1. Understand valuation limitations
a. There will always be a margin of error in your calculations
b. Future events and other unknown information cannot be wholly accounted for
c. Corporate financial data may be manipulated
d. It is important therefore to take a long-term view alongside your valuation and to diversify
a. There are many human biases which impact our decision-making capabilities
b. The most common example is how past performance affects our perception of an asset, but of course expensive assets have typically exhibited strong price performance.
c. Exhibiting strong biases may result in a style or factor preference and lead to a concentration of risk.
a. Companies may have a straightforward focus or be large global conglomerates. It may be impossible to dissect the granular detail but it is important that a company makes sense and fits into the modern world.
b. The company’s development strategy should be clear and focused.
c. The business should be making sound investment decisions.
d. This is an area where a depth of knowledge can add much value.
a. While a company is exposed to the economic environment, it will also be subject to pressure from its peers.
b. Is the company an industry leader, rising star, niche player or new entrant? and how does that position impact emerging threats and opportunities?
c. Understand the company’s competitive advantage. Is it well protected or vulnerable to substitutes or disruption?
a. Consumer trends, demographics, regulation, the environment and more. Long-term trends and positive structural factors may compound and play an important role in a company’s success. Being wise to these factors can improve your valuation methodology.
b. Understanding the individual business can add value but understanding how a company fits into the wider economy is equally important.
a. There is a wealth of data to assess but key focus will be on Earnings and Revenue growth, Profitability and Financial strength.
b. While qualitative analysis will justify your preference for a company, the financial data should guide your valuation.
c. Companies with large debt piles, poor cash flow and low growth should be discounted accordingly.
d. Predictable cashflows and earnings growth will command a higher premium.
a. Using your knowledge of a company’s history, financial performance, strategy, competition and market dynamics you can make well informed forecasts its prospects.
b. This is the necessary first step in calculating the valuation.
a. Your valuation model will typically discount future cash flows by a combination of your assessment of risk and opportunity cost.
b. There may be hidden value in ongoing corporate investment, research and development.
c. You may foresee various scenarios which lead to differing end valuations. This variance may need to be discounted and the manner in which these are combined into one single valuation may vary.
d. Various metrics can be used to corroborate the valuation to comparable companies
e. Remember, for your valuation to be correct, the market will have to agree with you
a. We typically associate stocks with specific company and market risk but other risk factors may include Geographic, Style, Economic, Regulatory, Inflation and Interest rate risks. Understanding the interaction with these risks will help discount valuations and build a well-diversified portfolio.
b. Some businesses may have outcomes with fatter tails and therefore be suitable for differing investment time horizons or valuation methods.
a. The proliferation of quantitative and trend following investment vehicles along with passive but selective vehicles means that sentiment and trends can carry more weight and leaving markets open to greater shifts in volatility.
b. Companies that have gained momentum may have done so because investment vehicles have channeled funds in their direction. An example of this that may play out in the years ahead with ESG assets.
c. Markets may determine prices which are not explained by normal investment behavior.