The Business Valuation Process Step by Step

The Business Valuation Process is probably the most important part of Value Investing. Before taking the investment decision, we have to analyze in dept all the characteristics of the company and its environment in order to understand its business and forecast its future performance. Once we finish the analysis, we will be able to value the company in an accurate way.

The Business Valuation Process is more complex than the valuation of other kinds of assets. For example, if we are valuing a real estate investment, we don’t have to take into account aspects such as accountancy or business strategy, which are fundamental in the case of business valuation.

In this article, I am going to try to highlight the most important steps of the Business Valuation Process. These steps are 4: Business Strategy Analysis, Accounting Analysis, Financial Analysis and Prospective Analysis.

I want to clarify that these are only the main steps of the Business Valuation Process, and that each step is complex and takes time. Hence, this article can be used as a guideline to new value investors want to carry out their first analysis step by step. I will explain each of each step more profoundly in further articles.

First Step – Business Strategy Analysis

The main objective of Business Strategy Analysis is to identify key profit drivers and business risks in order to assess company’s profit potential at a qualitative level.

This step is fundamental because it enables us to frame the subsequent accounting and financial analyses. For example, the accountant and financial analysis will not be the same for a biotech company and a utility company.

Second Step – Accounting Analysis

The objective of Accounting Analysis is to evaluate the degree to which a firm’s accountancy captures the underlying business reality. We are analyzing the adequacy of the accounting methodology used by the company.

An appropriate accounting analysis improves the reliability of conclusions from Financial Analysis (the next step in the valuation process). Accounting Analysis could warn us about companies with suspect accountancy such as Enron, which hided its huge losses using different kinds of accountancy tricks.

Third Step – Financial Analysis

The main goal of Financial Analysis is to use financial data in order to evaluate the current and past performance of a firm and to assess its future sustainability. There are two important characteristics related to the Financial Analysis: It should be systematic and efficient and it should allow the analyst to use financial data to explore business issues.

The two most commonly used financial tools for this kind of analysis are Ratio Analysis and Cash Flow Analysis. Ratios Analysis is used to assess product market performance and the financial policies of the company. Cash flow analysis is used to measure the liquidity and financial flexibility of the company.

Fourth Step – Prospective Analysis

This step focuses on forecasting a firm’s future. In this step we have to take into account all the conclusions taken from the three previous steps in order to make prediction about the future performance of the firm.

Prospective analysis depends considerably on the future business scenario. We have to take into account possible facts, such as mergers & acquisitions or the possibility of bankruptcy. As it is impossible to predict the future in an accurate way, we can make different scenarios and give different probabilities to each of them in order to obtain the final intrinsic value of the company.

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The Intelligent Investor by Benjamin Graham

This is my first article in which I talk about recommended bibliography for long-term investors and I’m glad to do it with this investment classic whose ideas are actually more important than ever, “The Intelligent Investor” by Benjamin Graham. This book, also known as “the Value Investing Bible”, is an unavoidable reference for people interested in it and, generally, in long-term investing. According to Warren Buffett, this is “By far the best book on investing ever written”.

If I had to define The Intelligent Investor in only one word, this word would be sensibility. Through the book we can see how Benjamin Graham explains, in a completely coherent and sensible manner, the way he understood investing and long and short-tem market behavior. Another important factor is its simplicity. This book is valid not only to university graduates, but also to people without large knowledge about the stock market who want to look for long-term profitability to their savings

The book differentiates between investors (long-term investors who buy parts of companies) and speculators (who are looking for short-term profits without taking into account the businesses they are buying). I recommend this book mainly to long-term investors, not to traders, which could think it’s useless for short-term speculation.

The book has many examples that illustrate its theories, as well as huge inefficient that the market could has. One of the examples which impacted me the most was the preferred stock of “Textile Finishing Machinery Company”. Preferred stocks were quoting at $3 in 1940. The firm had lost its profit generation capability and, therefore, in 1943 shareholders decided to liquidate the company. Once it was liquidated, shareholders received $190 in total. I meant 6,233% profitability. I know this is an extreme example, but we can see with the extreme inefficiencies of the market.

