There are an infinite number of ways to value a stock. For example, some investors choose to discount forecast future cash flows to their present value to determine a company's intrinsic value. Meanwhile, other investors may use ratios such as price-earnings or price-to-book to assess whether a firm offers good value for the money.
However, using one method in isolation may lead to an inefficient allocation of capital. Valuing a company may require an investor to take a wide range of factors into account. Indeed, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice chairman Charlie Munger (Trades, Portfolio) discussed this view at the company's 2016 annual shareholder meeting. When asked how he arrives at a valuation figure using discounted cash flow analysis, he stated:
"We don't use numeric formulas that way. We take into account a whole lot of factors. It's a multi-factor thing. And there are tradeoffs between factors. It's just like a bridge hand. You have to think of a lot of different things at once. There's never going to be a formula that will make you rich just by going through some horrible process. If that were true, every mathematical nerd who gets A's in algebra would be rich… Opportunity cost of course is crucial. And of course the risk-free rate is a factor."
A multi-factor approach
In my view, Munger's comments are a useful starting point for value investors. They detail that valuing a company is not a science that can be broken down to a finite number of formulas. Rather, it is an art that requires investor judgment and quantitative assessment to determine the merits of a stock relative to its peers and the wider market.
For example, interest rates can have a significant impact on the appeal of any stock. Lower interest rates may mean that higher stock valuations can be acceptable based on a lower opportunity cost of holding risk-free assets such as government bonds. In addition, a low interest rate such as that in place today could mean that the present values of discounted future cash flows are higher. This may make it easier to justify higher stock prices. Of course, the opposite would be true if interest rates were at high levels.
Furthermore, assessing the quantitative aspects of an investment cannot be broken down into formulas. For instance, assessing the size of a company's economic moat versus sector peers, understanding the strength of its business model and determining management competence can impact on a company's valuation. They cannot be wholly determined using facts and figures.
A structured method
However, I personally feel that Munger may be under-emphasising the importance of having a structured approach to valuing a company. For example, an investment checklist that uses a broad range of ratios, discounted cash flow analysis and other valuation metrics can paint a useful picture as to whether a company is undervalued or overvalued.
Additionally, a structured approach to valuing a company can help to lessen the impact of bias on an investor's decision-making. For instance, investors may naturally find they place higher values on stocks when sentiment is high during a bull market. The opposite may be true in a bear market.
Therefore, using a scientific process to value a stock, while accommodating the influence of quantitative factors, could be a sound compromise. It may lead to a more consistent methodology being used that makes finding undervalued shares a more efficient and reliable process.
Disclosure: The author has no position in any stocks mentioned.
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