Placing a value on a business is one of the most challenging tasks investors have to complete.
There are so many ways to establish a business's value, and even if you've decided on one method, it is best practice to calculate a range of possible outcomes to take into account the uncertainties of business valuation. The range acts as a margin of safety for investors. This is a simplification of the process. There's a limitless number of criteria that go into intrinsic value calculations, both quantitative and qualitative.
Charlie Munger's thoughts on valuation
It's easy to teach quantitative analysis and business valuation methods. Unfortunately, it's not so easy to teach qualitative methods. These can be taught, but learning from experience is often the best way. That's why many of the best investors tend to be business owners as well. It's easy to understand the qualities that make a good business when you have managed one and the drawbacks and pitfalls a company may encounter.
This is just one of the advantages Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have when it comes to investing. They've both been business managers as well as investors. Munger ran several of his own businesses before he started managing money. Meanwhile, Buffett had to run businesses as part of his investment campaigns against undervalued enterprises.
The importance of understanding other factors apart from a company's financial situation cannot be understated. It has been a part of Munger and Buffett's investment style since the beginning.
Decades ago, Munger was called to testify in court when a small Los Angeles legal publication sued the Daily Journal Corporation DJCO for unfair trade practices. To prove his insight into how businesses worked, the investor was asked about his record of buying and selling companies.
"Would you give the jury a little bit of a feel for what's involved in analyzing a company before an acquisition is made?" Munger was asked. He responded:
"You start with the accounting figures. But that is just the start. If you try and make judgments just based on accounting figures, you will make one terrible error after another. We've got to understand the accounting and the implications of the accounting and understand it thoroughly and also ask a lot of intelligent questions to enable us to judge what is really going on."
Munger was asked if this analysis included "an assessment of the direction of the general business climate," to which he responded:
"Yes. We do some of that. But more, we like the quality of the individual business. If we admire management enough, and we admire the way a company is run enough, we will occasionally buy one that's in kind of a lousy industry."
This is Munger saying that he and Buffett spend time analyzing a company's financial situation and the quality of management, and the industry the company operates within. In fact, the quote seems to suggest Munger and Buffett placed far less weight on the financials than the people.
This is something many investors can overlook. Investing is not just about buying a stock because it trades at a low price-earnings ratio or some other multiple. That multiple is worthless if the business is run by someone who does not care about the business or shareholders. The same is true of a high valuation.
Valuations and financials do matter, but they don't matter as much as the quality of management and employees. A bad business run well can be a good investment. Meanwhile, a good business run badly can be a bad investment.
Berkshire Hathaway BRK.A BRK.B is a classic example. Under the former management of Seabury Stanton, the firm wasted shareholder funds as management could not see that the textiles business was doomed. When Buffett arrived, he decided to deploy the firm's capital into other businesses. A good manager was able to turn the struggling textile business into one of the world's largest conglomerates.
Disclosure: The author owns no share mentioned.
Read more here:
- 3 Benjamin Graham Style Net Net Stocks
- The History of Charlie Munger and the Daily Journal
- GameStop: We've Been Here Before
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