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Robert Stephens, CFA
Robert Stephens, CFA
Articles (386) 

Charlie Munger on Valuing Stocks

Focusing on business fundamentals may help you to find undervalued stocks

July 29, 2020 | About:

It is never easy to accurately value a stock. However, in my view, determining how much a company is worth is even more challenging than usual at the moment due to an uncertain economic outlook and high valuations.

Therefore, it may be worth following Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) vice-chairman Charlie Munger (Trades, Portfolio)’s advice when seeking to value stocks. His ability to focus on the risks facing companies, as well as his use of an investment checklist, could be key reasons for Berkshire’s outperformance of the S&P 500 over recent decades.

Business fundamentals versus formulas

There is an increasingly large amount of data widely available on every publicly listed company. Therefore, it is tempting for investors to focus on complicated formulas when seeking to value a specific firm.

However, complex formulas may not tell the true story as to how much a business is worth. A large part of valuing a company is subjective. For instance, determining the strength of customer loyalty enjoyed by a specific company to estimate the size of its economic moat cannot be entirely represented through facts and figures. Likewise, assessing the dominance of a business over its peers requires an understanding of how an industry works, rather than just market share figures and other data.

Therefore, analyzing a company’s business model and considering how it can adjust to changing consumer trends may be a better idea than relying on complicated formulas. As Munger once said, “People calculate too much and think too little.”

Focusing on risks

The S&P 500’s 40%+ rise in little over four months has caused some investors to become more interested in potential returns than risk. Even though the economy faces a highly uncertain outlook, they are becoming increasingly bullish about the outlooks for some stocks – particularly those with a technology focus.

However, focusing on a company’s risks is crucial in determining its valuation. For instance, a firm may have the potential to deliver high returns due to a unique product. However, if it has a weak balance sheet then its valuation must reflect this.

It can be difficult to consider the opposite view of your own when analyzing any business. However, undertaking the process of listening to other standpoints on a stock can help you to identify potential weaknesses that may allow you to place a more accurate valuation on the company in question.

As Munger once said, “You must force yourself to consider opposing arguments. Especially when they challenge your best-loved ideas.”

A step-by-step process

It can be difficult to consider all relevant aspects of a business before adding it to your portfolio. For example, you may overlook a part of a company that is important when determining its valuation, or simply forget to factor in specific details that increase or decrease its intrinsic value in your opinion.

A simple means of ensuring that you consider all the important aspects about a business when valuing it is to use a checklist. It introduces a structure within your investment strategy that may reduce the chances of you failing to consider all potential catalysts and risks that could impact on a firm’s value.

An investment checklist may also provide a robust means of comparing two different companies to determine which one offers the best value for money. Scoring two businesses based on a range of factors may make the process of deciding how to apportion your capital much simpler and easier.

Charlie Munger (Trades, Portfolio) is known to use an investment checklist when choosing which stocks to buy. As he once said, “No wise pilot, no matter how great his talent and experience, fails to use a checklist.”

Disclosure: The author has no position in any stocks mentioned.

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