How to determine the fair value of a business
A great investment is determined by its price. Thus, in stock investing, it is key to determine the intrinsic value of a business and compare it to the current market price. There are some aspects you should always bear in mind.
A lot of people buy and sell stocks very frequently. They believe they can outperform the market. What drives their decision is a strong behavioral bias. Unfortunately, in most cases their decision is based upon emotions only. As a professional investor you will not act upon your feelings nor will you sell stocks very frequently. Instead, you are in permanent search for a great business to purchase at a good price. Once found, you may hold it for the rest of your entire life to take advantage of the profits it generates for you.
A key aspect in investing is to determine the intrinsic value of a business. In theory, the formula for fair (intrinsic) business value is straightforward:
However, in practice, it is tricky to find the appropriate values for the numerator and denominator.
The future cash flows.
A business uses assets to generate revenues. To do this, it too produces a bunch of costs. The very last piece of the cake that is left after all other stakeholders (suppliers, employees, banks, governments etc.) have been paid belongs to all business owners, i.e., shareholders.
To determine the future cash flows is what a whole armada of investors, analysts, and other experts are trying to do day after day. Some of them have almost unlimited resources and knowledge, but guess what: it turns out that they are failing in most of the times. If you ask seven experts about the future cash flows of Volkswagen, Tesla or Coca-Cola you are likely to get 13 different answers. Some are optimistic, others are pessimistic. Unfortunately, no one can predict the future. Great investors should not only know, but accept this fact.
You should not be disappointed since there is a silver lining. When you have to make a decision whether to invest in a business that is supposed to provide risky, i.e., uncertain, future cash flows to you, you should apply the Margin-of-Safety Principle and stay within your Circle of Competency. Following Warren Buffett:
"It is better to be approximately right than precisely wrong."
What he means by this is, you should live with the fact that you can come up with not more than a best guess about the future cash flows. As a passive investor you would reduce your risk by diversifying, i.e., to invest in the whole market. On the other hand, if you consider yourself a professional investor you may reduce your risk by doing exactly the opposite: only invest in a small number of great businesses you truly understand.
If you want to learn more about a particular business you need to understand its strategy, its business model (incl. the industry and competitors) as well as its financials. Doing so, you will be able to come up with a possible range for the future cash flows. Still, it is very likely that this range will turn out to be wrong, but if you are really pessimistic in your assumptions - by applying the Margin-of-Safety - it should serve as a risk buffer to you.
The discount factor.
To predict the future cash flows is one thing, but finding the appropriate discount factor is another. Indeed, it is necessary to discount the future cash flows to get to the present value of the business. Let's have a closer look on what "appropriate" means in this sense....
I have already concluded that the future cash flows of a business are uncertain, i.e., risky. The degree of risk inherent to the cash flows should be reflected by the discount factor. The higher the risk, the higher the discount factor.
A great part of finance theory and MBA classes is dedicated to find the correct discount factor. As always, theory offers a whole bunch of different valuation methods that are supposed to work under different circumstances. Note, you will still see many bankers, accountants, fund managers and CFO's applying what they have learned in classrooms. Maybe you have heard about the famous Capital Asset Pricing Model (CAPM), which is supposed to determine the company's cost of equity. Even though empirical studies have proven that the CAPM is not working at all, it still is the most commonly used approach - not only in classrooms.
Unfortunately, for the denominator the same thing is true what we have already concluded for the numerator: you can spend a lot of effort trying to compute an appropriate discount factor, but at the end it turns out to be useless. For instance, when Warren Buffett was once asked about how he determines the appropriate discount factor he said that it is nonsense to believe you could come up with an exact number for it. He rather applies the Margin-of-Safety principle and stays in his Circle of Competency. When doing so, he can reduce his risk and thus takes the rate of a Treasury Bill to serve as a proxy for the discount factor.
I highly recommend to read chapter 20 on the Margin-of-Safety as well as chapter 8 about the irrational behavior of markets in The Intelligent Investor by Benjamin Graham here*.