Value Investing should always begin with one thing: accurate valuation. But, the question for all investors is: “How do I accurately value a business?”
Business valuation is a complex beast for value investors. Ultimately, you’re trying to find undervalued stocks that will be worth a long-term investment. But the question isn’t so much “How to find undervalued stocks?” as it is “How to value a business?”. You can’t know the first without the latter. I’ll explain with a simple quote from everyone’s favourite value investor:
“Price is what you pay. Value is what you get.” – Warren Buffett
Value Investing 101: How to Value a Business
There are numerous methods on how to value a business, but I can’t say that there’s a single right way. However, there are many wrong ways. True valuation is a combined effort of different formulas and methodologies that reveal what you want to know about the business. In that way, it’s got an element of being a personal endeavour, because you have to decide how you will value businesses for yourself.
As a good rule, before you get into anything else, you can perform some Fundamental Analysis on the fair value (or intrinsic value) of a company’s stocks. You can do this by using metrics like price-to-earnings, debt-to-equity, price-to-book, return-on-equity, and many more.
But then you’ll want to dig a little deeper and balance this with some other valuation methodologies. You could use two or three, or all, of the different valuations that we’ve set out below.
As a base, you can begin by looking at what physical assets the company owns. This value is easy to determine and marks a foundation for your process going forward, as you know that the value of the company shouldn’t fall below their combined physical assets’ value.
These are trickier to attach value to. An intellectual property is really worth whatever you think it is. There might be some previous valuation that marks its value at a particular level, but when it comes down to it, intellectual-property’s value lies in its potential to provide future value.
Revenue vs. Profit
It’s not all about revenue… because a high revenue with low profit is a worrying investment, but if a company has low revenue with high profit then that’s far safer for an investor.
When you’re looking at revenue vs. profit, it’s about seeing if the company has a balance. The revenue stream shows how fast the company is moving in areas like: customer base size, customer loyalty, historical growth, and more. But, the profit shows how sustainable the company is for the long-term. Profit allows for increased growth and dividend payouts, where revenue does not, which is the key aspect of this relationship.
Discounted Cash Flow
Discounted Cash Flow (DCF) is all about estimating what the future potential cash flow of a company is worth today. Why would you do this? Because a company’s value doesn’t always rely on its current figures and stock value, it goes beyond that and must speak into its future potential earnings. It answers these two questions:
- How much profit is the company expected to make?
- How reliable is this estimate?
You’ll need to estimate the amount of profit that the company will make in the foreseeable future, and then work out what that profit is worth to you today. In starting this valuation process, it’s important to ask the following question: “How stable (predictable) is the company’s current cash flow?” This is important, as the more predictable it currently is, the greater its future potential is (meaning you can value the business on more years of future cash flow).
You can read the formula to calculate discounted cash flow here.
Comparable value is valuing a business against its competitors. If you’re onto this valuation method, you probably already know what the company in question does. But, if you don’t, then find out. A piece of advice from Warren Buffett is to not invest in anything that you don’t understand, which is simply food for thought when entering this valuation method.
Comparable value is determined by a variety of ways. The primary determiner, though, is seeing what competitor companies have sold for or been valued at. You can usually quite easily find this information out, as it’s generally made public. Another aspect of this method is to leverage the market that competitors have captured against the company in question’s value – will the competitors raise or drop value for your company?
The only real problem with the comparable value method is that, without really understanding what your selected company does, it can often lead to comparing apples to oranges… which is where Buffett's advice would be wise to follow.
If you’d like an easy valuation tool to help you along your way, book a free demo with STRIDE’s CEO, or download our Practical Guide to Value Investing: Starting Your Portfolio below.