The art of business valuation is not something that can be taught overnight. Understanding how to value a business and the various different factors that can influence valuation takes years to understand.
The thing is, every single company is different. That means every single valuation process will need to take into account the business's differences. Other factors such as interest rates, competitive forces and the wider industry's state will also need to be considered.
As much as some investors might like to boast, it's impossible to repeatedly accurately predict a company's value. There are just too many variables and factors to consider.
However, when it comes to the process of valuation, there's one method of learning that Warren Buffett (Trades, Portfolio) believed was better than any other, and that was the strategy taught by his mentor, Benjamin Graham.
At the 1998 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, Buffett explained:
"Ben made it terribly interesting, because what we did was we walked into that class and we valued companies. And he had various little games he would play with us. Sometimes he would have us evaluate company A and company B with a whole bunch of figures, and then we would find out that A and B were the same company at different points in its history, for example...
But I would, you know, if I were teaching a course on investments, there would be simply one valuation study after another with the students, trying to identify the key variables in that particular business, and evaluating how predictable they were first, because that is the first step. If something is not very predictable, forget it. You know, you don't have to be right about every company. You have to make a few good decisions in your lifetime."
This process is not designed to arrive at accurate valuations all the time. Indeed, that's something Graham and then Buffett tried to avoid because they knew how difficult it was to accurately predict a company's valuation down to the last dollar and cent.
However, what this process does is build a framework for investors. By repeating the tests, again and again, it's possible to compile a guide of what works and what does not. This can streamline the process in the future.
As Buffett said in 1998, knowing what you can and can't predict is critical when working with valuations. If one tries to predict something one has no insight into, the answer will be incorrect. That's not investing. That is gambling and speculating.
"Where we've been — where we've done well, Charlie and I made a dozen or so very big decisions relative to net worth...and we've known we were right on those going in. I mean they just weren't that complicated. And we knew we were focusing on the right variables and they were dominant. And we knew that even though we couldn't take it out to five decimal places or anything like that, we knew that in a general way we were right about them. And that's what we look for. The fat pitch."
That was the approach students should be using, Buffett summarized. They should not be trying to "learn the impossible." Rather than trying to understand something they don't know, investors should focus on what they do know and stick with companies in sectors they know well, increasing the probability of making an accurate prediction.
Put simply, it's all about practice and sticking with what one knows and understands. Unfortunately, there's no shortcut when it comes to the topic of business valuation. Hard work is key.
Disclosure: The author owns no share mentioned.
Read more here:
- The Challenges, Benefits and Drawbacks of Value and Momentum Investing
- The 1 Simple Rule Required to Be a Great Investor
- Peter Lynch's Advice From 1993 Is Still Relevant Today
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