How do you value a business?

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.