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Book of Value: 2 Ways to Value a Business

Every second the stock markets are open, there is an ongoing dance between price and value; at least for all equities that enjoy any volume. In times of turmoil, as there was in the third week of March 2020, that relationship took several dramatic twists and turns.

When stock markets plunge, the cost of buying future earnings plunges too. Just as spending "x" dollars for a gallon of gas which will take us "x" miles, we also invest "x" dollars now to buy "x" dollars worth of future income or capital gains. How much should we spend for each dollar of future income and capital gains?


That begs the question, what is the value of that stock? We don't want to invest more in it than we'll get back. More specifically, we want to earn a return on the money we're committing, so we want to buy at a price below its value.

In chapter 12 of "Book of Value: The Fine Art of Investing Wisely," Anurag Sharma explained there are two ways to value a business: market valuation and intrinsic valuation.

Market value might be found by comparing stocks like we compare houses, by comparing houses of similar size and location, etc. and then making adjustments that put the two on an equal footing. For stocks, that usually involves the use of ratios, including price-sales, price-earnings and so on. As the author describes it, this is capitalizing the variables in the denominator to get an idea of how the market is pricing each dollar of sales, earnings, cash flow and so on.

Such valuations are specific to a moment in time. For example, Sharma reported on Walmart (NYSE:WMT) fundamentals in 1999 and 2015, noting that valuations in 2015 were lower than those of 1999, despite the company growing bigger and becoming more profitable. A look at this 25-year chart may show why:

GuruFocus Walmart 25 year price chart

It appears that investors who bought in 1999 would not have broken even (on the share price) for nearly a decade and a half. The average annual return on shares held until 2015 would have been just under 2%, including dividends. Once again, we have an example of poor returns because investors paid too much or did not correctly assess the value of those shares in 1999.

Or perhaps they did their analysis, but did not pick the right ratios or compare their pick with the right companies. Sharma concluded, "The technique of capitalization and comparable metrics requires a good deal of guesswork about which ratios to use and which companies to compare with."

To do this, I would add another point, which is time horizons. In the short term, valuations are essentially meaningless; everything depends on the daily or weekly mood of the market. In the long term, however, price does become related to value to whatever extent.

If I were to invest now, with the markets falling every day, my only short-term strategy might be to short some stocks that I consider vulnerable. But if I were to invest for the long term, for five to 10 years or more, then I would have quite a few choices, including many long tactics. I could buy dividend stocks that have value because their yields have gone up thanks to lower prices. I could also buy stocks that might provide capital gains; they have value because of the new relationship between their value and their current prices.

Speaking of value in the long term, Sharma turned to intrinsic value and discounted cash flow analysis in the second half of this chapter. As the GuruFocus DCF manual explains, "the discounted cash flow valuation model combines the company's balance sheet value, future business earnings and earnings growth." It is a tool for finding intrinsic value.

Or not finding intrinsic value.

At the close of trading on Friday, March 20, Walmart competitor Target (NYSE:TGT) had a fair value price of $67.85 using the default parameters of the GuruFocus DCF calculator. That was significantly below the stock's closing price of $97.40. That resulted in a negative margin of safety, -43.55%, which raises a very large red flag.

GuruFocus uses the phrase "fair value" rather than intrinsic value, but the two are nearly identical in practice. Here, we see Target's fair valuation is not encouraging; it is well below the current price and that's a bad sign for a value investor. Because intrinsic value is less than the current price, the company has a negative margin of safety, i.e., no cushion at all.

Keep in mind this is the result using default parameters. Other investors might have different assumptions or expectations and set the parameters differently, which would lead to different outcomes.

With that refresher on DCF, let's return to Sharma's argument. He noted that DCF will not give you a precise answer to what a business will be worth a decade away (look at all the parameters that can be adjusted, growth over the next 10 years, terminal values), but it will give you a ballpark estimate. Further, it will make investors aware of their assumptions and that, in turn, will lead them to examine the drivers of profitability.

I'd like to wind up by emphasizing a couple of broader points. First, if you are checking DCF results, whether manually or with a calculator, you are doing analysis. Even if you are a newcomer and it's the only tool you use, it's an important transition--from intuition to reason.

Second, if you use DCF, you are forcing yourself to think 10 years ahead, and of the years between now and then. You might not make a particularly accurate guess, but again it is another step forward in making rational investment decisions.

Conclusion

In chapter 12 of "Book of Value: The Fine Art of Investing Wisely," Sharma set out to explain how to value a business, using two methods: market value and intrinsic value.

Both approaches require a significant number of assumptions, assumptions that can increase or decrease the accuracy of our forecasts. The problem is that we cannot know in advance which assumptions are good ones and which are not.

Nevertheless, when we make ourselves aware of our otherwise unconscious decisions and use tools like DCF, we have become rational investors.

Disclaimer: This review is based on "Book of Value: The Fine Art of Investing Wisely" by Anurag Sharma, published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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This article first appeared on GuruFocus.