How should investors choose among these several valuation methods?

How should investors choose among these 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.  

• 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.  
• Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  
• A closed-ended fund or other company that owns only marketable securities should be valued by the stock market method, no other makes sense.

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.  

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 reasons 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.

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

The discrepancy between the buyer's and the seller's perceptions of value can result from various factors

Markets exist because of differences of opinion among investors.

• If securities could be valued precisely, there would be many fewer differences of opinion; market prices would fluctuate less frequently, and trading activity would diminish. 
• To fundamentally oriented investors, the value of a security to the buyer must be greater than the price paid, and the value to the seller must be less, or no transaction would take place. 

The discrepancy  between the buyer's and the seller's perceptions of value can result from such factors as

• differences in assumptions regarding the future, 
• different intended uses for the asset, and 
• differences in the discount rates applied. 

Every asset being bought and sold thus has a possible range of values bounded by the value to the buyer and the value to the seller; the actual transaction price will be somewhere in between.


For example:

In early 1991, for example, the junk bonds of Tonka Corporation sold at steep discounts to par value, and the stock sold for a few dollars per share. The company was offered for sale by its investment bankers, and Hasbro, Inc., was evidently willing to pay more for Tonka than any other buyer because of economies that could be achieved in combining the two operations.  Tonka, in effect, provided appreciably higher cash flows
to Hasbro than it would have generated either as a stand-alone business or to most other buyers. There was a sharp difference of opinion between the financial markets and Hasbro regarding the value of Tonka, a disagreement that was resolved with Hasbro's acquisition of the company.

The difficulty of accurate business valuation,

To illustrate the difficulty of accurate business valuation, investors need only consider the wide range of Wall Street estimates that typically are offered whenever a company is put up for sale. 

• In 1989, for example, Campeau Corporation marketed Bloomingdales to prospective buyers; Harcourt Brace Jovanovich, Inc., held an auction of its Sea World subsidiary; and Hilton Hotels, Inc., offered itself for sale. 
• In each case Wall Street's value estimates ranged widely, with the highest estimate as much as twice the lowest figure. 

If expert analysts with extensive information cannot gauge the value of high-profile, well-regarded businesses with more certainty than this, investors should not fool themselves into believing they are capable of greater precision when buying marketable securities based only on limited, publicly available information

The essential point in security analysis is to establish that the value is adequate

Businesses, unlike debt instruments, do not have contractual cash flows.  As a result, they cannot be as precisely valued as bonds.  

Benjamin Graham knew how hard it is to pinpoint the value of businesses and thus of equity securities that represent fractional ownership of those businesses.  In Security Analysis he and Dodd discussed the concept of a range of value.

'The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security.  It needs only to establish that the value is adequate - e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price.  For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.'

Indeed, Graham frequently performed a calculation known as net working capital per share, a back-of-the-envelope estimate of a company's liquidation value. His use of this rough approximation was a tacit  admission that he was often unable to ascertain a company's value more precisely.

Business value cannot be precisely determined: Be approximately right than be precisely wrong

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?

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 it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

NPV and IRR - place more importance to the Assumptions than to the Output. "Garbage in, garbage out"

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 wi th a simple, hand-held calculator can perform net present va lue (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.

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really 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.

Net Present Value and Internal Rate of Return Summarize the Returns for a Given Series of Cash Flows

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.

The short-term and long-term perspectives on an investment can diverge.

In a rising market, many people feel wealthy in the short run due to unrealized capital gains, but they are likely to be worse off over the long run than if security prices had remained lower and the returns to incremental investment higher.

Ways to Limit Opportunity Cost - Most Important is holding Part of your Portfolio in Cash

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.  

• Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. 

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.  Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.  Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

• Equity investments in ongoing businesses typically throw off only minimal cash through payment of dividends.  
• The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.  
• Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.

Another way to limit opportunity cost is through hedging. 

• A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline. 
• If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities .