You want to buy a stake in a business. It can be traded on a stock exchange or privately owned. What’s the first thing you attempt to do?
You try to figure out a way to make sure you pay at least a fair price for what you buy. You want to avoid overpaying, but certainly don’t mind finding a good bargain.
How do you figure out what a business may be worth in order to deduce if the price is the right one?
There are two major categories of valuation methods – absolute and relative.
Absolute valuation methods aim to reveal the intrinsic value of an asset or a business without comparing it with others. The two most popular absolute valuation methods are the discounted cash flow and the net asset value.
The advantage of absolute valuation methods is that you can get a “pure” value of what the business or asset may be worth.
This is a number that (hopefully) reflects its intrinsic value which, when compared with the price that is being asked, allows you to judge if you are paying a premium, a discount or the actual intrinsic value.
I said “hopefully” above because the disadvantage of this approach lies in the assumptions that underline the calculations, especially for discounted cash flow. Of particular importance here is the discount rate that you use – the lower the rate used the higher the intrinsic value will be and vice versa.
What informs what rate you use is a wide range of factors, such as central bank interest rates, growth rate of earnings or dividends and your own intuition.
Relative valuation methods, such as the wide range of price-to-X metrics, where X can be net earnings, operating cash flow, free cash flow, book value and so on, enable investors to gauge how much they are paying for an asset or a business relative to others in the market.
The advantage of this approach is that you can have a feel of how much investors are willing to pay for other businesses or assets.
But this can also be the disadvantage: you need to make sure you are comparing apples with apples. This can be harder than it looks due to differences in accounting laws and guidelines and industry classifications.
Both of these methodologies will yield you numerical data, which is quantitative in nature – you can perform a range of statistical analysis on it to further extract relevant insights that can help you decide on the right price.
For now, I want to highlight a few non-quantitative factors that are crucial in understanding if the price you are about to pay is the right one.
Different business models require different approaches
Working for a boutique fund house, I learnt earlier on that each portfolio holding is different, even if it operates in the same industry as other investee companies.
In particular, they differ in their business model.
You should be aware of what the product or service is, how it is being produced, how and where it is being sold – the entire chain or production and distribution maps out the business model.
Dending on the business model, the valuation methods you will use will differ. For example, you value a well-established bank very differently than you value an early-stage biotechnology company or a tire manufacturer.
Here are some questions that can help guide you to figure out the chain of production and distribution:
- What is the core product offering and what other alternative products does the business offer?
- What are the revenue channels, markets and geographies?
- How is the business making a profit?
- What are the key resources needed to produce the product or offer the service?
- Who are the main suppliers of these key resources?
- Who are the main distributors of its final product?
- How are other businesses in the same industry or sector making money?
Going through these questions, as well as others that you deem relevant will help you figure out what valuation method to use.
Management matters, a lot
I was in a number of meetings with top management from Provident Financial (a UK sub-prime lender) as its share price cratered in 2017.
My main lessons from these discussions were twofold:
- Good leaders are people who are not only capable of running a business but also have the ability to cut through the noise of what’s going on with the company’s operations, especially if it is a fairly large organisation.
- Asking difficult questions, even if they may be uncomfortable is critical to get to the bottom of how management thinks about the business now and in the future.
For readers that are not working as analysists in asset managers or investment banks, this can be a daunting, if not impossible, task: not everyone has access to C-level management.
However, there is a way around it. It’s not perfect, but it gives you a lot more colour about the quality and ideas of those that manage the company than if you just read annual or quarterly reports and newspaper articles.
There are actually two ways around this barrier: earning calls and commentary written by current investors, either pro or against of investing in the business.
It is extra effort but in the long-term it pays off.
Stay out of politics but don’t ignore them
Political decisions obviously matter to what the economy and the financial markets do. As such, they matter to the value of the business you are trying to evaluate.
However, while it is important to stay on top of key political developments, such as proposed laws that may impact the industries in which the company in question operates, it is important to be impartial.
Taking sides in political debates can lead you to miss on opportunities or to make erroneous assumptions. Reality is often different than what we can see. This means that we rarely have all the necessary information to make categorical decisions based on swings in political moods. Stay flexible.
Navigate whatever political environment you find yourself in, without being caught by the storm.
Quantitative valuation methods are important when trying to decide if the price you are paying for a business or asset is a fair one. However, there are a number of qualitative factors that you should consider.
Remember that valuation is akin to a puzzle: the more pieces you have, the clearer the picture becomes. Nevertheless, it will never be completely visible, and that’s why patience is important; only with time you can develop the intuition to take a risk and buy or sell something.