Valuing a company is one of the most important tasks an investor has to solve. Buying an overpriced business all too often leads to massive losses. But how to value a company?
Valuing a company is difficult and associated with a lot of work. When I’m sneaking around social media and read about investments young investors make, I often discover that they’re not thinking about the value of the company, they’re interested in. The ratio between price and value is out of their sight. They just think about a possible bright outlook for the company and believe that their expectation justifies every stock price. These young investors are so convinced about the company – which are mostly everyone’s darling – that they don’t think about the real value of the company.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” (Philip Fisher)
“Value will always work out in the course of time.” (Charles Dow)
Ignoring the real value and the price-value-ratio is very dangerous. Your investment success depends on that ratio. The more you pay in relation to price, the riskier your investment and the more likely is a loss. That’s why value investors always calculate the intrinsic value and relate it to the market price. I know that not everybody wants to do this work. So, today I want to introduce three other different methods to value a company and I want to talk about the problems you have to face using them.
This method of valuing a company is a method we’re very familiar with, because we’re doing it all of the time. At least the most of us. No-one likes to pay too much for the things needed or wanted. In contrary, we all love to look for bargains and get the best at the cheapest price whenever it is possible. When we need a TV, we don’t buy the first one we see. We start comparing TVs. We are looking at the size and the features we get and compare them, trying to find out which one has the best price-performance ratio. The most look at the price range of TVs with the same size and ask themselves, which one has the best features or the ones they like to have. We’re trying to find out which device offers the most and best features at the lowest price.
Ask some questions
It’s the same with companies although many don’t do the same work when searching for an investment. That’s why Peter Lynch says that “people spent more time shopping for a good microwave oven than shopping for a good investment.” But we can find out if a company we’re interested in is cheap or not and therefore worth a buy by asking some simple questions and trying to answer them:
- First, what business is the company in?
This question is very important, because our comparison depends on the answer. Comparing to companies of two different businesses is not very helpful and by the way a bit more difficult.
- How much does the company cost and how much are companies in similar business selling for?
You can take a look at the earnings to price ratio and ask yourself, if the company is cheaper or more expensive than similar companies.
- What are the companies growth prospects? Are they better or worse than other companies in the same industry?
- Are the growth prospects reflected in the price?
- What’s about the net margin? Is it higher or lower than similar companies?
- Has the company, you’re interested in, higher or lower debt then others in the same business?
- What’s its return on equity? Compare it with the other companies.
You can continue this little catalogue of questions to find out the value of the company in relation to similar companies. All you have to do is to decide, if the company, based on the facts you researched, is cheaper or more expansive and therefore worth a buy or not.
The problem with this method
This method of valuing a special company is easy, but contains a very huge problem. It only says something about the value in relation to similar companies, but nothing about the real value. This is important, because even if the company seems pretty cheap in relation to others, it can still be too expansive. And another problem is that this method doesn’t work all of the time. There will always be times when the hole market is overpriced and nearly every company is too expensive.
Remember all the bubbles we knew from the past. The dotcom bubble which bursted March 2000. No-one was interested in the real value of a company. If the company has anything to do with the internet, it was worth a buy regardless of the price. Back then, I was a fool myself and bought without looking at the value. I wrote about in in my post “How I lost 98% of my Investment!” Right before the burst of the bubble, even those companies who seemed cheap in relation to others were much too expensive. So, using the method of relative value wouldn’t help to identify a company worth buying.
It was the same with houses around 2008. And in the stock market, mispricing happens all of the time, regardless of those who say markets were efficient. So, relying on this method alone is dangerous and all too often not very helpful, particularly because many companies operate in different businesses which makes a reasonable comparison very, very difficulty.
This method is very helpful in evaluating whether a company is a bargain or not. It says something about the real value of the company. But you have to take a deeper look into the company to find out. To get a notion about the liquidation value, you have to look at the assets of the company. For some companies, you get more money when you liquidate them instead of letting them run the business. Either their book value is obviously higher than their market value or you can find some assets in the financial statement that is worth more than ascribed.
You will find investors who are looking at the book value and are searching for some hidden diamonds. The advantage is that even when the company will be liquidated, you probably get a decent return with very low risk of losing. But the problem is that the most companies won’t be liquidated. Even if the company performs bad, the management will try to keep the business running. So, in the most cases, you won’t get the money for the value you buy.
But on the other hand, and you shouldn’t underestimate it. Taking a look at the book value and relate it to the price helps you with your risk management. The more value you get in relation to price, the less the risk of losing your money.
This valuing method tries to find out what a company could be worth to someone else. Let’s assume you’re the owner of a small business. You’re business is doing very well and you are quite satisfied. You run your business with little staff and some equipment. The most valuable item of your business are the loyal customers. These customers are the reason why another company wants to buy your company. Although these customers are very valuable for you, they are more valuable for the other company. Just because the purchaser can earn a lot more from your customers than you can. Why?
Well, while operating in different companies, you as well as the other company have costs for running the business. When you sell your business, the buyer’s costs for the additional customers are less than the costs you have. For example, they don’t need your back office , your equipment and maybe your staff. So, the value of your company is higher for the purchaser than the value for you running the business and the acquiring company is willing to pay you a premium for that.
How do you figure out how high that premium should be?
Well, that’s the problem. Figuring out the value of this is nothing but easy. As the owner of the small company you need to know if there are any possible buyers. Without demand no premium value. On the other hand, if the management never wants to sell the company, you have no premium to get.
You also need to know who gets the benefit of the cost savings. The buyer or the seller? And you want to know how high the benefit for a possible buyer is. And this is really difficult to find out, especially for the average private investor. You will have to guess the value and the premium and that’s, in my eyes, more difficult than estimating future earnings and success of a company.
How to deal with these methods?
Valuing a company with only one of these methods could end up worse and I really dissuade from doing it. In combination, these methods may give you a first hint, if the company is worth a closer look or not. Why researching the fifth best company of a branch of industry when you can research the best one. It’s your time, you’re saving or wasting.
From the three methods mentioned above I look mostly at the liquidation value. It is the most important of them and one criteria on my list for deciding to invest or not, albeit non of the three methods is the one I use to decide about an investment in the end. To get a notion of the value of a company, I would always use the discounted free cash flow and I recommend that to you, too.
In combining different methods of valuing a company you may get a good idea about the value of a company. This is important, because we have to look into the future where nothing is sure. And the better our estimation, the less the risk and the better our investment. We can’t predict the future, but we have to guess how near we come to a possible reality.