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I was asked this question recently. Valuing a business correctly depends on the state you find the business in, and this will differ for every business. A proper and complete answer to this question will take a book. But I think this is a great opportunity to talk about some of the things that are important in valuing a business correctly.
We will work with first principles. This means that we will figure out what really matters and start from there. Often, we humans have this tendency to think that “sophistication” means “correct”. This is not true.
What is the Real Question You are Asking?
Most of the time, when you wonder how to value a business, the question you are really interested in getting an answer to is, will I will make money on this investment? If yes, then how much?
You have to think as if you are purchasing the entire business. After you consider everything, there are only 2 things that matter:
1. How quickly do you want your investment to be paid back, assuming you will own the company long term?
The longer it takes to get paid back, higher the risk because many unplanned things can happen. In this case, you would look for greater undervaluation or margin of safety (which also correlates to greater expected returns).
Consider the following:
EBITDA of a company could be considered as what you are getting paid if buy the whole business. If you want to get paid back in 2 years, then you would pay less than 2 times EBITDA of the company (and you will ensure the EBITDA will stay constant or increase). Enterprise Value is what you are paying for the company in a private market. So in this example, EV/EBITDA should be < 2. Now private market valuations are quite a bit more strict than public market. In the public markets, if you can get EV/EBITDA < 6 or even 10, it should be acceptable. Your personal requirements will vary. The reason is that once your investment is paid back, everything after that is pure profit to you. The EV/EBITDA was an example. In reality, the things you look for will be different for each company because each company is in a unique situation with its own unique sets of challenges and opportunities. For example, when you find a net-net stock, none of these things are important because you know the company is worth more than what you are paying right in the beginning. You will also consider the time value of money. Quicker and faster is better, longer term paybacks require deeper discounts as the value of money gets eroded. Once you have this figured out, you worry about things such as, is the management good enough to run the company to maximize the value for you in the future.
2. In case you do not wish to own the company long term, your question becomes: How long I want to own the company and what I can sell it for in this period? Is the return acceptable to me?
To figure this out, you will have to consider what other buyers will pay for the company in a few years when you want to sell. That is: How the market will value the company?
How the market values the company is the important question for you to answer at the time of selling, because you are selling into the market. Your opinion of value at that time is only relevant as far as it justifies your decision to sell – beyond that the market does not care what price your receive. You have to take the market price.
To get a good idea of what the market price could be, you will need to estimate the company situation and also use the valuation metrics that the market will use (such as P/E or P/B ratios, or similar).
This assumes you create a general expectation of your possible holding period and the expected return at the time you are purchasing the stock. Most people do not do this. To them I ask this question: if you do not have any idea of how long you want to hold the stock and what you expect to get out of this, why you are even buying the stock?
Very likely the future will not go the way you expect. That is okay. You can adjust your view and expectation over time, if you have formed an initial expectation. If you do not have a reference point, you will have no basis to adjust, and therefore you are very likely to get caught off guard by events and not know how to react.
If you don’t know where you are going, you will end up somewhere else – Yogi Berra
3. Change Your Investment Lens and Approach
Very profound things happen once you figure out your own personal requirements in an investment. You will develop your own personal screens that will say something like “I need to have atleast 30% upside in next 2 years for the investment to be worthwhile” or variously as “I need a 40% margin of safety before I will consider getting into an investment, and then I will only buy if I can identify a catalyst”. There is no right or wrong approach, it is just a matter of developing your own approach to investing.
Once you start looking at each investment with your own set of filters, you will find that you will quickly and decisively eliminate most ideas as not worthy. The ideas that remain, you will go deeper into them and maybe do the valuation calculations if necessary. Most of the times, these calculations will act as a “gut check” to confirm your hypothesis you already have formed – they themselves are not your hypothesis.
What you ask is the key to value investing and the answer is not straightforward. It is part art and part science and part your investment philosophy. The valuation methods don’t matter much in the end, it is more important to approach each investment properly and stick to your discipline. Not everyone who can use a financial calculator and run a Discounted Cash Flow analysis turns out to be an effective value investor if the basic approach is not right.