One of the problems that I see in this book is the lack of examples of mistakes in value investments which seemed obvious “buys” but which became entire failures. I’m sure Benjamin Graham had some of this kind of errors, and if we know his errors I could be much more instructive than if we know his good choices.

The intelligent investor’s strategy is to look for undervalued companies, choosing companies basing on its fundamental value instead of basing on other people’s opinions or market trends. Once we have chosen the adequate companies, we have only to wait for the market to value them correctly with a higher price.

Benjamin Graham used the parable of Mr. Market in order to explain the short-term behavior of the market. Mr. Market has a kind of neurotic problem, which makers that his mood changes drastically from astronomical optimism to an absolute depression. When Mr. Market is depressed, he sells companies’ shares at lower prices than their real value; and when he is euphoric, he buys companies’ shares over that value. These changes in shares’ valuations are due to hid mood changes, without taking into account the real value of the shares that he is buying and selling.

Therefore, an intelligent investor could take advantage of the mood changes of Mr. Market and buy shares when he is depressed and sells very cheap, and sell when he is euphoric and pay much more money for the shares. In conclusion, these market fluctuations are opportunities, so they are not risk synonyms, as professors repeatedly are telling me in my MBS in Finance, as it is one of the bases of Modern Portfolio Theory which is used by many of the world’s most important investment funds. I’ll explain my opinion about risk in other articles.

Another important concept explained in the book is the Margin of Safety. We can say that the Margin of Safety is one of the most important concepts of Value Investing. The Margin of Safety is the difference between the intrinsic value that we calculate for an asset and its current price. For example, if we estimate that the intrinsic value of a company is €10 whilst its current price is €5, the Margin of Safety would be 50%.

Finally, Benjamin Graham concluded his book remembering that every company investment has to be considered as an investment in a business (which is precisely what it is, despite many people don’t take it into account). Hence, these investments have to follow the same principles that follow investments in any kind of business. These four principles of business investments are the following:

• Know what you are going, know your business.
• Do not let anyone else run your business, unless you can supervise his performance with adequate care and comprehension or you have unusually strong reasons for placing implicit confidence in his integrity and ability.
• Do not enter upon an operation – that is, manufacturing or trading an item – unless a reliable calculation shows that it has a fair chance to yield a reasonable profit. In particular, keep away from ventures in which you have little to gain and much to lose.
• Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ.

I would like to finish this article recommending this book to all people who are interested in long-term investment, as it is an essential investment classic for people with all knowledge levels in stock markets. Moreover, it’s one of that books that I’d strongly recommend to read relatively often in order to remind the main principles of an intelligent investor.

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Peripheral Vision: Detecting the weak signals that will make or break your company

In this new post, I am going to comment the last seminar where I could assist at my Business School. The lecturer was George S. Day, marketing professor at Wharton School of Business and consultant to numerous corporations, such as AT&T, Eastman Kodak, General Electric or IBM.

The first thing that surprised me was that George Day came to speak to me before the seminar, maybe because I was one of the few guys who did not seem Irish, and we asked me where was I from. It was curious for me that we knew Galicia because of Way of St. James, but this was only an anecdote.

Let’s talk about the seminar. The first that I want to highlight about George Day was his way to communicate and express. It was evident that he works for one of the world’s best business schools only for the way we maintained the attention of the audience on an enjoyable way all the time, combining pure theory with many examples and interesting anecdotes.

In the seminar we explained how many firms have problems when they have to detect future problems, which if they detect them on time they could have avoided high damages in their profits. These problems, detected on time, could have been great opportunities. The first example that we gave was the widely commented Subprime Crisis. Some experts detected the possibility of this kind of crisis long time ago, but big investment banks obviate all these dangerous peripheral signals, and these meant losses of billions that could be avoided.

