- Estimation error…that occurs while converting raw information into forecasts.
- Firm-specific uncertainty…as the firm may do much better or worse than you expected it to perform, resulting in earnings and cash flows to be quite different from your estimates.
- Macro uncertainty…which can be a result of drastic shifts in the macro-economic conditions that can also impact your company.
While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation.
Knowing that your valuation could be wrong (and in most cases, it would be) despite any kind of precision you employ in your calculations, it should not lead you to a refusal to value a business at all.
- Stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
- Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
- Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
- Avoid “analysis paralysis”. If you are looking for a lot of reasons to support your argument for the company, you are anyways suffering from the bias mentioned above.
- Calculate your intrinsic values using simple models, and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
- Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.
Will you be wrong sometimes? Of course, but so will everyone else. Success in investing comes not from being right but from being wrong less often than everyone else.