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Instead, I am going to talk about Chapter 8 from the book, entitled “The Art of Business Valuation.” Before jumping in, it is important to understand the goal of valuation. As Graham and Dodd wrote in "Security Analysis," the purpose is not to pinpoint an exact number: “The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate, e.g., to protect a bond or to justify a stock purchase — or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.”
As such, Klarman recommends three methods for deriving an estimate of intrinsic value:
1. Going-concern value through NPV analysis
2. Liquidation value
3. Stock market value
One thing to note: none of the three methods is a sure-fire model, and there is no all-encompassing formula to assess value; as such, a margin of safety is a necessity in any and all investments. As noted by Klarman: “Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.”
Going-concern
The first method (NPV analysis) is known to most investors by a different name: discount cash flow, or DCF. As is frequently noted, DCF suffers from a couple of problems, specifically the need to predict future cash flows and the choice of an appropriate discount rate. Even with the most stable and widely followed companies, predicting future cash flows is still subject to multiple variables.
The example Klarman gives about KO sums it up perfectly: “Will Coca-Cola (KO) sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less dear; factors such as pricing, the sensitivity of demand to changes in price, competitors' actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.”
What is the solution? Rather than throw the baby out with the bathwater, this methodology (or a variation such as a reverse DCF) must be used with conservative figures for both the cash flows and discount rate, and still provide an acceptable margin of safety when all is said and done. As such, value investors are often led away from growth companies (often fueled by optimistic forecasts) and towards the beaten down and unloved value stocks (which are often priced for future struggles regardless of the long term reality).
This exercise should be followed by a group of sensitivity analyses on the base assumptions. As a corollary, any changes that cause a substantial divergence should be looked at closely; in many cases, this may suggest that this methodology should be used with caution in order to avoid being misled.
Liquidation value
Liquidation is a conservative measure where only tangible assets are considered. Generally, liquidation value is a “worst case scenario” view, since most assets are worth significantly more as part of a going concern as opposed to in liquidation (think of the looms from Berkshire Hathaway’s old textile business that cost more to be hauled away at liquidation than they could be sold for).
A favorite measure of liquidation value is net-net working capital, or net working capital minus all liabilities. Another approach is breakup value, a form of liquidation analysis that looks at the value of business components, rather than on an individual asset level.
Obviously, any attempt at liquidation value analysis would require one to study the financial statements. Generally, the inventory account is central to this analysis since it may differ significantly from book value (during a fire sale, for example.
It is important to determine what is sitting in raw materials as opposed to finished goods (raw cotton may be worth close to book, while an out-of-fashion dress may be worth significantly less), and what kind of inventory is being held. The same can be said for plant and equipment, which will be vary in value depending upon whether it has utility in other businesses or if it will be sold for scrap; as always, the appropriate approach is to err on the side of caution. This includes accounting for off balance sheet or contingent liabilities, such as unfunded pension plans or pending lawsuits.
Stock Market value
This methodology is generally most appropriate when no other alternatives are available; a great example is a closed end mutual fund, which may only be appropriately valued by looking at the stock market values of the securities held. Importantly, it should be understood that this isn’t necessarily an estimation of intrinsic value; rather, it is an estimate of what may be expected to be received (the securities “value”) if the pieces were sold today.
Conclusion
Naturally, the valuation methods outlined are not applicable to every business. For example, using liquidation value would be an act in futility for companies like Coca-Cola; for others, an attempt to forecast cash flows as a going concern would be down-right impossible (any guesses for LinkedIn's 2020 FCF?).
As such, the best approach is to use all three to establish a range of values. Once multiple ranges are established, irrational values can be dismissed, while reasonable estimates can be more closely scrutinized. While this conservative approach could potentially lead to errors of omission, that isn’t the worst problem to have.
As always, this will leave a bunch of stocks that fall into two categories: too difficult to understand/contemplate looking forward, and not a sufficient margin of safety.
The solution is to be patient and keep on looking. Investing takes patience and dedication, both of which are easy to disregard (most people do); for the intelligent investor seeking a margin of safety, this is the only methodology for achieving long term success.
About the author:
I'm a value investor, with a focus on patience; I wait for great companies that are suffering from short term issues, and load up when those opportunities become present.
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