1. Valuation is an Art and a Science
Who said valuation is both an art and a science? The science part
is pretty easy. We can review a company's financials and calculate various
ratios, we can look at the company's track record or its performance over
time, we can also apply various statistical calculations using company data.
The more difficult aspect is the art of valuation, we would need to
evaluate the management team, the company culture and strategy,
whether the company has a sustainable and defensible moat, in other words,
does the company have a long term competitive advantage versus its competitors?
Also, forecasting is an art, you have to look at all of the
topics we've listed to help us predict how the company will perform in
the future. Let's look at an example of the relationship between the art
and science of valuation by looking at ratios and forecasting.
With regards to the science part of valuation,
we can look at the past performance of the company using common calculations
like return on equity, this is an easy and very common calculation,
all we need is the company's net income and its shareholders' equity.
We can then calculate return on equity and look at how that ratio
has changed over time. We can do the same with other ratios or
calculations, this is just simple math using a company's financials.
The more difficult part is trying to forecast company performance into the
future, this is where the art comes into play.
In order to project things like revenue, profits or cash flow,
we must have a deep understanding of the business and where it's going
for our forecast to be meaningful. We need to be able to assess
company management, how is their track record? Is the company culture one
of innovation? We also need to know a lot about the industry it
operates in, what is the nature of competition in the industry?
How competitive is the company with regards to its peers in the industry?
What are particular challenges or threats to the company we wish to consider?
There are also micro economic considerations like supply and demand for
the industry's products, as well as what is the optimal product price to
maximize revenue? Finally, you should also consider the macroeconomic environment,
what is happening with interest rates, foreign exchange, and any other macroeconomic
condition that might impact the value of a company?
This is all we mean when we talk about the art of valuation,
and based on all of this, we can then apply acceptable valuation methods
to determine what a company's worth. For more on analyzing a business,
we recommend you check out our course titled Analyzing Growth Drivers and
Business Risks.
2. Let's practice!