Valuing a company is one of the most important aspects of investing. After all, how can we invest if we do not have an idea of how much a company is really worth? However, since the valuation process can be subjective, we might not realize the mistakes we can be making when we are crunching the numbers. In light of that, here are some mistakes investors tend to make when valuing a company. Mistake No. 1: Thinking that a valuation model is better because it is more complex Warren Buffett once said: “There seems to be some perverse…
Valuing a company is one of the most important aspects of investing. After all, how can we invest if we do not have an idea of how much a company is really worth? However, since the valuation process can be subjective, we might not realize the mistakes we can be making when we are crunching the numbers. In light of that, here are some mistakes investors tend to make when valuing a company.
Mistake No. 1: Thinking that a valuation model is better because it is more complex
Warren Buffett once said: “There seems to be some perverse human characteristic that likes to make easy things difficult”. And unfortunately, it can be prevalent when trying to value a company. Some investors will try to make their valuation process as “complete” as possible by factoring in every variable they can think of; in the end though, shoe-horning every morsel of information they have into their spreadsheet might do more harm than good.
The reason is quite simple. The more variables they have in their model, the more assumptions they need to make. And the more assumptions they need to make, the more inaccurate the model might become.
Let’s run through a hypothetical-process of valuing the global commodity trader Noble Group (SGX: N21) as an example. As Noble is involved with commodity products that revolve around energy, metals, minerals, ores, and agriculture, investors might choose to make assumptions about every commodity the company trades in. In addition, given the global scale of the company’s business, investors obsessed over detail might even worry about the tax structures in every country that Noble operates in, and how currency fluctuations in each area might affect the company’s operations. But truth be told, given the magnitude of assumptions – not to mention the immense room for error each assumption contains – the carefully-crafted model that incorporates that diaspora of facts and assumptions might well be completely useless.
Mistake No.2: Placing undue emphasis on the final valuation figure
Meanwhile, there are investors who only care about the final value of the valuation process. Since we will need a figure to gauge if an investment is worth buying into, some investors might just rush through the whole analysis so that they can end up with a number in mind.
In doing so, they might not get to understand the full picture when it comes to the business and end up failing to ask fundamentally important questions. For example, there’s a real need to ask ourselves what are the risks each company is exposed to and what should be the discount rate we should be using in our valuation models in order for us to have confidence in our estimation. In a process that’s rushed-through, such careful thoughts might not have taken place.
What investors need is to probably find a middle ground between the two. There is always a tradeoff between the time spent, cost, and quality of our analysis. We should ask ourselves: With the time I have, how much information would I need to get the best estimation of value for a company?
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.