The cornerstone of investing and entrepreneurship and perhaps even of life, is valuation.
Thats not hyperbole.
Think about it. You are valuing and weighing all day long, every day.
Obviously you need to value stocks and bonds if you are to invest.
Its also evident you want to understand how much your business is worth if you have a startup.
But there is more.
Whats that house you want to buy worth?
How about the car you purchased last year?
Do you value your collectibles? Your art?
How do you do that?
Lets go into uncharted territory.
Do you value your relationships? Looking for a girlfriend?
What is she worth?
(Its only a little tongue in cheek. Later, someday I’ll explain why. For now, we will stick with inanimate objects!)
As I described in an earlier post, we are putting a value or worth on assets (remember assets?).
Value and worth, as I have said before need not necessarily be the same as the price of the asset.
If its less than the price of the asset, we have an investable opportunity. Otherwise we don’t.
Lets use the value of a company stock as an example.
What is it worth?
There are many ways to determine this but a few that are important to consider.
Lets talk about four of them.
1. Asset Valuation
2. Liquidation Value
3. Replacement (or Competing) Value
4. Discounted Cash Flow Valuation
One way to assess value is to add up the worth of all the things the company owns…its buildings, its inventory, its machines and its cash and calculate its total asset value.
Lets say, you are in the middle of a depression. Companies are selling cheap (ca 1929).
It was possible to pick up companies at the time for less than the sum of their parts.
Benjamin Graham, the father of value investing made his fortune this way.
A second way, in the case of a company that is being broken down and sold for its parts (liquidation value) is the total value of its assets minus some discount to account for the fact that everything it owns may not bring market value since it will be sold at fire sale prices.
More on this another day.
Replacement Value or the Valuation to Compete:
A third way to calculate value is to see the business as competition to us, and ask the following question:
“What would I need to do to build up a business just like this one and compete with it?”
Now that would include the asset value mentioned above but also the resources that have been deployed to build the brand(s), market the product(s), establish the customer and wholesaler relationships and distribution channels (among other things).
There is some hand waving involved here of course but its easy to see that the value of these intangibles (and semi intangibles) will add to the raw asset value we have described above.
Discounted Cash Flow valuation:
Finally, we can determine value by asking this question?
“If I owned this asset, what amount of money would I earn from it over a set period of time?”
If you owned a stock, what is the total value of dividends you would receive for it over time?
If you owned a whole business, what profit would you be able to get out of it every year for the duration of your ownership?
For each of these questions, we can (theoretically) construct a model of “cash flows“, i.e. the flow of money into your pocket over time.
Add that cash up.
Remember, you don’t have the cash in your pocket today. Its going to take time to get it all.
Over that time, you will live without that spending power.
So, the raw total of that cash must be “discounted” over the period you will need to get it into your pocket.
This is, in a word the discounted cash flow model of earnings (DCF) that allows you to estimate the value of an investment.
The discounted cash flow model of valuation (DCF) is de facto the most important method to understand, when valuing an asset that brings earnings.
Its incorrect to value a business with sales any other way (except in the situations I noted above).
I will speak more about DCF in later posts as it comprises the “V” in the “P/V” formula I introduced in the previous post.
I will leave you with a few final thoughts.
1. You cannot fully value an asset without cash flows (or the future promise of cash flows).
2. If you cannot fully value an asset, you cannot be sure of the relationship of Price to Value (P/V).
3. If you cannot estimate P/V and ensure a margin of safety, you are unable to ascertain whether an asset is investable.
4. If you decide to purchase the asset anyway, you have not invested. Rather you have speculated or gambled. Be clear on this.
5. Ergo, any asset without cash flows is not likely to be an investment.
Let me repeat that last statement.
An asset without cash flows is not likely to be an investment.
(Ahh…the chaos that idea will create!)