The art of business valuation: 3 Methods

Picture this: You’re walking down Wall Street, and suddenly you have the opportunity to buy a business. Not just any business, but one that’s caught your eye for months. The owner slides a folder across the table and says, “Make me an offer.” How would you determine what it’s worth?

This scenario isn’t as far-fetched as it might seem. Whether you’re investing in stocks, planning to buy a local business, or simply want to understand how the world’s top investors think, knowing how to value a business is an essential skill. As Warren Buffett, the Oracle of Omaha, famously said: “Investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.”

Let’s embark on a journey through the three fundamental approaches to business valuation, each with its own story to tell.

The neighborhood approach: Relative valuation

Imagine you’re house hunting. You find a beautiful three-bedroom home, but how do you know if the asking price is fair? Naturally, you’d look at similar houses in the neighborhood that recently sold. This same logic applies to valuing businesses.

The story behind the numbers

Take the beverage industry giants, Coca-Cola and Pepsi. When investors value these companies, they often compare them side by side, looking at metrics like their Price-to-Earnings (P/E) ratios. It’s like comparing two similar houses on the same street – they might look alike, but subtle differences can significantly impact their value.

Here’s what seasoned investors look for:

1. Price-to-Earnings (P/E) Ratio: Think of this as the price per slice of the profit pie. If Company A trades at a P/E of 20 and Company B at 15, you’re paying $20 vs. $15 for each dollar of profit.

2. Enterprise Value-to-Revenue (EV/Revenue): This is particularly useful for high-growth companies that aren’t profitable yet – imagine valuing a startup based on its potential rather than current profits.

3. Enterprise Value-to-EBITDA: Consider this the sophisticated cousin of P/E, accounting for different ways companies might finance their operations.

The treasure hunt: Asset-based valuation

Let’s switch gears and imagine you’re a treasure hunter. Instead of looking for gold, you’re searching for valuable assets within a company. This approach is like taking inventory of everything a business owns and determining what it’s all worth.

Hidden gems and concrete values

Consider a real estate company or a manufacturer with expensive machinery. Their value story isn’t just about profits – it’s about the concrete assets they own. This method reveals three interesting layers:

1. Book value: The accountant’s version of the story – what’s officially on the books.

2. Liquidation value: The “fire sale” scenario – what you’d get if you had to sell everything quickly.

3. Replacement cost: The “rebuild from scratch” number – particularly important when considering barriers to entry.

Take Porsche, for example. The company trades at a Price/Book value of just 0.2x – meaning you could theoretically buy the company for less than the value of its assets. But as with any good story, there’s usually more than meets the eye.

The crystal ball: Future earnings valuation

Now, let’s put on our fortune teller’s hat. The most sophisticated investors spend countless hours trying to predict a company’s future earnings. This is where the art of valuation truly meets science.

Reading the tea leaves

Imagine you’re buying a toll bridge. To value it, you’d want to know how many cars will cross it in the future and how much they’ll pay. Similarly, when valuing a business based on future earnings, investors use two primary crystal balls:

1. Discounted Cash Flow (DCF): This method attempts to calculate the present value of all future cash flows. It’s like determining how much money you’d need today to have a specific amount in the future, accounting for risk and time value of money.

2. Dividend Discount Model (DDM): Perfect for companies that pay regular dividends, this method is like valuing an apartment building based on expected future rent payments.

Putting it all together: The art of the deal

Like any good story, business valuation isn’t about following just one plot line. The best investors weave together multiple approaches to create a complete narrative. Here’s how to craft your own valuation story:

The master’s approach

1. Know your character: Understanding the business model is crucial. A tech startup needs a different valuation approach than a mature manufacturing company.

2. Set the scene: Consider the economic environment, industry trends, and competitive landscape.

3. Plot development: Use multiple valuation methods to cross-check your findings. Each method adds a new layer to the story.

4. The twist: Always be prepared for unexpected factors that could change the valuation – new technologies, regulatory changes, or market shifts.

Moral of the story

Business valuation isn’t just about crunching numbers – it’s about understanding the story behind those numbers. Whether you’re a seasoned investor or just starting your journey, remember that every business has its own unique narrative. Your job is to understand that narrative and determine what it’s worth.

As you develop your valuation skills, you’ll find that the process becomes less about rigid formulas and more about understanding the broader story. After all, as Warren Buffett demonstrates, the best investors are often the best storytellers – they just happen to tell their stories through valuations. Happy hunting!