In theory, valuing a business is a relatively straightforward process. All you need to know is the growth rate for the foreseeable future and the discount rate. You can then work up a cash flow analysis to estimate the intrinsic value of the enterprise.
However, in practice, business valuation is a very hit-and-miss process, as all of the above metrics are speculative and subject to change at a moment's notice.
Estimating long-term growth
For a start, trying to determine a company's long-term growth rate is almost impossible to do with any degree of accuracy.
The best way to get around this problem, according to Warren Buffett (Trades, Portfolio), is to stick with companies that you know and understand well. Companies that have a definite competitive advantage or a strong brand are particularly attractive.
These tend to have predictable growth rates, and while they are unlikely to see growth spike by 20% or 30% in a year, sales are also unlikely to fall significantly.
Growth should also be estimated with a conservative slant. There's no point in predicting base-case growth of 5% a year for a consumer goods company when inflation has averaged 2% for the past 20 years. In the very base case, sales would grow in line with inflation. Therefore, a conservative growth rate of 2% might be more appropriate.
Estimating the discount rate comes with its own set of problems. Buffett has offered some advice on this topic as well. At the 1993 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, Buffett said the following (comments are taken from the June Outstanding Investor Digest issue):
"And once you've estimated future cash inflows and outflows, what interest rate do you use to discount that number back to arrive at a present value? My own feeling is that the long-term government rate is probably the most appropriate figure for most assets. And when Charlie and I felt subjectively that interest rates were on the low side – we'd probably be less inclined to be willing to sign up for that long-term government rate. We might add a point or two just generally. But the logic would drive you to use the long-term government rate. If you do that, there is no difference in economic reality between a stock and a bond. The difference is that the bond may tell you what the future cash flows are going to be in the future – whereas with a stock, you have to estimate it. That's a harder job, but it's potentially a much more rewarding job. Logically, if you leave out psychic income,that should be the way you evaluate a farm, an apartment house or whatever. And in a general way, Charlie and I do that."
The margin of safety
At the core of Buffett's thinking on both the discount rate and growth rate is the margin of safety principle. Investors do not know what the future holds. It is impossible to predict future growth rates and discount rates accurately. As a result, we should err on the side of caution. That way, the risk of coming up with a projection that overstates a company's potential is significantly reduced.
It is sensible to keep this advice in mind in uncertain times. We don't know what the future holds for the stock market and global economy. However, we can reduce the risk of making a mistake by sticking with what we know and using conservative growth rates as well as discount rates when assessing new potential investments.
The economy and market will recover from the current shock at some point. The best way to profit is to stick with what you know and avoid unnecessary risks, as we never know if there's another shock on the horizon.
Disclosure: The author owns shares in Berkshire Hathway.
Read more here:
- Seth Klarman on Rational Thinking in Times of Market Stress
- Seth Klarman: The Risk of Buying Too Early
- Hunker Down, but Be Prepared
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