Some Thoughts on the Complex Process of Valuation
When investing in individual companies, one of the easiest mistakes to make is overpaying for a business. Overpaying for a stock can significantly alter the returns you achieve.
It is even possible to overpay for the market's best businesses. Just because a company has the best profit margins in a particular sector does not mean that it is worth an infinite amount.
In recent years, Warren Buffett (Trades, Portfolio) has admitted on several occasions that he has paid too much for individual companies, Kraft Heinz (NASDAQ:KHC) likely being the most notable example.
The fact that even the greatest investor of all time makes this mistake shows that it is impossible to avoid. However, it is possible to reduce your chances of overpaying for a business. One of the most straightforward ways to do this is to go through the process of finding your own valuation for the enterprise.
It's all about valuation
There are countless examples of hedge fund managers that have bought into companies thinking they are worth more than they really are. Many investors fail in this process because they rely on one or more previously established metrics to determine value.
To use a personal example, during the first few years of my investment career, I thought book value was the most accurate way to value a business. I didn't spend any time whatsoever looking at profits or cash flow. Clearly, I had spent too much time studying Benjamin Graham's investment process and was looking for a shortcut. This proved to be a colossal mistake. Luckily I saw sense (but only after some significant losses).
I would like to believe my investment style has changed for the better since then. Today I no longer rely on one metric, although I still use book value as a reference in some cases.
Over time, my strategy for valuing companies has come to be largely based on advice that Seth Klarman (Trades, Portfolio) issued several years ago.
Klarman's advice
The legendary value investor once claimed that the best way to value businesses is to use a range of three different valuation methods. He advocated using a discounted cash flow analysis, a sum of the parts analysis and a private market value analysis to come up with an estimate of intrinsic value.
The logic behind this strategy is simple, based on the fact that there is no correct answer to the question of how much a company is worth. It is worth more to some investors and less to others. If the company was broken up, for example, it might be worth significantly less than if it were sold as one to a private equity buyer. On the other hand, the stock market might place a higher value on a business based on its projected cash flow growth. The only way to reflect all of these scenarios in a value calculation is to reference all of them, and that's just what Klarman aims to do.
Using this approach also helps build a margin of safety into the equation. If you buy at a discount to all of these projected values, whatever outcome the company eventually faces, you should have a cushion in place.
To add an additional layer of protection, using different scenarios to arrive at an ultimate value of one of the three main components of intrinsic value could be sensible. For example, in using a discounted cash flow analysis, I find it helpful to assume different growth rates and then use these to compute a weighted average projection based on probabilities of certain scenarios unfolding.
This might not be as straightforward as using pre-established metrics, but investing is not supposed to be easy. The best way to reduce risk is to conduct thorough due diligence.
Disclosure: The author owns no share mentioned.
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This article first appeared on GuruFocus.
