Valuing equities is never going to be a straightforward process. There will always be different processes and methods investors and analysts use to arrive at intrinsic value.
The process used will differ from analyst to analyst. Some analysts might prefer one method of valuation, such as a discounted cash flow analysis, while others might prefer a sum-of-the-parts calculation.
According to Seth Klarman (Trades, Portfolio), to arrive at the best and most reliable outcome, investors and analysts should use a range of methods to arrive at a range of intrinsic values.
A process to reduce risk
This might seem counterintuitive. How can you calculate a company's intrinsic value using lots of different methods? Inevitably, this process would lead to a confusing outcome.
One of the best explanations I've seen, which details why this approach works best, was on Greg Speicher's blog:
"Klarman has said that he frequently sells too early. I suspect that this due not only to his aversion to speculating, but also because of his understanding of intrinsic value. Klarman, like Graham before him, sees intrinsic value not as a specific precise number, but as a range of values. Therefore, it makes sense to sell as the stock price move up into the lower end of this range of values. Otherwise, the higher the price goes, the more you become dependent on the 'greater fool' to bail you out."
As the quote explains, this approach of having a range of values does have one major drawback. It can lead you to sell the position too early. But this is also a bit of a safety valve. I am willing to bet that most investors would rather sell too soon, rather than too late, and risk losing all of their accrued gains.
However, this drawback could also be interpreted as a significant benefit as it helps reinforce the margin of safety principle into the investment process.
As the quote above explains, it also removes the risk of becoming dependent on "the greater fool," or someone who knows less about the business but is willing to pay significantly more.
Using a selection of different methodologies to arrive at a range of intrinsic values is something I've been thinking a lot about recently. With uncertainty building in the global economy, it is becoming more and more critical for investors to consider all eventualities when picking stocks.
We need to consider not just current rates of growth and current interest rates, but what may happen over the next 12 months.
With analysts becoming more concerned about the risk of inflation due to the massive amounts of money that have been created by policymakers over the past few months, investors and analysts may also need to consider higher interest rates in their intrinsic value calculations.
Considering the track record of interest rates over the past decade, this seems unlikely. But as 2020 has proven, nothing is ever certain in financial markets, and we need to prepare for all sorts of different market environment going forward.
Experienced investor
Klarman has built and developed his investment strategy over the past three to four decades. During this time, he has experienced some of the most volatile market environments in history. That's why he's so focused on valuation. He will only ever buy stocks when they are deeply undervalued, and there's a wide margin of safety between his most conservative estimate of intrinsic value and the price offered by the market.
This might seem unnecessary in a stock market that only ever goes up (as it has done for the past decade). Still, it is the only way to prepare for every eventuality and every market situation.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Charlie Munger: Always Be Ready for Change
- Charlie Munger: Always Allocate Your Assets Wisely
- Charlie Munger: Always Be Prepared and Think Ahead
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