Saturday, 23rd March 2013

How to value a business

Written by George Traganidas Topics: Stock Investing, Wealth Building

There seems to be a lot of confusion and discussion on how to value a business and determine what is a fair price to pay. If you are wondering whether to buy a share or the whole business you must be able to answer a simple question. How much is the value of the business and is the current price fair? After all a stock is part ownership of a business.

So let’s start from the beginning. Valuing a business is an eight step process and it takes time and effort.

First step, before you even start to think about the numbers you need to get to know the business and the industry it is in. Looking at the industry the business operates in, you need to figure if you understand it, what is its future, is it expanding or shrinking, is it heavily regulated, is it a monopoly, who are the big players, etc.

Second step, once you have a fairly good understanding of the industry you then look at the business itself more closely. Do you understand the business, how does it make money, what are the future prospects, what are the dangers, who are the competitors, what is the business’s position in the industry, etc.

Third step, after you gain an understanding of the business you need to look at the management of the business. Are they the kind of people you want to be partners with, are they candid in their communication with the shareholders, do they use the business to get rich themselves, etc.

Fourth step, now it is time to look at the numbers of the business. The best place to get this information is from the annual and the quarterly reports that they submit. This is the official information and you can trust them up to a point (there is still a lot of misreporting). You need to familiarise yourself with the last few years of operation of the business. Five years is a long enough period and it should give you a reasonable picture of the business. You need to look at what constitutes normal operations and what is a special event that happens once. Or maybe some special events happen too often and they should be considered normal operations. What are the assets and liabilities of the business? How efficiently does management use the cash? Questions like these you need to answer from the reports and familiarise yourself with the business.

Fifth step, at this stage you have all the information that you need to estimate a value for the business. You need to be careful here, because at this stage you are going to make some projections into the future and you should know that since these are projections they might be wrong. Chances are they will be wrong, but they should serve as a useful guideline. At this stage you are looking for a range of values for the business based on your assumptions of the future and not for a precise value.

The value of a business, as John Burr Williams first pointed out in his 1938 book “Theory of Investment Value”, and Warren Buffett has repeated several times since then, is the total sum of all the cash the business can return to you, the owner, discounted back to the present at an appropriate rate. To calculate this you use a discounted cash flow (DCF) model. With the knowledge that you have built so far about the business you should be able to choose the appropriate values to use in the model.

Sixth step, by now you should have some very good knowledge about the business and its value. Remember that the value of a business is based on its fundamentals and not on its market price. Now it is time to calculate a price. This should be what you are willing to pay to buy the whole business, based on your calculations of its value. Then you can divide the value of the business that you have calculated at step five by the number of outstanding share and that would give you a value per share.

If the market price of the shares is lower than the value per share that you have calculated then the business might be selling at a discount. The reason I say ‘might’ is because in step five you made a lot of assumptions in order to calculate the value. If one or more of these assumptions is wrong then your value is wrong and what you might think is a bargain might turn out not to be.

Benjamin Graham wrote in his book “The Intelligent Investor” about the idea of the margin of safety. This is one of the ways to protect yourself from the wrong assumptions that you might have made. You should look for companies that their value per share is more than the market price per share by a margin. This is the margin of safety. Thus, if you are wrong in your calculations you can still make some money is your margin is wide enough. Be careful though because if your margin is too wide then your universe of potential businesses to buy shrinks a lot. The size of the margin depends on you. This approach of finding undervalued businesses is called value investing.

Seventh step, when you have decided that a business is worth buying you need to write down your investment thesis. This is a short paragraph of the reasons why you think this business is worth buying. You should not go into too much detail, but this should always be a reminder of why you decided that this business is worth buying.

This thesis will be your basis for all your future decisions about the business. You need to always come back to it and see if anything has changed. For example, if the stock price of the business falls by 30% and people start to panic and sell the stock, you need to be rational. Do not follow the herd, but go back to your thesis and remind yourself of the reasons you have bought the business in the first place. Has any of the fundamentals changed or the market is just acting irrationally? If the reasons are still valid maybe this is an opportunity to buy more of a wonderful business at a cheaper price. If the reasons do not hold true anymore and things have changed maybe you should sell as well. At least your decision will be rational.

Eighth step, even after you have bought the business your job does not stop. You need to follow the business from now on. You need to monitor that the business is increasing in value (notice that I mention value and not price) and it is becoming stronger. In addition, you need to monitor your thesis about the business and make sure that it still holds. The thesis needs to be updated as time goes on, because the industry, management and financials of the business will change. This is a never ending process.

As you can see, there is a lot of research that has to be done prior to deciding if a business is worth buying. All this research is valuable to you so you can get a very good understanding of the business as a whole and the industry it operates in. Looking at the numbers is only a part of the whole process and you should not start there. The whole process is more of an art that a precise science and that is why different people form such diverse opinions about the value of companies.

You should always remember that when you buy a business because you think that there is value in it, someone else is selling it because they think there is no value. One of you is always right.

This process of valuing a business is very thorough and it gives you a good understanding of the business, its value and the reasons to buy it. A lot of people take shortcuts and skip one or more of the steps because they take time or are difficult. You can see though that skipping steps will create gaps in your knowledge and when it is time to buy or sell you will be missing bits of information that can make a difference.

That is one of the reasons why a lot of people lose money in the stock market. They try to make investments decisions without doing their research and they buy the wrong business or they sell for the wrong reason.

I hope that this post has helped you to get a better understanding of how you value a business and you will be more successful in it. You now know the steps and some of the pitfalls to avoid.

Follow the practical way,
George

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2 Comments to How to value a business

Hitwus
25 February 2014

Thanks for great article.
By the way, do you know where to learn ” How to Value a Business and How to Think About Market Prices” from Warren Buffettt?

admin
12 March 2014

Hitwus,

I am glad that you like the article. As far as I am aware, Warren Buffet has never written such an article. He provides though a lot of insights in the areas of business valuation and how to think about stocks and the market in his annual letters. They are a must read for any serious investor.

Regards,
George

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