Showing posts with label business valuation. Show all posts
Showing posts with label business valuation. Show all posts

Tuesday 5 March 2024

Is There An Opportunity With Johnson & Johnson's (NYSE:JNJ) 41% Undervaluation?

Comment:   

An example of using 2 stage growth model and discount cash flow method in valuing a company.

The discount cash flow method is based on 2 assumptions:   future cash flows and the applied discount rate.  

It is not an exact science.  One should you conservative assumptions in your valuation.

Charlie Munger mentioned that he had never seen Warren Buffett using the DCF method in his valuation.   There are better and easier ways to value a company.  Often you will know if a company is cheap or very expensive, even without having to do elaborate studies.   (An analogy is you do not need to know the weight to know that this person is overweight or obese or underweight.)  

Keep your valuation simple.  It is better to be approximately right than to be exactly wrong.

The article below shares how to do valuation in detail.

Happy investing.  




Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Johnson & Johnson fair value estimate is US$275

  • Johnson & Johnson is estimated to be 41% undervalued based on current share price of US$162

  • Analyst price target for JNJ is US$174 which is 37% below our fair value estimate

Does the March share price for Johnson & Johnson (NYSE:JNJ) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Johnson & Johnson

What's The Estimated Valuation?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF ($, Millions)

US$22.8b

US$23.9b

US$24.5b

US$25.0b

US$26.4b

US$27.2b

US$28.0b

US$28.7b

US$29.4b

US$30.2b

Growth Rate Estimate Source

Analyst x5

Analyst x6

Analyst x5

Analyst x3

Analyst x3

Est @ 2.99%

Est @ 2.78%

Est @ 2.63%

Est @ 2.53%

Est @ 2.46%

Present Value ($, Millions) Discounted @ 6.0%

US$21.5k

US$21.3k

US$20.6k

US$19.9k

US$19.8k

US$19.2k

US$18.6k

US$18.1k

US$17.5k

US$16.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$193b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.0%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$30b× (1 + 2.3%) ÷ (6.0%– 2.3%) = US$838b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$838b÷ ( 1 + 6.0%)10= US$469b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$663b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$162, the company appears quite good value at a 41% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Johnson & Johnson as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 6.0%, which is based on a levered beta of 0.800. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Johnson & Johnson

Strength

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings declined over the past year.

  • Dividend is low compared to the top 25% of dividend payers in the Pharmaceuticals market.

Opportunity

  • Annual earnings are forecast to grow for the next 3 years.

  • Good value based on P/E ratio and estimated fair value.

Threat

  • Annual earnings are forecast to grow slower than the American market.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Johnson & Johnson, there are three pertinent aspects you should consider:

  1. Risks: Every company has them, and we've spotted 1 warning sign for Johnson & Johnson you should know about.

  2. Future Earnings: How does JNJ's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

  3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.



 editorial-team@simplywallst.com (Simply Wall St)

https://uk.finance.yahoo.com/news/opportunity-johnson-johnsons-nyse-jnj-110049724.html

Friday 24 November 2023

HOW TO VALUE A COMPANY: 6 METHODS

 

1. Book Value

2. Discounted Cash Flows

3. Market Capitalization

4. Enterprise Value

5. EBITDA

6. Present Value of a Growing Perpetuity Formula


Additional notes:

Value of a Growing Perpetuity = Cash Flow / (Cost of Capital - Growth Rate)

In finance, growth is powerful.


https://online.hbs.edu/blog/post/how-to-value-a-company

Thursday 11 May 2023

Warren Buffett: How to Easily Value almost Any Business







Valuing a business and applying a margin of safety

How to get better and better at doing this.

1.20  
Ben Graham taught him about a certain types of businesses.
Charlie taught him about durable competitive advantage and first class businesses.
Over time, he learned more about other types of businesses.
Not important to know every businesses.
Important to know where your circle of competence is.
You don't have to be an expert on 90% of the businesses but you do have to know the ones that you put your money into, and that is a very small part of the universe.

