Over the past couple of years, it has become increasingly clear how difficult it is to accurately evaluate fast-growing businesses in a rapidly changing economic environment.
Some of the market's highest-flying growth stocks, like Netflix (NFLX, Financial), have seen their valuations surge only to crash back down as growth failed to live up to expectations.
On the other side of the equation, shares in companies like Dillard's (DDS, Financial), which were virtually written-off as failures when the pandemic began, have bounced back. The stock is up tenfold from its post-pandemic low.
The biggest challenge
Valuing a business is by far the most significant challenge any investor will encounter.
In theory, evaluating a business is relatively straightforward.
As Warren Buffett (Trades, Portfolio) said in 1998, a company's intrinsic value can be estimated by calculating "the present value of the stream of cash that's going to be generated by any financial asset between now and doomsday."
However, as the Oracle of Omaha went on to clarif, "that's easy to say and impossible to figure."
Crunching the numbers to compute an estimate of fair value is not the main challenge. The main challenge is trying to estimate a company's potential over the next five, 10 or even 20 years.
There is no shortcut for the process. As Charlie Munger (Trades, Portfolio) explained in 2007:
"There is no one easy method that could be simply mechanically applied by, say, a computer and make anybody who could punch the buttons rich. By definition, this is going to be a game which you play with multiple techniques and multiple models, and a lot of experience is very helpful."
Experience will help investors understand the drawbacks of any evaluation methodology. Experience will also help investors assess how different factors can help influence different outcomes in the valuation process.
There is really no way to work out intrinsic value accurately. This is something we can only really learn from experience.
Understanding how a company's current share price fits in with future expectations is only something one can understand after being involved in a full market cycle.
Another problem investors face when analyzing intrinsic value is that numbers only really tell us so much about an opportunity.
As Buffett said in 1994:
"The numbers in any accounting report mean nothing, per se, as to economic value. They are guidelines to tell you something about how to get at economic value. ... To figure out that answer, you have to understand something about business."
Multiple factors to consider
To truly understand how a company will perform over the next five or 10 years, one has to look at the numbers and the competitive environment, the company's competitive advantages and any future threats and opportunities.
For example, analyzing a company like Netflix at the beginning of the pandemic would have required an analyst to understand how the pandemic would have hit its growth as well as how it would have benefited its growth.
It also would have required an investor to understand if these trends were long-lasting and if the competitive environment would change significantly, drawing consumers away from the service.
This is why Buffett has also said that "what counts for most people in investing is not how much they know, but rather how realistically they define what they don't know."
Understanding what you don't know is just as important as understanding what you do when it comes to company valuation.
I understand that I cannot predict the future. Therefore, whenever I try to value a business, I always try to assess several different scenarios. I also know there are certain sectors I do not understand, so I try to avoid them.
I have only developed this understanding through the process with trial and error. Sadly, there is no shortcut for success.
