Common sense tells us that the adage “buy low and sell high” should lead to 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 for investing is the valuation 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 that the share represents. It represents ownership and our claim on the firm’s future cash flows. The sum of all these future cash flows is the intrinsic, or essential, value of the business.
Why Bother with Valuations?
The valuation is an estimate of the intrinsic value, and it is a necessary components of intelligent investing. The intrinsic value provides the reference point needed to make intelligent decisions. Without it we are guessing, speculating, or gambling—not investing.
Valuation the Key to Buy Low and Sell High
Price is what you pay and value is what you get. Intrinsic value is based on the ongoing earnings power, among other things, of the business and is independent of the random stock price fluctuation on any given day. A valuation of a business 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 concern 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 of explanations and examples. These are provided with good intention but at some point we can’t see the forest for the trees.
This is the first in a series of discussions on valuations, with the objective of boiling them down to the essential steps and short examples. Over time we’ll discuss the different choices for valuation, suggest when to use them, and provide the essential steps for each method of valuation.
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 because that is what the stock certificate represents, our piece of 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. 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: “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. Valuations 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 analysis because the assumptions or qualitative factors ultimately determine the math. We need to strive to be “approximately right” rather than “precisely wrong.”
Advice from the Best
Warren Buffett explained how there is 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.“
And, the only way we know it is priced attractively is if we know what it is worth. Advice well taken.
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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.