Value investors who have relied on traditional valuation methods such as discount cash flow analysis and book value may have been left behind by the bull market over the past decade.
Over the past few years, the market has shown why it is essential to use a wide range of valuation methodologies when calculating intrinsic value. This is the approach Seth Klarman (Trades, Portfolio) recommended in his book, "Margin of Safety," which I recommend reading for all value investors.
Klarman's advice on valuation
Klarman advised using a selection of valuation methods to arrive at an estimate of intrinsic value for a business. These included a discount cash flow analysis, private market value and sum of the parts evaluation.
Individually, these calculations only provide a rough guide of how much a business could be worth. But together, they can be used to provide a range, which generates a healthy margin of safety.
Not only does the combination of factors produce a range and margin of safety, but it is also a sort of dynamic value methodology. The discount cash flow analysis will vary depending on the discount rate used. Lower interest rates will lead to higher valuations. Meanwhile, private market value considers investor sentiment.
For example, over the past few years, the private market value of tech firms has surged. Some investors have argued that this is a temporary factor and have, as a result, been reluctant to pay similar multiples on the public market.
However, business valuation is not a precise science, and there's no "correct" formula to establish how much a business is or isn't worth. If a private market acquirer is willing to pay 15 times Ebitda, for example, that's one way of guessing how much the business is worth.
There are many reasons why an acquirer might be willing to pay more than the public market. Economies of scale, experience in the sector or lower funding costs are all examples. Investors on the outside are always going to find it difficult to factor these issues into the valuation. Still, using the private market value makes it possible to reduce the gap between what we do and do not know.
Covers all bases
Klarman's method for calculating a company's intrinsic value isn't perfect, but it covers all the major bases, which can be extremely helpful for investors. We will never be able to establish all of the factors that may influence a company's valuation.
Benjamin Graham, who was widely considered to be the Godfather of value investing, proclaimed that the best way to get around this issue is to use a margin of safety. Klarman has modernized it by advocating the use of several different approaches to calculate intrinsic value.
This method also helps take into account market sentiment and other factors that may influence valuation. This is important because the market, just like the global economy, changes over time. It is vital to consider these changes and move with the market.
A good example of these trends in action is the shift away from value towards growth over the past decade. Using the traditional definition of value (price-book ratio), value has underperformed growth over the past decade. But one of the critical components of book value, tangible assets, is no longer essential for a company's success. Intangible assets are now far more important.
Disclosure: The author owns no share mentioned.
Read more here:
- Is Price-Book Ratio Still Relevant for Value Investors?
- Buffett Adds to Bank of America: More Deals on the Way?
- Investment Lessons from Jesse Livermore
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