheet which other research methods fail to identify. It allows investors to identify which stocks will be a rising star or a sinking ship.

The Stability Curve

The stability ratio rates how strong, and as a consequence, how stable a firm’s balance sheet is. Generally speaking, the market will place a higher value, per dollar of earnings, on a firm which has a stronger, more stable balance sheet than on a firm which has a weaker or less stable balance sheet. This relationship exists only to a point on the stability curve. After this point, the stronger the balance sheet, the less value the market places on a dollar of a firm’s earnings. In some instances, a firm’s balance sheet can be too strong. The firm could actually maximize its stock price potential by weakening its balance sheet, and releasing the hidden balance sheet value to projects which help drive earnings and value.

As the curve shows, firms in the ‘Efficient Zone’ maximize their price potential per dollar of earnings. Both a stability ratio which is too weak and too strong will negatively impact the price potential of the firm’s stock.

When using the Stability Ratio as an evaluation tool, we look for improvement or declines in the balance sheet structure. Weak balance sheets which are being strengthened tend to strongly outperform the market, while firms with strong balance sheets which increase their leverage also perform well. By observing these events, investors can understand and take advantage of changes in a firm’s balance sheet that few others notice.

The Fair Market Value Price

Every corporation has a precise amount of earnings that it must make in order to stand in balance (neither grow nor diminish). This earnings level is known as the ‘Hurdle Rate,’ a measure which is directly related to the structure of the balance sheet itself. When profits exceed a given firm’s Hurdle Rate, the process called growth begins.

Since the market is forward-looking, we compare the company’s (one-year) consensus earnings forecast to the current Hurdle Rate of earnings. This comparison gives a strong gauge of how efficiently a firm will be able to meet its basic operational goals. This ratio is know as the ‘Earnings Efficiency Ratio’ (EER).

A Firm’s EER is directly proportional to a firm’s Price to Book (P/B) ratio, and this relationship can be used to determine an implied market value for a firm’s stock. We call this implied market value the Fair Market Value price.

Market Value Ratio

The cornerstone of the SVA methodology is a ratio known as the Market Value Ratio. This ratio uses price and a modified book value of the firm. By modifying the book value, we can make an apples to apples comparison between companies in different industries that exhibit different characteristics. The market value ratio serves as a key input to several aspects of the SVA method.

Success in using the MV ratio lies in understanding that the stock market can be naturally broken down into a series of valuation zones. Each zone has its own characteristic in terms of volatility, potential for price appreciation and risk. At the zone extremes, there is a natural and powerful tendency for prices to be turned back, a force which grows stronger as the price approaches the zone boundary point. These boundaries, or 'Structural Breakpoints', mark critical changes in the price dynamics of a given company.

Major Valuation Zones

The power of the Market Value ratio lies in the significant price movements that occur at the zone breakpoints, events that can be capitalized on by the investor. Two important events can occur when a stock reaches a structural breakpoint:

Inflections

In general, breakpoints act as resistance barriers to a stock’s advance or decline. When a stock price intersects one of the breakpoints, we expect the price (valuation) to reverse direction. If a stock’s price is falling, there is a very strong tendency for the stock to bounce off the breakpoint and rise in price. Similarly, if a stock’s price is rising, it will fall in value as it rebounds off the upper breakpoint of the Valuation zone.

Zone Transitions

When a stock fails to stop at the zone breakpoint and continues into the next higher or lower zone, we term these events zone transitions. Zone transitions are market signals that a major improvement or decline is occurring in the outlook for the company. As such, one would expect that such stocks should have unexpected and rapid changes in price. When a stock surges through an upper zone boundary, we call this a Positive Zone transition, if a stock falls through the bottom of a zone; it is appropriately called a Negative Zone Transition.

Putting it All Together

Whenever SVA is used for trading purposes or to improve returns for an investment portfolio, steady performance improvement can be easily introduced to individual stock selection and/or the portfolio management process.

These key pieces of information which the SVA methodology provides come together to form the cornerstone of our research product, the SVA Chart. The charts display the price history of a stock along side the structural boundaries. At a glance, one can see where the market has historically valued a stock, where the stock is presently valued, and what the potential for price appreciation might be. This visual evidence also helps to give a quick indication as to whether today’s price is relatively high or low.

Buying a Stock

When looking for a stock to buy, the investor should look for three things:

1. Does the company have a high FMV relative to the current price?
   The larger this differential, the better the value. Investors should be aware however, that the FMV price is only as good as the earnings estimates which underlie the value
2. Is the stock price sitting on strong structural support?
   The best stocks are those found on one of the four major zone breakpoints. If this breakpoint also happens to be at the low end of its historic valuation history, then a real bargain may be available! Note that in addition to major zone breakpoints, minor breakpoints also exist.
3. Is the balance sheet of the company efficiently structured?
   Those companies with Stability Ratios lying on the efficient zone tend to attract the largest market price per dollar of earnings. Other companies may be attractive purchase candidates if they are particularly profitable. Smaller changes in earnings have a larger impact on the potential for price appreciation for efficient companies.

If the answer to all three questions is yes, the investor should have confidence buying a stock. Keep in mind that none of these questions alone is enough to make an investment decision. Even when all three conditions appear favourable, a stock may still decline, possibly falling through a valuation support level. This triggers an immediate ‘sell’ signal, preventing the investor from being hurt by a sudden change in the outlook for the company.

Selling a Stock

When looking to sell a stock, there are two things the investor must keep an eye on:

1. Is the FMV Price equal to or less than the current price?
   When the FMV potential runs out, then the stock price of that company has become expensive. On occasion, firms do sell above their Fair Market Value, as the market may be looking much further into the future. While this longer, forward looking effect may drive the price higher, the downside risk of the stock is ever-widening.
2. Is the stock price up against structural resistance?
   Firms with no, or poor, FMV potential are unlikely to make Positive Zone Transitions, and consequently look towards Negative Inflections and price declines. Any Stock which makes a Negative Zone Transition offers significant downside risk. Such events, even with good apparent FMV potential, are warning of failing corporate fundamentals and often appear before bad news becomes public knowledge.

Upside & Downside Potential Tables

	BL	LC	LM	N	HM	HC	G	MG	SG	LSG	MSG	BB
BL		16%	39%	70%	107%	147%	241%	326%	488%	662%	834%	1159%
LC	-14%		20%	46%	78%	112%	193%	266%	405%	555%	702%	981%
LM	-28%	-16%		22%	49%	77%	144%	206%	322%	447%	570%	804%
N	-41%	-32%	-18%		22%	45%	100%	151%	246%	348%	449%	641%
HM	-52%	-44%	-33%	-18%		19%	64%	106%	184%	268%	351%	507%
HC	-59%	-53%	-44%	-31%	-16%		38%	73%	138%	209%	279%	410%
G	-71%	-66%	-59%	-50%	-39%	-28%		25%	73%	124%	174%	270%
MG	-77%	-73%	-67%	-60%	-51%	-42%	-20%		38%	79%	119%	196%
SG	-83%	-80%	-76%	-71%	-65%	-58%	-42%	-28%		30%	59%	114%
LSG	-87%	-85%	-82%	-78%	-73%	-68%	-55%	-44%	-23%		23%	65%
MSG	-89%	-88%	-85%	-82%	-78%	-74%	-64%	-54%	-37%	-18%		35%
BB	-92%	-91%	-89%	-87%	-84%	-80%	-73%	-66%	-53%	-39%	-26%