2.30
Think about the businesses you would pay in your own hometown.
Which would you like to buy into, which do you understand their economics, which do you think will be around in the next 10 or 20 years from now, which do you think will be very tough to compete with.
Just keep asking yourself questions about businesses, talk about this with other people about them, and you will extend your knowledge over time.
Always remember that margin of safety and I think you basically have the right attitude because you recognise your own limitations and that is enormously important in this business you will find things to do.

3.17
6 to 7 years ago, Buffett invested into Korean stocks.  He invested into 20 stocks which he felt had margin of safety.  Why 20 stocks?  Because he cannot anticipate which counter might be problematic (due to crooked managers or due to competition).  They were so cheap and this form of investing was based on Ben Graham approach.

4.00
If you wish to be good at something, you have to think about it a lot and learn a lot and practice doing it a lot, and in this field you have to keep learning because the world keep changing and your competitors keep learning.   Try to wake up each morning a bit wiser than when you went to bed the night before.  When you keep doing that for a long time, and accumulate experience (good and bad), as you try and master what you are trying to do; people who do that never fail utterly.  They may have a bad period when luck goes against them or something, but very few people have ever failed with that. If you have the right temperament, you may rise slowly but you are sure to rise.

5.15
Charlie, did you take any business course in school?   No, I took some accounting.  A gentleman in Omaha Club seemed so prosperous and Charlie wondered how he achieved this.  Well this man enjoys practically no competition in his business.  He gathers up and renders dead horses.  That was avoiding competition by one strategem..  By asking such questions from a young age, you eventually learn the same thing.   A lot of businesses gone broke, a lot of businesses sold out under distress, and some of the people who rose from small beginnings which nobody thought of as the great glories of that early time and that is the kind of the way life is.  It is hard to get anywhere near the top and it is hard to hold any position once you have attained it.  But I think it was likely to predict that this man is likely to win because he cared more about doing it right, they cared more about avoiding trouble, they are more discipline on themselves.  I was automatically doing it, what was working, what was failing, why was it failing, and if you have that temperament, you are gradually going to learn and if you don't have the temperament, I cannot help you.

8.20
It is avoiding the dumb things.  You don't really have to be brilliant.

9.10
Charlie was incapable of looking at a business without thinking the economic fundamentals of it.


10.00  
What businesses have the best return on capital on earth?

Capital necessary to run the business versus the capital we might have to pay for the business.

If you run the Coca Cola company excluding the bottling business, you can run it without any capital.  On the other hand, when you buy it for $100 million. you can look at this as the base capital.

When we define what is a good business, we look at the capital actually needed in the business and 
 whether it is a good investment or not depends on how much we pay for it in the end.
There are a number of businesses that operate on negative capital.  Any of the great magazines operate with negative capital (eg. Fortune).  Subscribers pay in advance, and there is no fixed assets and the receivables are not that much and the inventories are nothing.   There are many great businesses that operate needing very little capital, eg. Apple.  The best ones are those who can get very large while needing no capital.  See's Candy requires very little capital.  Generally, the great consumer businesses need relatively very little capital.  The businesses where the people pay you in advance, eg. magazines, insurance,  you are using your customers capital.  Of course, many other people like them too, so this can become very competitive and buying them.    Many of the service types businesses and consumer businesses require very little capital; and when they get to be successful, they really can be something.

13.18
Charlie:  The formula never changes.    If you were to own only one business in the world, what would it be?  If you name some businesses with incredible pricing power, you are talking about businesses that is a monopoly or a near monopoly.  

Thursday 29 December 2022

Three useful yardsticks of business value

 Business Valuation 

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.  NPV

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. 

[Using multiples.  A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses 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 considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value. 


Conclusions:

Each of these methods of valuation has strengths and weaknesses. 

None of them provides 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.

Wednesday 28 December 2022

The Art of Business Valuation. BUSINESS VALUE IS IMPRECISIVELY KNOWABLE.

