How to Value a Company

Legend has it that a company's fair valuation is a universal measure of value. It is, therefore, a necessary and sufficient condition to invest in the company. Like any generalization, this one is valid, but only in some instances.

Similarly, with efficient markets - markets swing between degrees of inefficiency and efficiency but are never absolutely efficient or inefficient. So, it is with the fair valuation of a company. It only works where markets are largely inefficient. Such markets are private equity (PE) and venture capital (VC).

These publicly traded stock markets are widely accessible, and every market participant can obtain (to a large extent) the same information. Global markets are more efficient than inefficient. This is especially true for large-cap US stocks. On the other hand, PE and VC markets have a limited number of participants with highly asymmetric information distribution. These markets are more inefficient than efficient.

(In)efficient markets and fair value

The less efficient the markets, the more useful the fair value estimate; conversely, the more efficient the markets, the more useless the fair value estimate is.

Market efficiency is determined by the number of market participants, their access to information, and the speed of information dissemination. Market efficiency is correlated with these three variables.

The US stock markets are a case in point - millions of market participants with instant access to (almost) the same information in terms of quality and quantity. The US equity markets are getting closer to the definition of efficient markets. The reflexivity cycle duration (price-fundamentals-narrative) is getting shorter and shorter, i.e., the availability of an information edge is shrinking.

The latter means that all market participants consume the same information, which does not deliver an advantage. Our advantage lies not in access to information but elsewhere. It is about:

• How we interpret widely available information, i.e., our analytical edge
• How we put into practice the conclusions, i.e., our behavioral edge

Why are our analytical and behavioral edges important?

All investors read the same reports, use the same evaluation techniques, and come to the same conclusions. When everyone agrees, no one thinks enough. Simply put, we have no edge over the others. And having no edge means we are the patsy in the game.

All popular analytics platforms have integrated valuation features. The fallacy of thinking is that by reading the same data and thinking the same way, we will come to different conclusions—complete nonsense.

Often, an "expensive" company with a 25 P/E ratio turns out to have been "cheap" just a year later when the P/E is already 50. The reverse is true - we've found an excellent (in our opinion) company trading at 2 P/E. We determine fair value based on Discounted cash flow and figure we are paying cents on the dollar of future cash flows. That’s it; we have the holy grail, a significant margin of safety.

We buy the "great" company with the idea that being cheap will guarantee the positive outcome of the transaction. However, the reality may be different, and the company may remain a bottom fish for a long time... offering an excellent margin of safety.

We should not forget that "awesome" is an adjective describing the qualities of the business, and "cheap" is its price. Analysis measures the "awesomeness" of a company, while valuation considers how expensive or cheap it is. We need great companies at an excellent price to increase our chances of success. The latter doesn't have to be "cheap."

Valuation methods

There are two primary methods of valuing a company - a business valuation and a comparative valuation.

The first determines the fair value of the company. Depending on the business, we have at our disposal the least inappropriate and extremely inappropriate valuation methods. The most popular are:

• Net Asset Value - suitable for companies with tangible assets
• Discounted Cash Flow - suitable for businesses with predominantly intangible assets
• Excess Return - suitable for banks
• Dividend Discount Model - suitable for banks and companies distributing dividends with at least 5% yield

Of the four methods, the first, Net Assets, has the fewest assumptions. It is based on stock variables, which makes it easy to calculate. The other three are based on flow variables and have more assumptions. Hence, they are more prone to deliver deceived outcomes.

Net Asset Value works best for companies with tangible assets, such as mines, ships, and oil rigs. NAV is relatively easy to calculate and has the lowest margin of error compared to other formulas.

The key is not to mismatch valuation methods - don't calculate a bank's discounted cash flow or a software company's Net Asset Value. Do not fall into the trap of using multiple valuation methods, assuming the more information, the better the outcome. It is a dangerous fallacy aiming to provide certainty in a place where it is, by definition, absent.

We choose the least inappropriate method according to the company`s industry and business model. The next step is to compare how the company performs relative to the past and relative to the competition.

I use Enterprise Value/Sales, Enterprise Value/Free Cash Flow, and Price/Book value. I rarely use Price to Earnings except for banks. Earnings are too often manipulated, while revenue and free cash flow are not. In this context, I like the following quote: earnings are opinion, and cash flow is fact.

If the added value is a stream flowing through a metal pipe, we have sales revenue as an inlet and free cash flow as outlet flow. Since the pipe is opaque, we cannot observe the flow inside, i.e., we are unable to determine the net profit. The latter is subject to broad adjustments according to management's objectives, whereas earnings and cash flow are facts.

There are exceptions when I also use Price to Earnings. Such examples are traditional banks or when I look at broad equity indexes.

Benchmarking seems simple, but it has its subtleties:

• For historical values, I used at least five years of history. The reason is that for shorter periods, the conclusions will be irrelevant.
• For comparison, I pick identical companies. It is not just the sector that matters but also the industry, the business model, and the company's size. I only compare junior gold miners to peers; I compare E&P mid-size companies operating in the Permian Basin and traditional banks operating in Brazil.

The purpose of valuation methods is not to give us certainty but guidance.? Sometimes, I am happy to pay $2 for every $1 of future cash flow when a company trades below its five-year average and is cheaper than its competitors. ?

Quick and dirty guide for company valuation

In this section, I share my favorite principles for business valuation. They are safety instructions or what not to do when evaluating a company:

• Stock valuation is not a substitute for a company`s fundamentals and risk management.
• The more assumptions in the equation, the more chances there are for errors and wrong conclusions.
• The valuation of a company is a quantitative parameter that does not include factors describing the quality of the business.
• A company's fair value will, more often than not, not match its market price. The reason is that market participants are irrational, and the market discounts their expectations more than the facts, i.e., the value of the business.
• There are two main valuation approaches: business valuation (Net Asset Value, Discounted Cash Flows, Excess Returns) and comparative valuation against the company's past and competitors' multiples.
• Often, benchmarking does a good enough job.
• If a complex formula with multiple assumptions is needed to determine the value of the business, change the method. Remember, less is more.
• According to the industry, less inappropriate and highly inappropriate assessment methods exist. Use Net Asset Value for companies with capital-intensive businesses, DCF for companies with short conversion cycles and predominantly intangible assets, and Excess Return for banks.

Conclusions

Financial markets discount expectations, not facts. If it were the opposite, the markets would be 100% efficient, and Alpha would not exist.

The price of a stock does not rise because market participants agree it is cheap but because they unanimously expect it to rise. If I spot a cheap company and get excited about it, that's my problem because it can stay cheap longer than I can wait.

There are no universal instruments, methods, and assets in financial markets. It all depends on the context, which in turn depends on the objectives and skills of the market participant. So, it is with valuation methods. We must know the markets and the industries we play. It is the only way to gain an analytical edge. This means to pick the right tools for the task. And more importantly, when and what not to use.

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