Business valuation has to be one of the most challenging parts of investing.
Trying to place a value on a stock's underlying business based on its fundamentals is not only a lengthy process but also one that is based on a considerable amount of subjectivity.
The figures and statistics used will be based on an investor's understanding of the company and its sector. Discount rates will also vary from invested to investor and industry to industry.
Building a strategy
With so much uncertainty in the evaluation process, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have decided that the best way to invest for the long-term is to find cheap, high-quality companies that they can own for several decades.
Buying these businesses and holding on for decades eliminates the risk that they will have to sell and find another opportunity.
Munger shares his advice on valuing good business in his unofficial biography, "Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger."
For example, on the topic of buying good companies for the long term, Munger wrote:
"We're partial to putting out large amounts of money where we won't have to make another decision. If you buy something because it's undervalued', then you have to think about selling it when it approaches your calculation of its intrinsic value. That's hard. But, if you can buy a few great companies, then you can sit on your ass. That's a good thing."
The book also contains his advice on how to find good companies. Specifically, Munger has said that investors should be looking for businesses that can earn a high return on capital, and this money can be taken out by its owners at the end of the year. Businesses that have to reinvest the majority of their profits should be avoided.
"There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested— there's never any cash. It reminds me of the guy who sells construction equipment— he looks at his used machines, taken in as customers bought new ones, and says, "There's all of my profit, rusting in my yard." We hate that kind of business."
The final tip from Munger that I'm going to highlight in this article is his thoughts on approaching business valuation as an owner.
Munger wasn't a huge fan of Benjamin Graham because he believed Graham spent too much time concentrating on the numbers and not enough time considering the intangible benefits of a business.
However, Munger has still praised some of Graham's ideas, including his belief that whenever you approach as stock, you should evaluate it as if you were looking to buy the entire business:
"As one factor, Graham had this concept of value to a private owner— what the whole enterprise would sell for if it were available. If you could take the stock price and multiply it by the number of shares and get something that was one-third or less of sellout value, you've got a lot of edge going for you."
Experience pays off
Over the past five decades, Munger has evaluated and invested in thousands of businesses.
Only Buffett has more experience in the process of valuation. It would be impossible to distill all of his ideas on valuation down to just three quotes, but I believe the above nicely summarizes his thoughts on the matter.
The quotes don't give you a short cut to investment valuation, but I think the sum up some of the essential parts quite well.
If you spend your investment career buying high-quality companies with good long-term outlooks and strong cash generation and approach each company as an owner, you won't become a great investor overnight, but you'll be on the right track.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Buffett's Advice for Improving Your Strategy: Keep Reading and Learning
- Ben Graham: Don't Chase Fashion Stocks
- What Is Important and What is Knowable
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