The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.
The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.
Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.
Discounted Cash Flow / Net Present Value
In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.
DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.
Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.
The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.
To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.
However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.
The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.
Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?
A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.
All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."
- Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 121 - 135.
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
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