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Wednesday, May 10, 2017

Valuable Valuation Methods

Valuable Valuation Methods

Some think the market, being efficient, will tell you the exact value of a business, but history has shown that in the short term it often happens that the market values businesses extremely irrationally, either on the upside or on the downside. Knowing how to properly value a business gives an investor the perfect investing edge as it allows them to disregard what the market thinks and turn that into their own advantage by exploiting market mispricings.
Let’s see what business valuation its all about.
Business Valuation Is An Art, Not A Science
There are many beautiful mathematical models that show future cash flows, then discount those cash flows to a present value and estimate a return on investment. However, the problem is that the assumptions included in such valuation models constantly change. Therefore, it’s practically impossible to have a static number as a precise valuation figure.
Klarman suggests that we should never aim for precision in our valuation efforts, but merely for accuracy. As much as mathematical models seem precise, more often than not, a back of a napkin calculation is worth more than hundreds of spreadsheets of data.
A simple example of how difficult it is to value a company comes from the fact that Wall Street analysts, who have all the data available, always give a wide range of estimates. The current Wall Street estimates for Apple (NASDAQ: AAPL) range from $85 to $185 per share, while the actual price is $143.

Figure 1: Target price values have extreme ranges – AAPL, MSFT, GOOG, AMZN. Source: Nasdaq.
The differences in opinion on what the value is of a company is staggering. However, without differences in opinion, there wouldn’t be a need for financial markets as a trade occurs when an asset is more valuable than the paid price to the buyer and less valuable than the received price to the seller. Now, to outperform the market, one must buy when the seller is wrong, thus, buy at a discount, which again leads to the art of business valuation.
Three Useful Methods For Business Valuation 
The three methods finds useful are:

-Net Present Value (NPV) Analysis,
-Liquidation Value,
-and Stock Market Value. 
Net Present Value Analysis
The net present value is the discounted value of all future cash flows a business is expected to generate. The difficult part comes from estimating future cash flows and determining a discount rate. Predicting the future is impossible, so it boils down to accurate guessing. We suggests the only way to create a valuable net present value analysis is to be conservative in estimating future cash flows. The opposite of conservative is to be an optimist.. The best example I can think of is Tesla (NASDAQ: TSLA).
An optimist would assume all projects—solar panels, energy storage batteries, and electric vehicles—will work out fine and take over the respective industry. In such a scenario, TSLA’s revenue would easily be in the hundreds of billions and TSLA would become the new Apple (NASDAQ: AAPL). Such a perspective clearly justifies the current market valuation of over $50 billion.
On the other hand, a conservative estimation would look at TSLA’s debt and estimate what would happen if a recession slows down vehicle sales and the solar systems don’t reach profitability. In this scenario, TSLA would probably go bankrupt which leads us to the second valuation method recommended by Klarman.
Liquidation Value
The liquidation value of a business is one where we look at the net value of the tangible assets remaining after all the debt is repaid. For conservative reasons, we doesn’t include the value of intangible assets in his methodology. The philosophy behind this methodology is that when a company is trading close to or below its liquidation value, it often makes a good investment. However, the liquidation value depends on whether it’s a fire sale or the business is slowly winding down operations and perhaps even just selling business units separately. In addition, the sale value of assets might depend on whether or not the inventory is a commodity or a specialized product.
Applying the liquidation value methodology on the current market seems like an old-fashioned strategy because the market is extremely overvalued. The S&P 500 has a price to book value ratio of 3.1 which means that you can expect less than a third of what you are paying now for the stock if the assets held were sold at liquidation values. The 3.1 ratio doesn’t even exclude intangible assets.

Figure 2: The price to book ratio of the S&P 500 increased from 1.85 in 2011 to the current 3.1. Source: Multpl.
The liquidation value is the only real value related to investing as it translates all asset values and cash flows to cash and settles the debate on what the correct price of a stock is once and for all with a cash amount.
Stock Market Value
It might be surprising. However, this is only in specific cases where a unit of a business is valued by comparing it to similar businesses traded on the stock market or for the valuation of an investment company.
The more conservative you are in your estimations of cash flows, the lower your net present values will be and therefore, the more difficult it will be to find a bargain. However, your investing risk will also be much lower as by buying stocks at a discount, you lower your risks and increase your returns.
This shouldn’t only be an essential check to perform for the value investor before investing as such a low risk high reward approach would benefit all kinds of investors, from traders to growth investors.

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