 



BUSINESS VALUE IS IMPRECISIVELY KNOWABLE

Many investors insist on affixing exact values to their investments, seeking precision in an imprecise world, but business value cannot be precisely determined

Reported book value, earnings, and cash flow are, after all, only the best guesses of accountants who follow a fairly strict set of standards and practices designed more to achieve conformity than to reflect economic value. 

Projected results are less precise still. 

You cannot appraise the value of your home to the nearest thousand dollars. Why would it be any easier to place a value on vast and complex businesses?



BUSINESS VALUE CHANGES OVER TIME.  REQUIRES CONTINUOUS REASSESSMENTS.

Not only is business value imprecisely knowable, it also changes over time, fluctuating with numerous macroeconomic, microeconomic, and market-related factors. So while investors at any given time cannot determine business value with precision, they must nevertheless almost continuously reassess their estimates of value in order to incorporate all known factors that could influence their appraisal.

Any attempt to value businesses with precision will yield values that are precisely inaccurate. The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones. 

Anyone with a simple, handheld calculator can perform net present value (NPV) and internal rate of return (IRR) calculations. 
  • The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present. 
  • IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.


NPV AND IRR ARE ONLY AS ACCURATE AS THE CASH FLOW ASSUMPTIONS USED

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really only as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful 
analysis, even for the most haphazard of efforts. Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions. 
“Garbage in, garbage out” is an apt description of the process. 

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows. 

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, 
  • IRR provides the precise rate of return to the investor while 
  • NPV describes the value of the investment at a given discount rate. 

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due. 

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.

Sunday 29 August 2021

How are we going to figure out value? How can anyone? Do we have the answer yet?

Valuing a company you are investing into.


For simplicity, we will assume that the business in question will earn $10,000 each year for the next thirty-plus years.

Intuitively, we know that collecting $10,000 each year for the next thirty years is not the same as receiving all $300,000 today.  


Present value 
=  Annual Cash Flow / Discount rate
= $10,000 / 0.06 
= $166,667

(In reality, we should look for how much cash we receive from the business over its lifetime.  For the purposes in this post, we will assume that earnings are a good approximation for cash received.)

So, earning $10,000 a year for the next thirty-plus years turns out to be worth about $166,667 today.   




In practice, predicting so far into the future is pretty hard to do.  
You will probably pay less for those estimated earnings than if they were guaranteed.
How much less?  

That's not exactly clear, but we would certainly discount that hoped-for $10,000 by more than the 6% we used when the $10,000 was guaranteed - maybe we'd use a discount of 8% or 10% or 12%, or even more. (the amount of our discount would reflect in part how confident we were in our earnings estimate).  



Value of the Company

At 6% discount rate
$10,000 /0.06 = $166,667

At 8% discount rate
$10,000 / 0.08 = $125,000

At 12% discount rate
$10,000 / 0.12 = $ 83,333

As it turns out, using a 12% discount rate, the value of the company is only $83,000.  

What is crystal clear, however, is that using different discount rates for our estimated earnings can lead to wildly different results when we try to value a business.




Figuring out the right discount rate isn't our only problem, we also have to estimate earnings


Many businesses grow their earnings over time, while others due to competition, a bad product, or a poor business plan, see their earnings shrink or even disappear over the years.  

Let us see how funny the math gets when we try to value a business using not only different estimates for discount rates but we throw on top of that some different guesses for future earnings growth rates!

Value of the Business

At 4% growth rate, 8% discount rate
$10,000 / (0.08 - 0.04) = $250,000

At 4% growth rate, 12% discount rate
$10,000 / (0.12 - 0.04) = $125,000

At 6% growth rate, 8% discount rate
$10,000 / (0.08 - 0.06) = $500,000.

Annual Cash Flow / (Discount Rate - Growth Rate) = Present Value

According to finance theory and logic, the value of a business should equal the sum of all of the earnings that we expect to collect from that business over its lifetime (discounted back to a value in today's dollars based upon how long it will take us to collect those earnings and how risky we believe our estimates of future earnings to be).  


Will earnings grow at 2%, 4%, 6% or not at all?  Is the right discount rate 8%, 105, 12%, or some other number?   

The math says that small changes in estimated growth rates or discount rates or both can end up making huge differences in what value we come up with!


At 2% growth rate, 12% discount rate
$10,000 / (0.12 - 0.02) = $100,000

At 5% growth rate, 8% discount rate
$10,000 / (0.08 - 0.05) = $333,333

Annual Cash Flow / (Discount Rate - Growth Rate) = Present Value



Which numbers are right?

It is incredibly hard to know.  Whose estimates of earnings over the next thirty-plus years should we trust?  What discount rate is the right one to use?

The secret to successful investing is to figure out the value of something and then - pay a lot less.  

How are we going to figure out value?  How can anyone?  Do we have the answer yet?  Hopefully, we have learned some very valuable lessons even if we cannot answer them yet.

Monday 23 August 2021

The secret to successful investing is to figure out the value of something and then pay a lot less!



Valuing a company you are investing into.

For simplicity, we will assume that the business in question will earn $10,000 each year for the next thirty-plus years.

Intuitively, we know that collecting $10,000 each year for the next thirty years is not the same as receiving all $300,000 today.  

Let us analyse and see what thirty-plus years of earning $10,000 per year are really worth to us today, using a discount rate of 6%.

Present value 
=  Annual Cash Flow / Discount rate
= $10,000 / 0.06 
= $166,667

(In reality, we should look for how much cash we receive from the business over its lifetime.  For the purposes in this post, we will assume that earnings are a good approximation for cash received.)

So, earning $10,000 a year for the next thirty-plus years turns out to be worth about $166,667 today.   



We have just figured out something incredibly important.  

A business guaranteed to earn us $10,000 each year for the next thirty-plus years or so, is worth the same as having $166,667 cash in our pocket today!

If we could be guaranteed that all of our assumptions were correct and someone offered to sell us the company for $80,000, should we do it?  If someone offered to give us $166,667 right now in exchange for $80,000, should we do it?  

Given all of our assumptions, the answer is easy:  of course we should do it!  


This is an incredibly important concept.  

If we can really figure out the value of a business, investing becomes very simple!  

The secret to successful investing is to figure out the value of something and then - pay a lot less!  

In fact, it couldn't be simpler:  $166,667 is a lot more than $80,000.


In practice, predicting so far into the future is pretty hard to do.

Are you really going to trust my predictions about what earnings will be over the next thirty years?

But will earnings actually shrink over those years?
Will they grow?
Will the company even be around in another thirty years?

In practice, predicting so far into the future is pretty hard to do.  In addition, many businesses are actually more complicated.

In fact, forget thirty years - it turns out that Wall Street analysts are actually pretty bad at predicting earnings for even the next quarter or the next year.  


You will probably pay less for those estimated earnings than if they were guaranteed.

Since no one rally knows for sure what earnings will be over the next thirty-plus years, whatever we use for estimated earnings during that time is just going to be a guess.   Even if this guess is made by a very smart, informed "expert", it will still be a guess.  

In practice, investors discount the price they will pay for future earnings that are based only on estimates.  

If there is no guarantee that you will actually collect that $10,000 after the first year of owning the business, you will probably pay less for those earnings than if they were guaranteed.  

In the above example, where next year's earnings of $10,000 were guaranteed, we discounted that payment by 6%, reflecting the fact that we had to wait a year to collect our $10,000.  Now, with only an estimated $10,000 coming in at the end of the first year, we will pay less.


How much less?  

That's not exactly clear, but we would certainly discount that hoped-for $10,000 by more than the 6% we used when the $10,000 was guaranteed - maybe we'd use a discount of 8% or 10% or 12%, or even more. (the amount of our discount would reflect in part how confident we were in our earnings estimate).  

But when we apply that higher discount to the next thirty-plus years of earnings estimates, that's when things really start to get silly (yes, it's true, math can be hilarious).