Barbie vs. Bratz

Another clear example about the lack of peripheral vision was the one that the toy company Mattel with its star doll, the famous Barbie. Despite its huge investment in market research and R+D+I, they couldn’t forecast the change in the likings of their objective clients, girls between 4 and 13 years old approximately. Another company, MGA Entertainment, could forecast the new market conditions much better than Mattel and they created Bratz dolls, which destroyed Barbie’s market share reducing its objective clients to girls between 4 and 9 years old and finishing with a hegemony which lasted many decades. They problem of Mattel was its inability to see these signals that other companies could see. This was not caused by its lack on investments in market research; it was caused because they did not know to ask themselves the adequate questions. Another problem was the lack of flexibility of Barbie doll (Mattel had a manual of more than 100 pages with the characteristics that Barbie doll has to obey). Currently, it seems that Mattel is going to try to recover its market share, but this is going to be much more difficult and costly than if they had a good peripheral vision.

How can we improve peripheral vision?

The first thing that we have to know if we want to improve our peripheral vision is where to look. We have to get rid of everything that could hinder our peripheral vision, such as overconfidence, mental filter (such as discarding some scenarios), or confirmation bias (which consist of looking for data which confirm that we think).

Once we discarded these peripheral vision blinders, we have to ask us the adequate questions, such as:

- What surprises could damage or benefit the company?

- What technological innovations could change completely the industry?

- Is there an unthinkable scenario?

Then, it is important to deeply analyze the answers using different points of view without discarding any of them. George stressed the importance of blog when we have to detect these future problems and find a solution as soon as possible. Nike, for example, searchs daily on the Internet in order to find articles and comments about the company and everything related to it. The firm analyze all this data carefully, looking for clues and signs that could help them to improve its brand.

Peripheral vision and Value Investing

A way to make money in the stock market is seeing what the market haven’t seen jet. This is a very complex task, often almost impossible, but sometimes could happen and became very profitable. For example, Willian O’Neill knew how to anticipate to the market investing in Syntex’s (this company was the first mass manufacturer of the birth control pill) shares just before the “sexual revolution”. The market could not discount the real potential of this company before to know its earnings, and William could take advantage of this. Syntex’s shares rose from $100 to $550 in less than 6 months.

Another factor that could be interesting for value investors is the preference to invest in companies whose managers take into account these peripheral danger signals and know to adapt to changes in market and industry conditions. Finally, I want to conclude with the same sentence that George Day used in the conclusion of his seminar.

“It’s not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change”. (Charles Darwin)

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Philosophical Basis for Value Investing

Value investing is based on that every asset has a value. A good investment occurs when we pay less than the real value of the asset or equity for it. In words of Warren Buffett, “Price is what "Price is what you pay. Value is what you get."

Value Investing vs. Market Efficiency Theory

Market Efficiency Theory says that stock prices fully reflect all available information on a particular stock; hence, it’s impossible to predict a return on a stock price because nobody has access to information not already available to everyone else.

However, this theory is not completely true. I was demonstrated that they are some clear signal which mean than market is inefficient. For example, the fact that many Value Investors, such as Warren Buffett, John Templeton or Joel Greenblatt, could beat the market repeatedly is a good evidence of market inefficiency. I will study this topic more in depth in an upcoming article.

Value Investing vs. “Bigger Fool” Theory

This theory argues that the value of an asset is not important as long as there is a “bigger fool” around willing to buy the asset from them. I know that people can make good profits using this method, but the problem is that is dangerous because there is no guarantee that there will be a “bigger fool” when you want to sell.

A good example of that you can earn a lot of money and that you can lose it with the same ease is the case of Infospace.com. During the dot-com bubble, people could make a lot of money investing on this company with the “Biggest Fool”. The company went public in December 1998 closing at $20. It reached a peak of $1,305 in March 2000. Its share price is currently below $11. Here you can see the graph of its share price.

The company was the same, its fundamentals were the same, but the price fluctuated move by the greedy of big fools who wanted easy money. People lost millions because of using this bubble. However, real intelligent investors did not.

Can we value a company objectively?

Some people might say that value is in the eye of the beholder, but companies are not pieces of art. Value comes from the present value of the future cash flows that the company will generate, so the value of the company is completely objective.

