How to Approach Determining Value

 | Dec 13, 2011 | 10:30 AM EST  | Comments
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In my previous two columns, I noted the importance of focusing on the sustainability and predictability of a company's sales and earnings and discussed what I believe is a deficiency in the traditional use of its P/E-based valuation to reflect the full value of these business characteristics. Some readers commented that they understood that concept -- but they asked, "What should we use to make a value judgment on an investment?"

As I pondered a response to that question, I could only think of the final words uttered by Kurtz in Joseph Conrad's Heart of Darkness, "The horror! The horror!" Why? Because the more time I traveled up the river of equity valuation tools (NAV, DCF, P/E, EV/EBITDA, etc.), the less confidence I have that any of them in isolation would accurately indicate a company's worth or the success of an investment.

In practice, I have learned that equity valuation is as much an art as it is a science. While each valuation methodology mentioned above can be valuable, they are all based on endless assumptions with great variability and sensitivity to small changes.

For this reason, I believe the emphasis should begin with a common sense inquiry with critical thought given to whether a potential investment is a good business in a growing industry. Does it have a sustainable and predictable business model? A correct judgment on those items will likely be more valuable than an investment made exclusively on a valuation methodology basis. Why? Because the affirmative and correct answer to questions like those gives you room to be wrong in the short term.

Accepting that no valuation method is perfect, great businesses can grow into an imperfectly timed stock purchase. However, the valuation floor for cyclical and short-cycle business models is much lower and less forgiving than for exceptional companies. Need some evidence? Let's take a closer look within the bear market of 2008. Of course, 2008 was a financially focused collapse, but the most severe price erosion occurred in previously low valuation stocks including Dow Chemical (DOW), Citigroup (C) and General Electric (GE). The relative declines experienced by terminally cited high fliers such as T. Rowe Price (TROW), Amazon (AMZN), and Danaher (DHR) were much less severe and their subsequent recoveries were  substantially greater.

While I recognize this column is short on hard answers about how to pin down valuation, I wish to emphasize that it's important to begin your investment analysis by trusting in a vital investment tool we all possess (albeit in different magnitudes): common sense.

From there, be flexible and base your common sense review of a business on a variety of valuation methodologies. No formulas exist to capture a confirmed intersection of the two, so spacing out your buy and sell decisions can help you create the best timing.

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