Value of the Company

At 6% discount rate
$10,000 /0.06 = $166,667

At 8% discount rate
$10,000 / 0.08 = $125,000

At 12% discount rate
$10,000 / 0.12 = $ 83,333

As it turns out, using a 12% discount rate, the value of the company is only $83,000.  We are starting to get in trouble!  It is no longer so obvious that a purchase price of $80,000 is such a bargain!


Figuring out the right discount rate isn't our only problem, we also have to estimate earnings

What is crystal clear, however, is that using different discount rates for our estimated earnings can lead to wildly different results when we try to value a business.   But figuring out the right discount rate isn't our only problem.  For simplicity, we have made some other assumptions that don't really hold up in the real world.  

For instance, as you might intuitively guess, most companies don't earn the same amount each year for thirty straight years.  Also, many businesses grow their earnings over time, while others due to competition, a bad product, or a poor business plan, see their earnings shrink or even disappear over the years.  

Let us see how funny the math gets when we try to value a business using not only different estimates for discount rates but we throw on top of that some different guesses for future earnings growth rates!

Value of the Business

At 4% growth rate, 8% discount rate
$10,000 / (0.08 - 0.04) = $250,000

At 4% growth rate, 12% discount rate
$10,000 / (0.12 - 0.04) = $125,000

At 6% growth rate, 8% discount rate
$10,000 / (0.08 - 0.06) = $500,000.

Annual Cash Flow / (Discount Rate - Growth Rate) = Present Value

According to finance theory and logic, the value of a business should equal the sum of all of the earnings that we expect to collect from that business over its lifetime (discounted back to a value in today's dollars based upon how long it will take us to collect those earnings and how risky we believe our estimates of future earnings to be).  


Will earnings grow at 2%, 4%, 6% or not at all?  Is the right discount rate 8%, 105, 12%, or some other number?   

The math says that small changes in estimated growth rates or discount rates or both can end up making huge differences in what value we come up with!


At 2% growth rate, 12% discount rate
$10,000 / (0.12 - 0.02) = $100,000

At 5% growth rate, 8% discount rate
$10,000 / (0.08 - 0.05) = $333,333

Annual Cash Flow / (Discount Rate - Growth Rate) = Present Value



Which numbers are right?

It is incredibly hard to know.  Whose estimates of earnings over the next thirty-plus years should we trust?  What discount rate is the right one to use?

The secret to successful investing is to figure out the value of something and then - pay a lot less.  

How are we going to figure out value?  How can anyone?  Do we have the answer yet?  Hopefully, we have learned some very valuable lessons even if we cannot answer them yet.



Summary:

1.  The secret to successful investing is to figure out the value of something and then pay a lot less!

2.  The value of a business is equal to the sum of all of the earnings we expect to collect from that business over its lifetime (discounted back to a value in today's dollars).  Earnings over the next twenty or thirty years are where most of this value comes from.  Earnings from next quarter or next year represent only a tiny portion of this value.

3.  The calculation of value in #2 above is based on guesses.  Small changes in our guesses about future earnings over the next thirty-plus years will result in wildly different estimates of value for our business.  Small changes in our guesses about the proper rate to discount those earnings back into today's dollars will also result in wildly different estimates of value for our business.  Small changes in both will drive us crazy.

4.  If our estimate of value can change dramatically with even small changes in our guesses about the proper earnings growth rate to use or the proper discount rate, how meaningful can the estimates of value made by "experts" really be?

5.  The answer to #4 above is - "not very."




Additional notes:

These concepts involve a discussion of the time value of money and discounted cash flow.  

In reality, we should look for how much cash we receive from the business over its lifetime.  For the above purposes, we will assume that earnings are a good approximation for cash received.

Saturday 11 January 2020

Business valuation is a complex process yielding imprecise and uncertain results.

1.   Many businesses simply cannot be valued intelligently.
Many businesses are so diverse or difficult to understand that they simply cannot be valued.

Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipline required by value investing.


2.   Wait for the right pitch to swing
Investors must remember that they need not swing at every pitch to do well over time; indeed, selectivity undoubtedly improves an investor's results. 


3.   Stay within your Circle of Competence
For every business that cannot be valued, there are many others that can. 

Investors who confine themselves to what they know, as difficult as that may be, have a considerable advantage over everyone else.