The problem is that we might not know surely the future cash flows that a company will generate. Can we value objectively them? The answer is yes. There are some methods to objectively value companies with this problem, but I tell you more about this topic in forthcoming articles.

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Daily Value Investments: CFLs

This section of my blog is about Daily Value Investments. In this section, I will try to find daily value investments which could mean savings for consumers without reducing the quality of the product or their standard of living.

One of the most appropriate examples that we can find in daily value investments is CFLs (compact fluorescent lamps). This kind of light bulbs has a higher price than standard light bulbs, but, as you can conclude after reading this article, they are a long-term better option.

The main characteristic of this kind of light bulbs is that, while standard light bulbs only use 5% of the energy that they consume in illumination (because the other 95% is transformed in heat), CLFs transform almost all the energy in illumination without wasting energy.

This means a reduction in energy consumption. Thanks to this king of light bulbs we can save as much as 80% in the energy bill with more and better light, as they last between 6 and 10 times more than standard light bulbs.

Therefore, despite the price of CFLs is considerably higher than traditional light bulbs, they are much economic, since their low energy consumption pays for itself in the long run.

Moreover, this energy saving which is good for our bank account, it is also good for the environment, since CFLs help to reduce energy consumption and, hence, they help to reduce greenhouse gas emissions to the atmosphere.

This analysis of the long-term savings of using CFLs is also valid to other articles, such as electrical appliances. Before buying a new electrical appliance, he must take into account its energy consumption as I could be most cost-effective in the long-term to buy a more expensive electrical appliance with lower energy consumption.

If you want to calculate the saving on the energy bill and in CO2 emissions after changing from standard light bulbs to CFLs, you can do it easily in this website.

In conclusion, the intelligent investor will buy CFLs because they are a better long-term investment to their bank account and to the natural environment.

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Valuation Techniques I: Discounted Cash Flow

Value Investing consist simply on investing in assets whose intrinsic value is considerably lower than its market price. Therefore, the only two things that we have to take into account when we want to invest our money are current price of the asset and its intrinsic value. It seems very simple, but it’s not. As Jesse Livermore, one of the most brilliant investors, said:

“If you have one minute I’ll tell you how to earn money in the stock market. Buy at low prices and sell at high prices. If you have 5 or 10 years I’ll tell you when prices are low and when they are high.”

Discounted Cash Flows

There are several methods to calculate the intrinsic value of an asset. One of the most used is the Discounted Cash Flow (DCF) method. This valuation technique consists of calculating the current value of the asset discounting future cash flows to their current value. In order to do this, we use a discount factor, which is our required rate of return for that asset. This is its formula:

Let’s see an example of how it works. Let’s imagine that we have an asset whose expected cash flows for the following years are:

Year 1: 1000

Year 2: 1050

Year 3: 1200

Year 4: 1550

Year 5: 1400

Year 6: 2000

Moreover, let’s suppose that our required rate of return is 8%.

After calculating the discounted cash flow, we have the value of 6,131.18 € for the asset. This means that if we pay 6,131.18 € for this asset now, it will give us 8% annual yield during the next 6 years. If our discount factor was, for example, 10%, the value of the asset would change to 5,735.35 €. I have uploaded this excel file in which you can see the calculations and you can change the different values of the cash flows and discount factor and see how the value of the asset changes. It is important to get used to use excel spreadsheets in financial asset valuation because it is a very useful and complete tool in which we can calculate values in an easy way.

The problem of using discounted cash flow model in company valuations is that it is not as straightforward as it looks. Firstly, we have to select the appropriate discount factor, which will be different for each investor and will depend on the equity and the expected return of the investor. Another problem is that we are taking into account FUTURE cash flows, so we are forecasting something that we don’t know accurately. Sometimes we will not have any idea at all. For example, anybody could forecast Google's or Apple's profits in 5 or 6 years time?

In forthcoming articles we will study more in depth discounted cash flow method and other ways of asset valuation, such as the use of multiples, real options and other qualitative valuation methods.

