What should be the price for the high quality business?
Updated: Aug 9, 2021
Before we try to answer the right price point, we must first understand what creates the price of a company or, in other words, the ‘value’. Although there are many valuation approaches used by investment professionals, the one used by Warren Buffet based on Benjamin Graham investment philosophy is the most logical.
Element 1: The value of the assets
Financial analysis requires you to have basic accounting knowledge. You don’t have to remember accounting standards, but you have to have knowledge that helps you understand what’s going on in a company.
Any company would have some worth associated with its asset base. Knowing the “asset worth minus any liabilities” is the first element of value for the company. There would be cash, accounts receivable, marketable securities etc., whose value is more reliable. And there would be assets such as plant, property, machinery etc., that may not represent the actual worth. You can take the value of current assets as given in the balance sheet. But the fixed asset value has to be adjusted to represent its current worth. Similarly, current liabilities are assumed to be fair, as represented in the balance sheet. The exact calculation would depend upon whether the company is going into liquidation or you expect the company to exist going forward.
Element 2: Earning power value (EPV)
We always want to look into the future and identify investment opportunities. There is no way anyone can look into the future and be 100% sure that the forecast will become a reality. Another way to look at a company is to assume that the company will not grow. The company continues to exist, but the growth is zero. EPV would indicate the worth of the company in today’s time without any assumptions about the future.
EPV can be calculated as Earnings / Cost of capital
The difference between earning power value and the asset value is the Franchise value of the company. If the difference is positive, it indicates the competitive advantage enjoyed by the company. If the difference is negative, management is not using the firm's assets as it should.
Element 3: The value of growth
The value of growth is the most unpredictable element of value for a company. Unfortunately, many professional investors spend most of their time refining analysis related to the value of growth. A company that enjoys a competitive advantage and has a barrier of entry will enjoy the value of growth. However, companies that do not have any competitive advantage will have a negative value to this bucket. Growth in any company comes when new investments earn a return higher than the cost it spends. Unfortunately, only those companies with a competitive edge can make the return more elevated than the cost over a long period.
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