The problem for a beginning or intermediate skilled investor is in learning how to properly arrive at intrinsic value. Analyzing and valuing businesses is an exceedingly tough task, if it could be boiled down to a mathematical equation or model it would have been done so a long time ago and used by quants to rule the markets and out perform.
Instead simple common sense and basic math are all that are truly needed, along with an inquisitive mind and flexibility. We know empirically that out performance is inherently linked to pricing. Money is made at the time of purchase, in the price paid for the asset, and the lower the price paid the higher the potential rate of return.
There are a myriad of studies that demonstrate that the lower the price to earnings, price to sales, and price to book, the higher the rate of return is for a security. It really is that simple. Unfortunately what is not simple is an understanding of what those ratios will be in the future, and there is where the art of investing begins.
The future cash flows from a business are not necessarily predicted by its past earnings history. Looking at a business and getting a true feel for the industry, life cycle, growth potential, competition, and capital structure is sometimes a bewildering exercise. Quite frankly, average business acumen and common sense are in fact all that is needed. Gauging what to pay for a business though is hard. A lesson from Bill Miller and Warren Buffet is that there are some businesses that are worth paying a premium to own.
For example a business with rapidly growing earnings and revenues should merit a premium over a business with static revenue growth. In other words the value of a growing stream of earnings is greater than the value of a slow or no growth earnings stream. The price paid for the business is still critical, but the appropriate price to pay is certainly affected by the growth rate. The same concept of a premium can be applied to a myriad of other factors also in determining a businesses intrinsic value.
Valuation must be used within a framework of understanding the underlying business and its future prospects. What looks cheap solely on valuation metrics may well not be a bargain. Out performance is achieved by investing in businesses trading below their intrinsic value based on a thorough understanding of how to properly value that business. There in lies the art of investing and successful out performance.