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Biographies: Warren Buffett

Since the name of this blog is “Buffett’s Smile”, the first biography could not be another person. I understand that most of you would know many things about his life and all related to Warren Buffett, but he is a compulsory bibliographic reference inside the Value Investing world. I know that there are many things to say about Warren Buffett, but I will try to summarize the most important aspects of his life, investing approach, achievement, quotes, etc.

Buffett’s life

Warren Edward Buffett, also known as “the Oracle of Omaha”, was born 30 August 1930 in Omaha, Nebraska (USA).

He studied in Nebraska University, and after that, a master’s degree in Columbia Business School, where he was student of Benjamin Graham, authors of books such as “Security Analysis” or “The intelligent Investor”.

After that period, he worked with Graham, following the investment rules of this master. He came back to Omaha in 1956 without any plan in his mind, since some people asked him to manage their investments. Warren Buffett started that way.

In 1965, he bought a company of the textile sector with financial problems, called Berkshire Hathaway. It was transformed in a holding for his investments in media, insurance and consumer products, among others. Buffett bought several of these companies at a very low price in the 1973/1974 recession.

Nowadays, he is still managing Berkshire Hathaway. His last purchases were stocks of companies such as Tesco retailer (where I buy my food here in Dublin), Kraft Foods Company and rail transportation company Burlington Northern Santa Fe.

His political ideas are related to the Democratic Party. He has positioned himself several times in favour of an increase on taxes for the richest people and in favour of an increase on inheritance tax, since, according to Buffett, it is an obstacle to meritocracy.

Buffett is also famous by its philanthropy. In fact, he has gone down in history thanks to its donation to Bill & Melinda Gates Foundation, of over 30 billion, which is the highest donation in history.

Investing Approach

Warren Buffet is the best representative in Value Investing. The main characteristics of his investments are the following:

• Simplicity: They are easy to understand and manage.
• Predictability: Their profits can be forecasted with relative accuracy.
• High return on equity, obtained without accountancy tricks or excessive indebtedness.
• High cash flow generation.
• Managed by people whose objective is to achieve shareholder value.
• Long-term investments.
• Never get carried away by trendy stocks.

Achievements

Buffett is the most successful long-term investor, with a compounded annual rate of return of 22.3% during 36 years, which means 128,515%.

The purchase of Coca-Cola stocks by Buffett meant for Berkshire’s Shareholders a profitability of near 800% in 12 years. Another less well-known investment was the purchase of Interpublic marketing company in 1973, with a profitability of over 900% in 11 years.

Buffett es el inversor a largo plazo con más éxito de todos los tiempos, con una tasa de retorno compuesta de 22,3% durante 36 años, lo que equivale a un 128.515%.

He bought Berkshire Hathaway’s shares at a price between $7.60 and $14.86. Berkshire Hathaway’s current share price is over $140.000.

His estimated net worth is $56.9 billion.

Curiosities

He filled his first tax form at the age of 13 in order to deduct its bicycle as a work expense.

His favourite drink is Cherry Coke.

His favourite music instrument is ukulele. In fact, he plays ukulele in each Berkshire Hathaway’s Annual Shareholder Meeting.

Warren is still living in the house that he bought in 1958 for $31,500. Nowadays, that house is worth $700,000.

Buffett was the only student who got a mark of “A+” with Benjamin Graham as professor.

His salary is $100,000 annually, the lowest salary of all chairmen of the 500 largest American companies.

Quotes

Warren Buffett has many famous and good quotes, most of them brilliant. I am going to show my favourites, but I want to encourage you to add your favourites to the comments.

"Rule No.1: Never lose money. Rule No.2: Never forget rule No.1."

"Price is what you pay. Value is what you get."

“The dumbest reason in the world to buy a stock is because it's going up.”

Personal Opinion

There are very few people like Warren Buffett in the world. Warren in an example on how working hard, persevering and with clear ideas, people can go far, as much in life as in business. I would like to highlight three qualities of Buffett: simplicity, sensibility and integrity. Probably, these three qualities brought Warren Buffett to where he currently is. Finally, Warren, I wish you good luck in your life. Go on Mr. Buffett!

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