The greatest investor of all times puts high emphasis in the importance of business valuation. Think about it, if you were buying a private business, terms like earnings-per-share (EPS) or price-earnings (P/E) and many other ratios, do not matter if you are purchasing a private entity. You shouldn't change this approach when valuing a public company.
The important thing to know is how much cash the company will generate. Where will the cash go? To pay for expenses or buy equipment, pay employees or to their bank account, this is the key.
There is a pretty famous example detailing valuation. It involves a "dollar machine" handing out one dollar every year for ten years. Pause for a moment and think, how much would you pay for this machine? See the answer at the end and measure how you did!
To grow a business you need cash. Revenue and earnings can be irrelevant if all the sales are made on credit. A company who sells annually 1000 automobiles for $10,000 each on credit, totaling $10,000,000 in annual sales but does not receive cash until the customer makes their first monthly payment, shows really no merit to base a valuation in their EPS or to determine the enterprise value using their P/E. In this case, the $10,000,000 is really not an important figure unless you are able to determine how likely the customers are able to pay.
The net worth of a company (sometimes refer to as tangible net worth) plus the future cash the business will generate should be able to provide you an approximate value for a business in the future and today. Remember from our previous blog (Buying AutoNation?), you need to set a discount to the valuation. Your valuation numbers should not be a precise science and you must leave room for mistakes. Benjamin Graham called this, margin of safety, listen to him, he was a pretty smart guy.
I will finish this post with a perfect example of cash value. Take a look at Apple (AAPL) and you will see why Berkshire Hathaway (BRK.A) started buying Apple shares when the company was valued at $575,000,000,000 or $108 / share. Just in cash and investments Apple holds $237,000,000 or $45 / share.
Going back to the "dollar machine", it is pretty common sense that you should not pay $10 or higher for this machine. What about $9? Good! But let's assume you can invest $9 at 7% annually in another investment . You will have $17 by year 10 and the "dollar machine" might not look like a great deal. So, if you can achieve 7% annually in another investment but without the certainty the "dollar machine" gives you of $1 annually. You can reverse engineer how much should you pay for the machine today in order to achieve 7% annually. The magic number is around $5.08!
Remember, this is your investment opportunity. Other investors will reach different valuations highly dependent on what other returns they can achieve elsewhere.
Follow this form of business valuation and create the habit and mentality that you are buying wonderful businesses in their entirely and not just a share. This will help you to free yourself from market noise and nonsense. It will make you a better investor!
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