The practice of Value Investing, any investing for that matter, calls for valuing a business. The concept of Margin of Safety for instance, talks of buying a security when there is a significant gap between the price of a security and its intrinsic value.
The question is how do you define value? What are the different methods available to value a business. What are the pros and cons of each method? Which should be the method of choice?
Chapter 8 of the book 'Margin of Safety' written by Seth Klarman talks of Business Valuation. The reported valuation numbers
like book value, earnings and cashflow are best guesses of accountants.
Also value is not static. It changes over time with different
macro-economic factors. The business value cannot be precisely
estimated, but the apparent precision offered by mathematical formulae
like NPV and IRR can lull investors forgetting that these are based on
assumptions of cash flow far into the future.The other assumptions in
valuation could be regarding future, different intended uses of the
asset and different discount rates used.
Three
valuation methods that author finds useful are Net Present Value (NPV) -
valuing the cashflows of a going concern, and its offshoot Private
Market Value, the value paid by a sophisticated buyer of the business,
Liquidation value - the expected proceeds if the company were to be sold
off, an offshoot of which is Breakup value that values each components
of the business separately and Stock Market Value - the estimated price
at which a company will sell in stock market.
These valuation methods are illustrated in the diagram below.
Two
aspects of valuation are Expected Growth in earnings and Discount Rate.
If future cashflow is predictable, NPV can be very accurate. However
cashflow depends on many factors like market share, the volume growth,
pricing power, brand loyalty etc, each of which can be assumptions.
Growth investors face many challenges One, they show higher confidence
in their ability to predict future value than is warranted. Two, even
small differences from one's estimate can have catastrophic
consequences. Three, since many investors are focused on such companies,
the prices may go up lowering the margin of safety. Four, investors
tend to oversimplify growth into a single number, while it is based on
many factors. Just as an example, earnings growth can come from more
units being sold due to increase in population or it may also be due to
increased usage by the existing customers. It could also be due to
increased market share or due to price increases. While some of these
are predictable, others are less so.
Investors by
nature are overly optimistic of the future. Since future is
unpredictable, value investors have to be conservative in their
assumptions of growth as well as discount rates.
The
other factor in valuation is the discount rate. The more conservative
you are, the higher rate you will use to discount future cash flows. The
discount rate should depend on Investor's preference of present
consumption over future returns, his risk profile, the risk of
investment under consideration and on the returns available from other
comparative investments. However, investors often simplify and use 10%
as discount rate.
When interest rates are low, investors pay high multiples assuming rates to remain low.
Once
future cash flows are forecast conservatively and an appropriate
discount rate is chosen, present value can be calculated. In theory,
investors might assign different probabilities to numerous cash flow
scenarios, then calculate the expected value of an investment,
multiplying the probability of each scenario by its respective present
value and then summing these numbers.
Given many valuation methodologies, which one should an investor choose? The answer to this question depends on
the nature of the company the investor is evaluating. NPV may be a good approach to value a company with stable
cash flows, liquidation method may be used to value a company selling
well below its book value, a mutual fund may be valued at stock market
price. Sometimes you may used different methods for different units of a
conglomerate. Ideally multiple methods should be applied and the lowest
value chosen.
A wild card in valuation is the theory
of reflexivity propounded by George Soros. It says that stock prices can
influence the valuation, rather than the other way round. For example,
an under-capitalized bank, trading at high multiple can raise cheap
capital in the market based on its price multiple. On the other hand if
the stock was trading at low multiples, it would not have been able to
raise funds leading to bankruptcy. In this case, the stock multiple
acted as the valuation cue for the bank. It could be true for a highly
leveraged company with impending redemption. Good market perception can
help it raise funds to honor the redemption. Sometimes managers accept
the market value as a signal of the business value and may issue
additional shares at values lower than market thereby worsening the
situations. A bad market can depress prices lowering the liquidation
value, thus becoming a self fulfilling prophesy.
The
author gives reasons why valuation based on Earnings, Book Value and
Dividend Yield are easily manipulated by crooked management. He suggests
not to trust such valuations.
This is the review of the book 'The Zurich Axioms' written by Max Gunther, who also wrote the book 'How to get lucky'. You can read my review HERE (I have not published the post yet, I will update this link, once I do that). 
