What is value? Value as defined by the dictionary is “the regard that something is held to deserve; the importance, worth, or usefulness of something.” They key words in this definition for the purposes in this article is “the worth of something.” Value investing focuses on the worth of a business.
Valuation is the process of determining value or worth of something. For most materialistic items in our daily lifes worth is determined for us. When we go to the grocery store the price of the product we want to buy is listed on the product. The store is telling us that in order to buy this product it is worth this amount of money if you want to own it today. For an item like a loaf of bread or a case of water these prices are determined by what the item’s manufacturing costs are and if they can sell it for a profit based on what the competition is selling thier competing product for.
For determining value of investments like real estate or a business there are appraissers or analysts that spend their days factoring value for others. Ultimately, much like the loaf of bread and case of water, an investment’s final value will always be determined by what a willing buyer and a willing seller will transfer ownership of the investment on the open market. Most buyers won’t pay much more for a house when the exact same house down the street sold for less. The same holds for investing in stocks, since the purchase of a stock is the purchase of a piece of a business knowing what that business is worth is very important.
The tricky part of valuing a business, unlike most other asset classes, is there are multiple methods that can be used to ascertain value. Methods that are based on tangible asset value, historical growth value, pay back value, income value, dividend returns, and discounted cash flow value are a few examples of some methods used in factoring a business’s value. As stated above until you know what something is worth you can’t know where to start to determine what you should pay for it.
When I value a business for which I am looking to invest in I normally use two and sometimes more than two valuation methods to check my research. Only using one method in my opinion doesn’t always paint the fullest picture, since a business that is growing fast verses a business that is consistent will attract different types of buyers using different methods. The same goes for businesses that have a lot of physical or hard assets verses a business that relies on intellectual property as it’s product will require different methods to determine value.
Remember, ultimate worth, irrespective of what value method you use will be determined by what a willing buyer will pay for that investment. If there is fear in the economy or market then the amount that a buyer will pay is going to drop, because there will be less buyers willing to take a risk at that time. This is why using historical knowledge of that asset’s market coupled with an understanding of how to figure its value is so important. If you are armed with these skills it makes it much easier to capitalize on good oportunities. This is when you can invest in a business at a discount due to factors that aren’t relevant to the investment’s worth. This provides a downside margin of safety, but more importantly provides the confidence to make the purchase. The most important test of knowing you have good valuation skills is when and investment you have purchased drops lower than your entry point, and you have the confidence in your analysis to purchase more of that investment.
One last point, when I was learning valuation methods the biggest question I found myself asking is how would I know if my ending valuation calculation was right or a good number. The answer to this question came when I would match up my valuation numbers to what the current price of the company’s stock I was researching was trading for on the open market. When your numbers for current value start lining up with what the Market currently is pricing a stock at as its valuation in normal times it is affirmation that you are on the right track for determining value. The market gets it wrong once in a while, but generally there are a lot of very smart people out there buying or owning the stock you are looking at, so if you can match up with them in none volatile times it generally means you are doing something right. Once you get to this point, then you can search for special situations where value is misunderstood or wait for an event that drives the market’s prices down and your target business gets taken down with the market out of non-sense and then you capitalize on it.