How to Value a Company in 3 Easy Steps

How should investors choose among these several valuation methods?

How should investors choose among these several valuation methods?  When is one clearly preferable to the others?  When one method yields very different values from the others, which should be trusted?

At times a particular method may stand out as the most appropriate.  

• Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.
• Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.  
• Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  
• A closed-ended fund or other company that owns only marketable securities should be valued by the stock market method, no other makes sense.

Often several valuation methods should be employed simultaneously.  

• To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another.  

Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  

• In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reasons to do otherwise.  
• True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

Analyzing Investment Opportunity Begins with an assessment of Business Value

To be a value investor, you must buy at a discount from underlying value.

Analyzing each potential value investment opportunity therefore begins with an assessment of business value.

While a great many methods of business valuation exist, there are only three that I find useful.

1.  Net Present Value
The first is an analysis of going-concern value, known as net present value (NPV) analysis.  NPV is the discounted value of all future cash flows that a business is expected to generate.  A frequently used but flawed short cut method of valuing a going concern is known as private-market value.  This is an investor's assessment of the price that a sophisticated business person would be willing to pay for a business.  Investors using this shortcut, in effect, value business using the multiples paid when comparable businesses were previously bought and sold in their entirety.

2.  Liquidation value.
The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off.  Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.

3.  Stock market value.
The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries consider separately, would trade in the stock market.  Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses.

• None of them provide accurate values all the time.
• Unfortunately no better methods of valuation exist.  

Investors have no choice but to consider the values generated by each of them, when they appreciably diverge, investors should generally err on the side of conservatism.


Ref:  Margin of Safety by Seth Klarman

NPV and IRR - place more importance to the Assumptions than to the Output. "Garbage in, garbage out"

Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

Anyone wi th a simple, hand-held calculator can perform net present va lue (NPV) and internal rate of return (IRR) calculations.  The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present.  IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts.  Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.  "Garbage in, garbage out" is an apt description of the process.

Net Present Value and Internal Rate of Return Summarize the Returns for a Given Series of Cash Flows

NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows.

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, IRR provides the precise rate of return to the investor while NPV describes the value of the investment at a given discount rate.

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due.

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.