2 Useful Steps to Get Better at Valuing Companies

Avid Foolish readers may be aware that the act of valuing of a company is part science and part art. The language of choice for company valuation may be mathematics, but the effectiveness of the valuation technique is far more subjective. With that in mind, I would like to share two useful, pragmatic tips on how to be better at valuation for the Foolish investor to consider.

Alice Schroeder on how Warren Buffett values companies:

Alice Schroeder is the author of the best selling biography of Warren Buffett, Snowball: Warren Buffett and the Business of Life. Once responding to a question in an online forum about Buffett’s valuation techniques, she provided this interesting insight:

“How Warren would value a company. First let me just start by saying that all value investing works. If you buy a dollar bill for sixty cents over time you will make money. So the search for a single method is to some extent a chimera. Warren’s way is very simple. I have copies of an envelope or two where he did his calculation on the back – literally. If the margin of safety is wide enough, it almost doesn’t matter what method you choose.”

Her comment deserves more attention.

Firstly, there is no perfect way to value a company. Secondly, it is up to the private investor to choose good businesses which can make the job of valuing a company easier. If the good businesses that are chosen continue to perform, it might be sufficient to stick to simple calculations – in this case, even on the back of an envelope.

In my opinion, investing is not an activity where you can choose a poor company, and attempt to “make up the difference” through the wizardry of valuation. I believe that it is much more important for the business to fulfill whatever projections or assumptions you make, rather than to perform complex mathematical gymnastics which may turn out to be ineffective.

In short, when it comes to valuation, investors should perhaps pay more attention to the quality of the assumptions which go into the calculation, and not the cleverness of the mathematics involved.

Advice from Tom Gayner, Chief Investment Officer of Markel:

Tom Gayner is the Chief Investment Officer and President of US-based speciality insurer, Markel. Over the 20 years ended 2013, the value of Markel’s investment portfolio per share has compounded at 13% per year under Gayner’s guidance, far outpacing the 8.6% annualized returns of the S&P 500 (a broad US share market index). Gayner had this to say about valuing businesses:

“The numbers are important but not as important as your soul or other intangibles. Just giving the numbers is like describing people using their body temperature.”

Gayner had a key point to make about valuing a company and that is investors should pay attention to both the business behind the ticker and the chosen valuation technique. Performing a valuation on a company should not the be-all and end-all of a complete rational analysis of a firm. Defining a company by one metric alone (say, the price-earnings ratio) would indeed be like defining a person based on just his or her body temperature. The numbers may not be wrong, but it would be a woefully incomplete view of a company.

A Fool’s Take

Valuation techniques are but one of the many tools that Foolish investors have at their disposal to create an investment thesis for a company. If we want to beat the SPDR STI ETF (SGX: ES3) – a proxy for the market barometer, the Straits Times Index (SGX: ^STI) – we should use our tools in the best possible manner. And, that means figuring out pragmatic ways to incorporate valuation into our overall investing thesis.

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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 Chin Hui Leong owns shares in Markel.