Seth Klarman on the Art of Business Valuation

This is a series of posts exploring the investment philosophy of Seth Klarman, as detailed in his book Margin of Safety.

The Art of Business Valuation

“Security analysis does not seek to determine exactly the intrinsic value of a given security. It needs only to establish that the value is considerably higher or considerably lower than the market price to justify an investment action. For such purposes an indefinite and approximate measure of intrinsic value may be sufficient.”  -Benjamin Graham, Security Analysis

Value investors buy at a discount from underlying value, which necessitates an assessment of business value. According to Seth Klarman, there are only three useful methods of business valuation.

The first is net present value (NPV) analysis, which is the discounted value of all future cash flows that a business is expected to generate.

The second is liquidation value analysis, or the expected proceeds if a company were to be dissolved and the assets sold off.

The last useful method of business valuation is stock market value, which is an estimate of the price that a company or its subsidiaries would trade in the stock market.

NPV analysis is one of the most accurate and precise methods of valuation when future cash flows are predictable and an appropriate discount rate can be determined. The trouble is that future cash flows are often highly uncertain and discount rates can be somewhat arbitrary.

To perform NPV analysis, one must attempt to predict a future that is not reliably predictable. This is why investors need a margin of safety which is achieved through conservative projections and then investing at a substantial discount from the resulting valuation.

The liquidation value of a business is a conservative measure of value based only on tangible assets. Some value investors use “net-net working capital” to approximate liquidation value. Net working capital is current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year). Net-net working capital is net working capital minus long-term liabilities.

Earnings per share (EPS) is a common valuation metric for investors, but it is highly susceptible to manipulation and accounting vagaries. Managements are aware that many investors focus on growth in EPS and it’s simple enough to massage earnings to create a consistent upward trend. An analysis of cash flow is more representative of the true economics of a business.

Valuation is complex and the results are imprecise, but you can only find bargains if you have some sense of what a company is worth. The techniques listed above are the best available.