Saturday, September 23, 2006

Ways to value a company

When one is buying a company, an ETF or a mutual fund - there are two things to make sure of. The first one is if the right security is being bought and the second thing to make sure is that the securities are bought at an appropriate price. Two types of investing has been known to work - momentum investing and value investing. In this article, we look at methods that may be used to value a security using different approaches.

Momentum investing is typically done over a short period of time typically over a few months or a few years. The number of years for momentum investing is typically less than three and definitely not more than five. One example of this showed itself during the .com boom which lasted for about four years from 1996-2000. Recently we have had the commodities boom which also is not likely to last over longer than five years. In other words, performance in each sector is bound to revert to its mean over long periods of time.

First, there is the problem of finding the right security. The right security can be obtained by screening message boards, reading business magazines and or using the "magic formula". Joel Greenblatt in his book the little book that beats the market introduced the so called magic formula. The formula involves

  • Buying stocks that rank highest in a combination of
  • Earnings yield (the inverse of the price-to-earnings [P/E] ratio) and
  • Return on capital.have doubled the market's returns

This system can be used as an effective screen but the mechanical screen itself will not identify great businesses at attractive prices.

It is always good to apply the basics that Charlie Munger talks about in Poor Charlies Almanac to the stocks selected. The basic principles that Charlie talks about are.

  • Answer the no brainer questions first.
  • Apply mathematical models to assert scientific reality.
  • Think problems forward and backward - or "invert, always invert".
  • Apply fundamentals from different disciplines to analyze the company further.
  • Really big effects, lallapalooza effects will often come only from large combination of factors.

In this article we look at possible mathematical models that can be applied to value a company. One should always value a company conservatively so that a margin of safety is built into the company that prevents the downside during market downturns.

The book "Value Investing from Graham to Buffett and Beyond", Bruce Greenwald describe a few methods to value a company. Some of the methods they describe are:

  • Valuing the asset value that is required to produce the necessary goods or service. This model assumes no competitive advantage - i.e., another market entrant can produce the same goods and service by investing similar capital.
  • Earning power value - this minus the asset value of the company gives the franchise value because of competitive advantages.
  • The value of growth is the value of the company on top of EPV.

Needless to say, the Munger factors kick in before one can value the company properly using these approaches. Typically, calculating the EPV involves taking the net income and adding a part of R&D and sales budget and dividing by the cost of capital. Adjusting the net income is a complicated process and involves significant guess work. Any calculation that involves significant guess work is likely prone to errors.

Another way to calculate the intrinsic value of a company is to take the book value of a company and add to it the discounted cash flow for the next ten years. This model is simple and works fairly well. For a company with no growth with 11% discount rate, this value can be calculated as book value + 7 x cash flow + 0.3 terminal cash flow. Appropriate adjustments can be made to value the company appropriately. If one can be reasonably sure the company is going to be around for the next next one hundred years, the value of the company can be calculated as book value + 10 x cash flow.

In future segments, we will use of the afore mentioned methods to value a company and we will specify the model used.

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