There is no exact way to value a business. Not only does the value of the business change each day, but it is difficult to identify what management will do next to change the equation.
We can guess if management is going to make an irrational decision, like go on an acquisition spree or buy back shares at high prices.
We just don't know for sure. What we do know is that there is a great chance irrational decisions will be made.
With increasing institutional ownership of American business, there are fewer checks and balances in the compensation structure of management. A family that relies on the success of their sole business for daily bread and butter is much more likely to oversee management than some corporate entity that owns hundreds of companies.
This is the reason whyWarren Buffett (Trades, Portfolio) likes companies that have directors who own a lot of company stock. They tend to care about what management does because it affects their bottom line, so they will have an incentive to be cautious when they need to be and greedy when they can be.
Too often in corporate America today, as Warren Buffett states we have, "so called independent director[s]" wagging their "cocker spaniel" tail at a "$200,000 to $300,000 per year" bone. When these "independent stewards" of the American capitalist system rely on this for their bread and butter instead of the performance of the stock, management accountability reduces in importance.
As this "diworsification" of American business ownership continues, management incompetence will certainly expand. That is the reason why we must be more diligent in investing. We must identify a margin of safety in each and every investment. If we can't, we should just consider it no better than a gamble.
One way to identify a margin of safety is to look at the business as if it was a family business that provided for our basic necessities. Let us begin by studying Brookdale Senior Living, Inc. (BKD, Financial), an operator of senior living communities.
First, we study revenue. Investing in public corporations allows the individual to be a part of an entity larger than oneself. This entity has the ability to provide goods and services for society. The investor should demand this entity be a good steward to society by providing these services to more and more people as the economy demands. Below is a chart of those services being provided to more and more individuals.
Next, we would do a calculation of all the costs involved and subtract that number from revenue to figure out what our earnings would be at the end of the year. A quick way for us to do that is by studying profit margins. An astute investor would look at current profit margins and compare them to the past. They know in some years competition is heavier than others so they normalize for both good and bad times. The best way for us to do this is by plotting a chart of historical profit margins.
For Brookdale Senior Living, one would observe thin margins. The range in operating margin was from a high of 8% to a low of -12% with an average near 3.5%. With both substantial swings in margins in addition to very low numbers, an investor must identify a large margin of safety.
Knowing both revenue and margins, the investor can now create an "owner's yield." This "yield" is a rough calculation of what the investor would receive compared to the price paid. It produces a number that can be compared to its own historical range as well as the risk-free rate. Based on 4% operating margins, one can see the historical range of the "owner's yield" in the chart below.
Another way we can visualize this "owner's yield" is by plotting price compared to revenue. An educated investor will observe the massive swings the market has priced Brookdale's revenue. Witnessed when the price of revenue was lower than the revenue itself, the value investor might consider buying at that level. The correlating high "owner's yield" could provide a large margin of safety.
Thanks to Gurufocus for providing the Brookdale Senior Living Interactive Charts.
