It is important to ask what business it is that we, as investors, are in. What is it that we are trying to do in the stock market.
Once we can answer this simple question, the approach and thinking that dictate our analysis will follow.
That is, if stocks are mere commodities to be traded, then it does not really matter at all what lies behind any particular stock – as long as we can buy low and sell higher, a stock by any name smells just as nice.
If we see the role of the investor as a business analyst and business valuation expert, then we do what any self-respecting specialists does and look real busy working at really difficult stuff for very reasonable hourly rates.
But if we see our ownership stock as ownership of a (share in the) business, then our approach to its analysis and valuation ought to be pretty simple.
That is, if we see ourselves as (part)owner of the business, then this investing business of ours is to own businesses – not to appraise or re-imagine its accounting; not to accurately predict its future growth rate and other trajectories.
In other words, we business owners are in the investment business, not in the accounting or business appraisal business.
While this sounds obvious, and maybe it is to everyone else but me, but I have seen a lot of very smart people putting too much emphasis on the accounting and business appraisal aspect of investing and not enough, if any, emphasis on what it is an investor, as a business owner, is getting themselves into.
While accounting is important; forecasts and future assumptions helpful… these are but preliminary work of secondary importance.
I know, accounting is the language of business; forecast and insight into future survival are key to the business as a going concern. I actually spent a couple of years developing a financial statement analysis software (ahem) so I do appreciate the importance of accounting…
So why then are accounting and projections secondary?
For one, accounting tells you past performance and always only provide a snapshot of the company’s position as at the end of some date back.
Second, pretty much all forecasts and assumptions beyond six to twelve months will turn out wrong; Forecasts beyond two to three years are just smarter people’s way of trying to look busy and sophisticated. That and even if the forecasts turns out right, they can be right due to reasons that weren’t factored in or given much weight in the original calculation.
Since past performance are not necessarily indication of future ones; since the future cannot be predicted with any certainty… unless you’re paid handsomely by the hour, why in the world would anyone want to forecast something based on various assumptions of all things being equal when in reality, nothing remains equal. It just does not make sense to be precise based on imprecise assumptions and estimates.
But most importantly, accounting and forecasts are of secondary importance because we investors are in the business-ownership business, not in the accounting or business appraisal business.
In other words, the company’s financials and accounting bring us investors up to date with its progress and previous achievements. It too provide some confident in our, often remote armchair warrior, analysis of the business and its likely future prospects… but to use accounting and maths beyond this getting-to-know-you phase is quite useless, time-wasting, and often dangerous and unprofitable.
That is, once our understanding of the financial statements brought us up to speed with the business and its position, the future can only be guessed at; should only be use as a rough guide that the business would do pretty much the same in the future it has in the past.
That however the business will perform in the future, we as its owners will be wearing it.
Since no one else (beside the taxpayers in most cases) will take the losses, why in the world would we priced in future gains and improvements, discount it back to today, then pay the current owner that possible gain but wear all the potential risks?
In other words, Discounted Cash Flow analysis of the various steps and assumptions are pretty much useless in the valuation of stock as a living, organic, business enterprise.
But mate, you’re saying, if we could more accurately know the business’ future cash flows, we’d have a better idea of its intrinsic, true, value… then we’d know how hard to bargain from that true value.
To really have a close-to-precise idea of any business’s future performance, precise enough to satisfy the precision that any DCF models and its various growth rate assumptions, interest rate estimates at various stages… an investor would need to understand not just the business itself but also its industry, its competitors; then know with some precision the interplay between said industry in said country, know the interaction between countries and industries; the implication of new technologies, trade and various policies and industrial relations… know how all these interactions will affect the business’ performance.
Let say a person could manage to do all that, or to go a fairly long way towards that precise estimate… the confidence in that estimate can only go so far into the future – say 10 years. Beyond ten years, as any DCF models will tell you, are assumptions that business will go on as projected, indefinitely.
Infinity is a lot longer than 10 years.
WHAT IS BUSINESS OWNERSHIP
Just as empires wax and wane, states coalesces and fall asunder (Luo Guanzhong, Romance of the Three Kingdom), so too are the fortune of any other human enterprise.
The best that a new owner of the business could hope for at the time of purchase would be to buy into a good business (well established or have “enough” investments made in it); one with valuable assets (tangible or otherwise) and strong enough a financial position (little or no debt) enabling it to continue as it has and hopefully grow and adapt from then on.
It should follow, then, that the investor as the business-owner does not care for precise cashflow projections and estimates of this and that other macro-economic factors that are not only beyond accurate prediction, but under which it is assumed that “everything else being equal” anyway. That is, the impact of war and peace; of interest rates; of political “meddling” through fine speeches or midnight tweets… they all affect the general economy, almost all equally. The business that gain or loses from such general, macro moves are ones with able management or not; with strong financial position or debt to the eyeballs; with strong business fundamentals or just another run of the mill kind of business…
As such, a rough estimate of the business current earning power, projected into infinity… done through that very simple PE ratio method; that infinite coupon pricing model… that is all that’s required.
Any additional earning above the current prospects; any luck and other fortunate windfalls ahead… those are rewards and bonuses for the investor as the business owner and should not be discounted back and priced in to the purchase price.
A great business, suffering a slight decline in its sales growth are selling at very reasonable price at $14s to $15s.