Common sense tells us that the adage “buy low and sell high” captures investment success. Like anything else we buy, we need a reference point to decide if price is low, high, or somewhere else. That reference point is the valuations of the underlying business or its “intrinsic value.”
When we buy a share of a company’s stock, we acquire a piece of the underlying business the share represents. It represents our ownership and our claim on the firm’s future cash flows. The sum of all the future cash flows is the intrinsic, or essential, value of the business.
Why Bother with Valuations?
Valuations estimate that intrinsic value, and are necessary components of intelligent investing. The intrinsic value provides the reference point to make intelligent decisions, and without it we are guessing, speculating, or gambling—not investing.
Intrinsic value is independent of the random stock price fluctuation on any given day. It answers the investor’s most fundamental question: How much money will be returned to me if I buy a share of the business at this price?Taking Valuations Step by Step
Don’t let the word valuation scare you. It can be as simple or as complicated as we want to make it. Books, including those on valuation, take a lot of work, and money to write, and publish. And, there is the expectation books need to be a certain length. So, simple, and good ideas can get buried in hundreds of pages and examples. We can’t see the forest for the trees.
This post is the first in a series of discussions on valuations, boiling them down to the essential steps using short examples. Over a few posts, we’ll discuss the different choices for valuation, suggest when to use them, and provide the essential steps for each type.
The goal is to get comfortable doing valuations and provide the tools for intelligent investing. With a fundamental understanding in place, we’ll then look at shortcuts that don’t sacrifice the quality of the decision and may save a lot of time.
I’m betting if you follow this series, you’ll be able to do valuation along with the best of them. And in doing so, you will become a better investor. Learning to do your own valuations can both make and save a fortune over the long haul. But it does require your participation, attention, and some basic math skills that we’ll cover. Are you willing to make this important high return investment in yourself so you can become a better investor?
Discounted Cash Flow
For our purposes, the valuation of a stock is the same as valuing the business. Most businesses are valued using a discounted cash flow (DCF) analysis of earnings, cash flow, or dividend payments.
Discounted cash flow is my preferred method because 1) it determines the business intrinsic value in an absolute way, 2) it is vigorous, and 3) it allows different types of businesses to be compared on a more apple-to-apple basis.
Stocks represent our ownership in a company or our equity. Equity is more difficult to value than bonds paying a fixed interest rate, for example, because future equity cash flows are less certain. In these posts, we’ll use three equity cash flows, starting with dividends. Later, we’ll examine free cash flow for valuing equity and for valuing the entire firm.
Valuation is Qualitative and Quantitative
Valuations, although important, are only half the story. We need “good thinking” to make reasonable assumptions that support the valuations. If we can’t make good assumptions, the numbers are meaningless.
Investor, author, philanthropist, and hedge fund manager Whitney Tilson writes, in an Overview of Valuation: “If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard — and it’s ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It’s neither art nor science — it’s roughly equal amounts of both.”
“The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses…”
This is an important point. Valuation can also give us a false sense of precision because of the math and formulas. We need “good thinking” on the assumptions that go into the math and on the qualitative factors. We should strive to be “approximately right” rather than “precisely wrong.”
Advice from the Best
Warren Buffett explained the concept of there being more to investing than “just the numbers” in Berkshire Hathaway’s 1978 Letter to Shareholders:
“We get excited enough to commit a big percentage of…net worth to equities only when we find:
- businesses we can understand,
- with favorable long-term prospects,
- operated by honest and competent people, and
- priced very attractively.
We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.“
Advice Well Taken, Let’s Get Started
Long Brookfield Infrastructure
The Fine Print
Do your own independent research, i.e., due diligence, on any ideas discussed at Value by George. Value by George does not recommend buying or selling any particular security. Only opinions are expressed. Consult a professional for personal advice in order to meet your specialized needs. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.