value of a business

The essence

The crux of the matter when it comes to investing is valuation. Unfortunately, value is often mistaken to be price, and vice versa. Just as investing itself is often confused with speculation. Understanding the difference is far too important for an investor. 

Speculation, especially calculated speculation, is not bad as long as one knows that one is speculating, not investing. Similarly, estimating the price is fine for an investor or speculator as long as he knows that he is chasing price, not value. 

The value

Let's come to value. The value of any cash flow generating asset is the present value of its cash flows over its life. Obviously you need to discount these cash flows at an appropriate rate to bring them to the present value. Thus, estimating value poses twin challenges: estimating cash flows and using the right discount rate. 

The value of a business is, accordingly, the present value of the cash flows it is going to generate over its life. If the life is considered finite, cash flows are estimated over that period. However, often, a business has infinite life. Consequently, cash flows have to be estimated over perpetuity. 

The cash flows

When this is the case, the cash flows period is split into more than one. First is to estimate when the business will reach the stable growth. It can be in 5, 10 or any other number of years. The period until stable growth is the growth period. Then cash flows are estimated during the growth period using an appropriate growth rate over this period. Lastly cash flows are estimated during the stable growth period considering the fact that business has become mature. The behavior of the business is different during the growth and the stable growth periods. Naturally, you expect decisions regarding investing, financing and dividends to be different too. The key to estimating cash flows then is to understand the behavior of the firm under different conditions. That is to know that revenues, margins, reinvestment and return on capital change as the firm's characteristics change. As the behavior of the firms changes, their value changes.

The discount rate

It is the easiest when cash flows are almost a certainty.  In this case, you just use the risk-free rate to bring them to the present value. Heck, cash flows are never certain. Using the right discount rate then becomes more challenging. 

The garbage in

It appears quite clear that once you input cash flows and discount rate, out comes the value. This is easily manipulated if the analyst is exposed to bias arising either due to his own emotions, or market-driven conditions. Therefore, it is imperative that caution is exercised before estimating cash flows and discount rate.

What is not value

Every other method used to calculate the so-called value is actually not value. That may appear surprising to many since value is used so much loosely in context by too many on too many occasions.

The most popular method used is the multiples-based method. Here, multiples such as price-earnings, price-book, price-sales, or enterprise value based multiples are used to estimate value. In reality, however, what the analyst is doing is to estimate the price, not value. Fundamentally, he is assuming that markets are overall correct all the time, but on individual stocks they are often wrong. Therefore, under-priced and over-priced stocks are selected for transaction purposes. Income-based valuation is nothing but a pricing method.

Asset-based methods use either book values which is nonsense, or market values which is again pricing. 

Liquidation value method is a valuation method if based on cash flows, discounted when required, or is a pricing method if you turn to the markets for clue.

Then there is option-pricing model used to value an asset, especially out-of-the-money, as an option. When estimating cash flows as they are is not easy, estimating inputs used for option-pricing seems rather too uncomfortable. The only way I see it is that since the downside risk is fixed, an option gives just that, an option to buy or sell, which should be used with caution. Let's not get attracted to the fancy stuff; let's concentrate on how comfortable we are with the cash flows, although they are probable.

The explicit

It is quite clear that the only way you can value an asset is based on the discounted cash flows. Every other method is useless if you are trying to estimate value. Pricing is fine if you know that you are trying to price for the short term. Prices change too quickly while value does not. Therefore, a prudent long term investor would want to value the stock rather than price it. 

It is amazing that so many professional analysts get it wrong. They seem to know nothing about the difference between value and price, or they seem to ignore it. The result is that their reports use models to estimate price, which is unfortunate because these reports are pitched to the potential buyers.

Now, if the buyers are unaware of the difference, they will fall prey to the pricing pitches, and will be exposed to lose money.

Get it right

You will be alright if you know what you are doing, and more importantly, if you know what you are not doing. Understanding the limitations and constraints is the key. Behave right!