Placing a value on a business has to be one of the most challenging parts of the investment process. There are many different metrics and methods investors can use to try and assess the intrinsic value of any enterprise. Each of these methods has its own supporters, and there are usually some studies that show how well these methods have performed in the past.
I always view these studies and performance figures with doubt. I learned long ago that any trading strategy would work if the author wants to prove their particular method performs best. They often just tweak the figures until it does.
What's more, the best investors don't rely on just one metric or data point for an investment strategy. For example, Seth Klarman (Trades, Portfolio) uses several valuation methods at the same time to produce a range of outcomes.
A case study in valuation
In his book, "The Margin of Safety," Klarman presented a valuation case study for readers, which explains his investment process in detail.
The company in question was a spin-off called Esco Electronics, a defense business that separated from its parent Emerson Electric Company in Oct. 1990. According to the book, Esco was spun off at around $5 per share and quickly fell to $3.
So, what was Esco really worth? The first step in valuing the business in Oct. 1990 was to try and understand earnings and cash flow. In the preceding two years, the company had taken significant and non-recurring charges. However, these charges were set to end, and the company's prospects looked brighter over the next decade than they did the previous. Here's what Klarman had to say:
"What was Esco worth if it never did better than its current depressed level of results? Cash flow would equal forty-five cents per share for five years and ninety cents thereafter when the guaranty payments to Emerson had ceased. The present value of these cash flows is $5.87 and $4.70 per share, calculated at 12% and 15% discount rates, respectively, which themselves reflect considerable uncertainty...What if Esco managed to increase its free cash flow by just $2.2 million a year, or twenty cents per share, for the next ten years, after which it leveled off? The present value of these flows at 12% and 15% discount rates is $14.76 and $10.83, respectively."
That gave a prospective range of $4.70 per share to $14.76. This was "Clearly a wide range but in either case well above the $3 stock price and in no case making highly optimistic assumptions."
The value investor also presented some other evaluation methods. The private market value was not particularly helpful, he wrote, because there had been so few recent transactions involving sizable defense companies. However, based on historical transactions, a valuation of $15 per share was presented.
Another option, liquidation analysis, was also not "particularly applicable" because defense companies cannot easily be liquidated. Nevertheless, Klarman concluded that the company would not be worth less than its net-net working capital value of $15 per share if broken up and sold.
Stock market value was another useful yardstick. At $3 per share, Klarman noted, the stock was selling for just 12% of tangible book value. "However, most comparable firms were trading at between 60% and 100% of book value and had historically traded considerably above that," Klarman pointed out.
Based on all of the above, Klarman made the following conclusion:
"It is difficult, if not impossible, to determine precisely what Esco stock was worth. It is far simpler to determine that it was worth considerably more than the market price. With the shares selling for $3, yet having $25 per share of tangible book value and little debt, investors' margin of safety was high.
Esco appeared to be worth easily twice its $3 market price, a level that was only six times adjusted earnings, 40% of net-net working capital, and less than 25% of tangible book value. Was it worth $10 per share? Probably, either on the basis of NPV using mildly optimistic
assumptions or on a gradual liquidation basis."
The stock rose to $8 a year later, presumably netting Klarman and his investors a healthy profit.
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman: Investors Should Not Rely on Book Value, EPS or Yield
- Seth Klarman's Advice on Portfolio Management
- Ben Graham on Market Fluctuations
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