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Seth Klarman's Methods for Valuing Companies
In his phenomenal book Margin of Safety, Klarman talks about The Art of Business Valuation. The Problems and how he approaches them. Let's discuss his strategy!
The Difficulty of Valuing Companies
The problem of valuing companies lies in the nature of uncertainty and our incapability to properly deal with it.
Whenever we have to do with numbers, we get a false sense of precision and correctness. Ultimately, the result shown in our calculator or spreadsheets is correct, mathematically.
The problem is not the calculation part. The problem is the input.
“Any attempt to value businesses with precision will yield values that are precisely inaccurate.” - Seth Klarman
The seeming precision of DCF models, NPV or IRR calculations gives investors a false sense of certainty in their results.
We place great importance on the output and little attention to the assumptions made in our model.
We should do it the other way around. The primary focus should be on the inputs and skepticism should be placed on the outputs.
In finance, there is a term that describes the process of flawed models and calculations with regard to wrong assumptions: “Garbage in, garbage out.”
Seth Klarman’s Strategies to Solve this Problem
In his book, Margin of Safety, Seth Klarman outlines what he does to tackle this inherent problem of modern valuation calculations. Here they are:
1. A Range of Value
The first and simplest thing to do is to look at the “expert” opinions of Wall Street analysts. Search for a stock and look at the price range of analyst estimates.
It’s not uncommon to see 100% discrepancies between the highest and the lowest estimates.
“Markets exist because of differences of opinion among investors.”
2. Business Valuation
Klarman only uses three different ways to analyze a business.
2.1 Net Present Value
The Net Present Value (NPV) is the discounted value of all future cash flows that a business is expected to generate. In my post last week, I walked you through it. Check it out if you missed it:
The method has its flaws, as I explained in the article. But with the idea in mind that you shouldn’t place too much weight on the outcome and rather question your inputs and their likeliness, it can be a helpful tool.
2.2 Liquidation Value
Liquidation value analyzes the expected proceeds if a company were to be dismantled and all assets were to be sold off.
Depending on the situation, you would need to apply discounts to assets that can’t be sold easily at market value. This approach varies a lot from company to company and their individual situations.
2.3 Relative Value
This method takes into account at what prices or multiples similar businesses trade. It’s less precise than the other two methods, and the main problem is finding these “similar” businesses.
Very few businesses are actually comparable and it’s a method only helpful when there’s a very clear undervaluation in contrast to industry peers.
If you want further information on any of these methods, let me know. As mentioned, the DCF is explained in detail in last week’s episode.
If you want stock examples, look at my Visa or Alibaba valuation:
A Net Asset Value approach will follow in my next Deep Dive (Send to Paid Subscribers on December 1st).
Choosing Among Valuation Methods
Generally, a Net Present Value calculation, for example, through a Discounted Cash Flow Model, should be used when you value a company that is mature enough to generate reliable and, as best as possible, predictable cash flows.
It is also useful when you value utility businesses or other businesses that are characterized by regulated rates of return. They are “bond-like” businesses in terms of predictability of cash flows and thus can be valued by a DCF pretty well.
Liquidation value should be used when you value unprofitable and “dying” businesses that are not likely to achieve a turnaround and become profitable again.
Their future will be a liquidation sooner or later and thus, this method is the most accurate way to come up with intrinsic value.
In cases that are not as clear, which is true for most, you should use all three or variations of them. Many businesses have volatile cash flows, for example.
They can produce large cash flows but also have years where their cash flow is significantly lower. Other companies might be in short-term trouble and face bankruptcy but can turn around and suddenly become profitable again.
In the end, there’s no 101 guide for Investing.
The art of business valuation is getting a feeling for context and acting upon that feeling.
Thanks for taking the time, and have a wonderful Sunday!
See you next week!