By far the biggest challenge any investor will have to deal with is understanding a company's valuation. Over the years, analysts have come up with a whole range of different metrics to streamline the process of evaluating businesses.
The simplest ratio often used as a shortcut is the price-earnings ratio. This compares a company's earnings per share to its share price. It is easy to use and easy to understand. That seems to be why the metric is so widely used. But it has its drawbacks. The biggest is the fact that earnings do not provide an accurate depiction of a company's success. These figures can be manipulated and twisted to produce a more favorable picture. The income statement also does not allow any value for non-tangible items, such as brand value.
The price-earnings ratio is not the only metric investors can use to try and work out how much a business could be worth. Other strategies include looking at earnings before interest, tax, depreciation and amortization (Ebitda) figures, the total addressable market (TAM), the price-sales ratio, the discounted cash flow model, and many more.
All of these metrics have their benefits and drawbacks. The question is, which method is the right method? Unfortunately, there is no clear answer to this question, and we also need to consider many other factors that can't be expressed on a balance sheet.
The right way to value a company
Some of the best advice on this topic comes from Warren Buffett (Trades, Portfolio). In 1998, at the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting, he described the art of finding a company's intrinsic value as discovering "the present value of the stream of cash that's going to be generated by any financial asset between now and doomsday."
As he went on to add, "That's easy to say and impossible to figure." The hard part is understanding how much cash the business will generate and being able to predict what this figure will be going forward with a high level of certainty.
This is why Buffett has also stated that one of the main qualities investors must possess when looking at valuation is to understand "not how much they know, but rather how realistically they define what they don't know." One could argue understanding this point is far more important than anything else when it comes to the process of valuation.
Any of the metrics I have outlined above, including the style Buffett prefers, the discount cash flow projection, can be used to work out a company's valuation. However, they all have drawbacks. Understanding how these drawbacks can impact a valuation process will help investors choose the right approach with the knowledge they have.
More often than not, the best way to go about valuation is to use several metrics. This can help overcome the drawbacks of the individual ratios, although it does not overcome the problem of finding the correct data in the first place.
Put another way, the first stage of any valuation process should be for the investor to ask themselves what they know about the company and its sector. If they have a broad understanding of the business and how it makes money, they can then set about working out which metrics to use.
For example, it may not make much sense to value a tech business using book value. However, it could make sense for an industrial business if one believes that the company is undervaluing its assets.
What's more, if one understands a particular tech sector, putting together a model based on future cash flow projections is far more straightforward and will involve much less guesswork.
The valuation process involves much more than just using the right metric or a combination of metrics. It requires in-depth knowledge of a sector or industry and understanding one's personal limitations. Not understanding what you don't know is the easiest way to get caught out of your depth.
