Friday, 20 September 2013 10:35
Financial — The Best Way to Value a Business
My equity investment philosophy is deceivingly simple buy stakes in great businesses, run by great managers when they are priced below what I believe they are worth. Hold them until they become overpriced, I find a better opportunity, or my assessment has changed. The lynchpin to this investment approach is having a strong sense of a company’s value. After all, how do you know you are getting a bargain price unless you know what something is worth? Valuing a business is part art, part science. It is a complicated process that requires clear thinking, due diligence, patience, and a generous helping of humility. My investment approach helps me to both reduce errors and uncover opportunities in pursuit of capital preservation and growth. Comparatively, the industry convention of relying on simple multiples of reported earnings is a shortcut - and taking shortcuts endangers capital. Valuing a Business The main sources of intrinsic value for most businesses are its cash flow and assets. If a company is a profitable, going concern, it is worth the present value of the stream of cash the business will produce for its owners plus the net value of any non-operating assets on the balance sheet. For companies with no - or rapidly dwindling - cash earnings power the enterprise’s worth might be the liquidation or secondary market value of its assets. I focus on the former so much of my appraisal effort is determining how much cash the business produces and how that amount will likely change over time. Forecasting future cash flow is obviously a challenge. However, calculating current year cash generation - the starting point of any reliable appraisal - is also complicated. Reported Earnings Reported earnings (earnings per share - EPS) are calculated in accordance with Generally Accepted Accounting Principles (GAAP), a set of guidelines which allows plenty of room for estimation and interpretation. This alone should lead one to be wary of reported earnings. Add to that the strong incentive for executives to manipulate earnings, either up or down, and one should be downright skeptical. A recent study found that 20% of publicly-traded firms manage reported earnings. The bottom line is applying one set of accounting rules that satisfies multiple objectives for multiple constituencies to all global, public companies leads to results that are, at best, suspect. Owner Earnings I rarely mention earnings per share when discussing the value of a business. Instead, I focus on a term Warren Buffett coined - Owner Earnings (O/E). Though my calculation of O/E varies a bit from Mr. Buffett’s, I borrowed the label because it effectively focuses me on what, at the end of the day, is the key source of value - the amount of cash generated by a business that could be distributed to owners without harming long-term operations. Calculating O/E requires an analyst to spend as much time with the Cash Flow Statement as the Income Statement or Balance Sheet. Each line item and accompanying note must be scrutinized for its potential to be manipulated and its impact on the company’s sustainable cash generation. Occasionally, at the end of the exercise, my owner earnings are similar to reported earnings. More often than not, however, the two differ materially. Unconventional Investing Rote reliance on EPS and P/E (price-earnings) ratios can result in investing errors - of both omission and commission - that jeopardize capital and squander opportunities. Through a careful study of the data and rigorous due diligence, I strive to thoroughly understand how the companies I research operate and the true drivers of their intrinsic value. With this strong sense of economic worth and my commitment to in-depth research, I gain unique insights that put me in a better position to protect and grow capital. FenimoreAssetManagement is an independent investment advisory firm located in Cobleskill, NY since 1974. Fenimore’s affiliates are the Fenimore Private Client Group & FAM Funds – offering separately managed accounts and mutual funds. In-depth research. Insightful investing.