Saturday, 18 February 2012

Analyzing Investment Opportunity Begins with an assessment of Business Value

To be a value investor, you must buy at a discount from underlying value.

Analyzing each potential value investment opportunity therefore begins with an assessment of business value.

While a great many methods of business valuation exist, there are only three that I find useful.

1.  Net Present Value
The first is an analysis of going-concern value, known as net present value (NPV) analysis.  NPV is the discounted value of all future cash flows that a business is expected to generate.  A frequently used but flawed short cut method of valuing a going concern is known as private-market value.  This is an investor's assessment of the price that a sophisticated business person would be willing to pay for a business.  Investors using this shortcut, in effect, value business using the multiples paid when comparable businesses were previously bought and sold in their entirety.

2.  Liquidation value.
The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off.  Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.

3.  Stock market value.
The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries consider separately, would trade in the stock market.  Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses.

  • None of them provide accurate values all the time.
  • Unfortunately no better methods of valuation exist.  
Investors have no choice but to consider the values generated by each of them, when they appreciably diverge, investors should generally err on the side of conservatism.

Ref:  Margin of Safety by Seth Klarman

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