Choosing Among Valuation Methods

How should investors choose among the several valuation methods

When is one clearly preferable to the others? 

When one method yields very different values from the others, which should be trusted?

At times, a particular method may stand out as the most appropriate. 



Valuation Methods

1.   Net Present Value, NPV
Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.

Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.


2.   Liquidation Value
Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  


3.   Stock Market Value
A closed-end fund or other company that owns only marketable securities should be valued by the stock market method; no other makes sense.


4.   Several methods to value a complex business
Often, several valuation methods should be employed simultaneously.  To value a complex entity such as a conglomerate operating several distinct businesses for example,  some portion of the assets might be best valued using one method and the rest with another. 


5.   Several methods to value a single business to obtain a range of values.
Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  In this case, investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reason to do otherwise.  True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.



Wednesday 10 April 2019

The Investment shown by the DCF calculation to be the cheapest is the one that the investor should purchase.

How does Buffett value his companies?

For Buffett, determining a company's value is easy as long as you plug in the right variables: 

  • the stream of cash and 
  • the proper discount rate.

If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company  This is the distinction of his approach.



Critics of Buffett's DCF valuation method.

Despite Buffett's claims, critics argue that estimating future cash flow is tricky, and selecting the proper discount rate can leave room for substantial errors in valuation.

Instead these critics have employed various shorthand methods to identify value:

  • low price-to-earnings ratios, 
  • price-to-book values and 
  • high dividend yields.  

Practitioners have vigorously back tested these ratios and concluded that success can be had by isolating and purchasing companies that possess exactly these financial ratios.




Value investors versus Growth investors

People who consistently purchase companies that exhibit low price-to-earnings, low price-to-book, and high dividend yields are customarily called "value investors."

People who claim to have identified value by selecting companies with above-average growth in earnings are called "growth investors."  Typically, growth companies possess high price-to-earnings ratios and low dividend yields.  These financial traits are the exact opposite of what value investors look for in a company.



Growth and Value investing are joined at the hip.

Investors who seek to purchase value often must choose between the value and growth approach to selecting stocks.

Buffett admits that years ago, he participated in this intellectual tug-of-war.  Today he thinks the debate between these two schools of thought is nonsense.  

Growth and value investing are joined at the hip, says Buffett.

Value is the discounted present value of an investment's future cash flow; growth is simply a calculation used to determine value.




Growth can be add to and also can destroy value.

Growth in sales, earnings, and assets can either add or detract from an investment's value.

Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created.
However, growth for a business earning low returns on capital can be detrimental to shareholders.

For example, the airline business has been a story of incredible growth, but its inability to earn decent returns on capital have left most owners off theses companies in a  poor position.



Which valuation method(s) to use?  Which stock to buy?

All the shorthand methods - high or low price-earnings ratios, price-to-book ratios, and dividend yields, in any number of combinations - fall short, Buffett says, in determining whether "an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investments.............Irrespective of whether a business:

  • grows or doesn't,
  • displays volatility or smoothness in earnings , 
  • or carries a high price or low in relation to its current earnings and book value, 
the investment shown by the discounted -flows-of-cash calculation to be the cheapest is the one that the investor should purchase.





Monday 11 September 2017

Stock Valuation Manifesto Checklist

September 11, 2017 | Vishal Khandelwal  
https://www.safalniveshak.com/stock-valuation-manifesto/



I had released my Investor’s Manifesto couple of years back. Now, here is my fifteen-point stock valuation manifesto that I penned down a few months back though I have been using it as part of my investment process for a few years now.
It is evolving but is something I reflect back on if I ever feel stuck in my stock valuation process. You may modify it to suit your own process and requirements. But this in itself should keep you safe.
Read it. Print it. Face it. Remember it. Practice it.



