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Seth Klarman's 3-Step Approach to Valuation

Seth Klarman (Trades, Portfolio) is widely considered to be one of the best value investors alive today. He has achieved annualized returns of around 20% per annum for investors at his hedge fund Baupost since inception by concentrating on finding undervalued securities, wherever in the world they may be hidden.

The value investor approaches evaluation using three different methods. Rather than relying on one single valuation metric or process, such as the discount cash flow analysis, he uses a three-pronged approach. Specifically, when approaching valuation, Klarman calculates a company's:

  1. Net present value.
  2. Liquidation value.
  3. Sum-of-the-parts stock analysis.



A multi-layered approach

Each of these methods has its own benefits and drawbacks. As a result, the value investor believes that they must be used together to give a rough range of a company's underlying intrinsic value.

Klarman has said it is foolish to seek precision in an imprecise world, especially when it comes to determining the underlying value of a business, which cannot be precisely determined (no matter how many Wall Street analysts think it can be).

Net present value

The first stage of the evaluation process is to work out the net present value of a business. Some analysts often refer to this as the private market value, and there can be many routes to arriving at a final value. However, Klarman suggests the best method to use is a discount cash flow analysis discounting all future cash flows that the business is expected to generate.

This is a fairly standard method of valuation, but Klarman, who is always aware of the unknown and uncertainty that comes with investing in the financial markets, cautions that investors face an irresolvable contradiction when trying to perform present value analysis.

He once noted that to perform present value analysis, "You must predict the future, yet the future is not reliably predictable."

With this being the case, Klarman recommended using highly conservative numbers and discount rates to arrive at an estimate of net present value. He also advocated using a range of different values to determine a range of intrinsic values and then layering these values over the intrinsic value estimates achieved using the other two methods.

Liquidation value

The first of these two methods is liquidation analysis. Using liquidation analysis gives you some idea of how much the company might be worth if it was liquidated, which isn't particularly accurate. Investors, for example, must pay particular attention to operating losses, which deplete working capital and off-balance-sheet liabilities, the value of which can be difficult to assess accurately.

Nonetheless, this process gives you some idea how much the business might be worth in the worst-case scenario. Values should be adjusted to appropriately reflect that in any worst-case scenario, assets would be sold at fire-sale prices, which may reduce the overall liquidation value of the business.

The third and final method Klarman likes to use is a sum-of-the-parts analysis. Baupost's chief investment officer warned that this method, much like the other two, isn't a particularly accurate way of arriving at intrinsic value. However, he said that it is a good "yardstick" to support the two other methods. During this process, he would value the business on a sum-of-the-parts basis using either private market or public market value.

The margin of safety

One of the reasons Klarman has been able to achieve such fantastic returns for his investors over the years is that he never takes anything for granted. Further, he always looks for a wide margin of safety when buying investments.

This three-pronged valuation process is designed to indicate underlying intrinsic value without placing too much weight on any particular figure or estimate. If he cannot figure out an input into any of the building blocks of the valuation process, the idea is disregarded. It is all about knowing what you own and making sure it is cheap enough when you buy.

Disclosure: The author owns no share mentioned.

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This article first appeared on GuruFocus.