One area academics seem to confuse significantly is the subject of valuation. Sitting through my finance courses in colleges did little, if anything to help solidify my views on how to value a business. Theoretical models of discounted cash flows, residual income models, and regression analysis seemed to skirt the crucial issue of valuation. That crucial, and yet often-overlooked view of valuation, is exceedingly simple but not necessarily easy to figure out. It is this:
As a potential owner, what am I willing to pay for this business?
This eliminates much of the noise that typically arises in classrooms. The risk-free rates, risk premiums, securities market line, and beta all attempt to use outward-facing metrics to understand individual securities. They all ask what other market participants are paying for securities as opposed to what you, the individual, would pay for them. If you were looking to engage in market arbitrage this would be a different discussion, but alas, the valuation we are pursuing is for that of an owner, not someone looking to buy and sell quickly for a short-term, potentially riskless profit.
To take this fallacy a step further, would the collective opinions of home values from everyone living on a street influence your purchase decision? I sure would hope not. That decision to buy a house is yours and yours alone to make. You can ask what property values are in the area to get relative valuations, but at the end of the day the purchase decision should come down to absolute numbers and qualifying information that influences you. Businesses are not any different.
One quote comes to mind before I proceed into my thoughts on valuation, which is a quote from Warren Buffett:
“It has been helpful to me to have tens of thousands turned out of business schools taught that it didn’t do any good to think.” ~Warren Buffett
his is a powerful comment directed at the academic work on valuation over the past 50-70 years. Unfortunately, this is what most financiers come inundated with when they reach the real world. They may have the tools as provided by highly complex applied statistics and market theory but the intuitive thought behind buying a business is largely absent.
So in attempting to answer the question of what I am willing to pay for the business, I focus on a few key areas.
This gets the most attention from me and encompasses a significant amount of my analysis. I look to returns on capital in a few different forms to drive this from a quantiative and consistent methodology. But additionally, and just as important, I study competitive dynamics, customers, cyclicality, industry trends, and management, to name some major categories. The collective qualitative information I gather, alongside the returns on capital metrics, helps me to place a business into one of a few categories for valuation. The low quality businesses get far less respect than the higher quality ones, as quality significantly influences corporate performance over the long term, and I adjust strictly for it with my valuation model.
This is also highly important to me, as a business growing quickly will become worth far more than one that stagnates over the next 5 or 10 years. But in tying this back to business quality, that growth must come from a productive source. Share issuances, dilutive acquisitions, or other value-destructive means of growing the business should still be avoided. Retained earnings in high return businesses account for additional premiums I will place in my valuation, assuming the growth is sensible and in line with my expectations for the industry in question.
Although there are many ways to divide up the way I approach valuation, these 2 categories take the lion’s share. This is especially the case for business quality, as so much goes into that assessment.
Pulling It All Together
From here, it comes down to asking yourself about what you want from a business. Are you buying it for the assets the business owns? If so, it is likely the business isn’t earning a reasonable return on those assets and you would do best in an orderly liquidation scenario. The majority of us buy businesses for the stream of earnings over time, with the belief being the business is worth more alive than dead.
In assessing earnings, an analyst should look to understand the differences between the cash flows and income statement. There will be major non-cash items deducted that shouldn’t be, or just as important, some cash items that are not deducted which should be. This is more of an art than a science, although repetition a few hundred times helps to cure any struggle that might arise. Ultimately you are trying to come up with the economic value created each year by the enterprise in question.
Once you can come up with 1) an approximation of annual earning power 2) business quality and 3) future expected growth, you are well on your way to sensible and intelligent valuations. And just as you would prefer to walk around inside a house you are looking to purchase, rather than ask the neighbors, so too should you attempt to “walk around” inside the businesses you are looking to buy stock in.