[Your Name]’s Stock Valuation Manifesto

  1. I must remember that all valuation is biased. I will reach the valuation stage after analyzing a company for a few days or weeks, and by that time I’ll already be in love with my idea. Plus, I wouldn’t want my research effort go waste (commitment and consistency). So, I will start justifying valuation numbers.
  2. I must remember that no valuation is dependable because all valuation is wrong, especially when it is precise (like target price of Rs 1001 or Rs 857). In fact, precision is the last thing I must look at in valuation. It must be an approximate number, though based on facts and analysis.
  3. I must know that any valuation method that goes beyond simple arithmetic can be safely avoided. If I need more than four or five variables or calculations, I must avoid that valuation method.
  4. I must use multiple valuation methods (like DCFDhandho IVexit multiples) and then arrive at a broad range of values. Using just a single number or method to identify whether a stock is cheap or expensive is too much oversimplification. So, while simplicity is a good habit, oversimplifying everything may not be so.
  5. If I am trying to seek help from spreadsheet based valuation models to tell me whether I should buy, hold, sell, or avoid stocks, I am doing it wrong. Valuation is important, but more important is my understanding of the business and the quality of management. Also, valuation – high or low – should scream at me. So, I may use spreadsheets but keep the process and my underlying thoughts simple.
  6. I must remember that value is different from price. And the price can remain above or below value for a long time. In fact, an overvalued (expensive) stock can become more overvalued, and an undervalued (cheap) stock can become more undervalued over time. It seems harsh, but I cannot expect to fight that.
  7. I must not take someone else’s valuation number at face value. Instead, I must make my own judgment. After all, two equally well-informed evaluators might make judgments that are wide apart.
  8. I must know that methods like P/E (price to earnings) or P/B (price to book value) cannot be used to calculate a business’ intrinsic value. These can only tell me how much a business’ earnings or book value are priced at vis-à-vis another related business. These also show me a static picture or temperature of the stock at a point in time, not how the business’ value has emerged over time and where it might go in the future.
  9. I must know that how much ever I understand a business and its future, I will be wrong in my valuation – business, after all, is a motion picture with a lot of thrill and suspense and characters I may not know much about. Only in accepting that I’ll be wrong, I’ll be at peace and more sensible while valuing stuff.
  10. I must remember that good quality businesses often don’t stay at good value for a long time, especially when I don’t already own them. I must prepare in advance to identify such businesses (by maintaining a watchlist) and buy them when I see them priced at or near fair values without bothering whether the value will become fairer (often, they do).
  11. I must remember that good quality businesses sometimes stay priced at or near fair value after I’ve already bought them, and sometimes for an extended period of time. In such times, it’s important for me to remain focused on the underlying business value than the stock price. If the value keeps rising, I must be patient with the price even if I need to wait for a few years (yes, years!).
  12. Knowing that my valuation will be biased and wrong should not lead me to a refusal to value a business at all. Instead, here’s what I may do to increase the probability of getting my valuation reasonably (not perfectly) right –

    • I must stay within my circle of competence and study businesses I understand. I must simply exclude everything that I cannot understand in 30 minutes.
    • I must write down my initial view on the businesswhat I like and not like about it – even before I start my analysis. This should help me in dealing with the “I love this company” bias.
    • I must run my analysis through my investment checklist. I have seen that a checklist saves life…during surgery and in investing.
    • I must, at all cost, avoid analysis paralysis. If I am looking for a lot of reasons to support my argument for the company, I am anyways suffering from the bias mentioned above.
    • I must use the most important concept in value investing – margin of safety, the concept of buying something worth Rs 100 for much less than Rs 100. Without this, any valuation calculation I perform will be useless. In fact, the most important way to accept that I will be wrong in my valuation is by applying a margin of safety.
  13. Ultimately, it’s not how sophisticated I am in my valuation model, but how well I know the business and how well I can assess its competitive advantage. If I wish to be sensible in my investing, I must know that most things cannot be modeled mathematically but has more to do with my own experience in understating businesses.
  14. When it comes to bad businesses, I must know that it is a bad investment however attractive the valuation may seem. I love how Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”
  15. I must get going on valuing good businesses…but when I find that the business is bad, I must exercise my options. Not a call or a put option, but a “No” option.