I think that what has helped me improve my ability to value companies the most over the years is thinking about different aspects of valuations, and getting experience with different companies and the situations / people involved – all of which have an effect on valuations.
One of the most difficult things about that is getting the right experiences that lead to the right things to think about, because experience takes time and it’s difficult to know where to start. To that end, I figured an article about doing valuations which focuses on the thinking around valuations might help beginners.
To be clear, the aim of this article is not to teach you how to do a valuation. Rather it’s to get you thinking about how the valuations you do relate to your financial return and your situation.
This isn’t a planned set of thoughts, I’m just going to freewheel it and see what comes out. So let’s dive in!
Valuing A Company That Does Nothing
How much do you suppose a theoretical company is worth that doesn’t do anything, doesn’t have any costs and has $1m in the bank? It could be argued that it’s worth $1m, right?
But then why would you buy an entity that has the same value as money, but is less fungible? For all your efforts, all you could do is get your $1m back if you drained the money our the company’s bank account, then it’d be worth nothing. Perhaps we can say that actually it’s worth $1m, minus the value of your effort to extract the money and do the valuation, minus the profit you require for doing that work?
But what if you got it wrong and it turned out that the company had some hidden debts? Maybe that same company should also have a risk premium removed from it’s value to cover off some percentage change that you didn’t do your due diligence properly?
A Company That’s Earning
How much do you suppose a theoretical company that earns $10k every year is worth? I suppose in part it depends how much percentage of your money you want back each year. Say that company pays all the money out in dividends and you’re getting 5% pa from having your money in the bank, you might want at least 5% pa return from the dividends to match the bank (which we might consider the risk free rate). That would value the company at $200k ($10k / 5 * 100). I suppose you’d probably want to deduct a risk premium, etc. as in the previous example, so actually it’d be worth less than $200k.
What if the company earned $10k pa, but retained those earnings so you could never get them? Would that affect the value? Would it even be worth anything? Perhaps if you can buy the entire company then you can make them pay you out? Perhaps there’s another shareholder with different goals to you and wants to keep putting the money back into the company to try to grow the company? How does that affect the valuation?
A Company That’s Growing
How much do you suppose a theoretical company that earns $10k a year, but grows it’s earnings by 14% pa is worth? It wouldn’t be fair to ascribe the same value as the previous example because in 5 years of compounding return, the company would be returning double the yield. Perhaps it’s worth double? But then in 10 years time it will have doubled again. Perhaps it’s worth quadruple? But then you’re paying the price for a company now that’s actually a future version of itself. Somewhere in between there’s the right price. Maybe this depends on your investment time-frame, how much risk you think there is to future earnings and other opportunities that are available at the time? Here’s a set of graphs I’ve made to try to solve this problem (hint: I use these a LOT).
Summary
Hopefully that’s given you something to think about that you can apply to the logic you use in investing and valuing. What other considerations might impact how you value a company? Leave a comment below and we can continue the conversation and improve our thinking together 🙂
