Book Valuation Quotes

Growth requires reinvestment.

Einstein was right about relativity, but even he would have had a difficult time applying relative valuation in today's stock markets.

The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows.

A firm can have value only if it ultimately delivers earnings.

Avoid companies that are cavalier about issuing new options to managers

Nature always takes you at your own valuation. Believe that you are the child of God. Believe that you express Life, Truth, Love. Believe that Wisdom guides you. Believe that you are a special enterprise on the part of God—and what you really believe, that you will demonstrate. Beloved, now are we the sons of God, and it doth not yet appear what we shall be … (1 John

Growth firms get more of their value from investments that they expect to make in the future and less from investments already made.

Success in investing comes not from being right but from being wrong less often than everyone else.

Through valuation only is there value; and without valuation the nut of existence would be hollow.

In the intrinsic valuation chapter, we observed that the value of a firm is a function of three variables—its capacity to generate cash flows, its expected growth in these cash flows, and the uncertainty associated with these cash flows.

Sometimes management thinks it must determine a minimum acceptable price upfront. This is not possible when selling an intangible company. The price, the real price, is determined by the market and not by any other means. I suggest to sellers that they not worry so much about the valuation right now but rather that we go out to the market, contact all the good buyers, get offers, and negotiate the best price that we can and then accept the highest offer. People

The question concerning the origin of moral valuations is therefore a matter of the highest importance to me because it determines the future of mankind. The demand made upon us to believe that everything is really in the best hands, that a certain book, the Bible, gives us the definite and comforting assurance that there is a Providence that wisely rules the fate of man — when translated back into reality amounts simply to this, namely, the will to stifle the truth which maintains the reverse of all this, which is that hitherto man has been in the worst possible hands, and that he has been governed by the physiologically botched, the men of cunning and burning revengefulness, and the so-called "saints" — those slanderers of the world and traducers of humanity. The definite proof of the fact that the priest (including the priest in disguise, the philosopher) has become master, not only within a certain limited religious community, but everywhere, and that the morality of decadence, the will to nonentity, has become morality per se, is to be found in this: that altruism is now an absolute value, and egoism is regarded with hostility everywhere. He who disagrees with me on this point, I regard as infected. But all the world disagrees with me.

Do not be afraid to make mistakes.

Until we really behold the horror of the pit in which by nature we lie, we can never properly appreciate Christ's so-great salvation. In man's fallen condition we have the awful disease for which divine redemption is the only cure, and our estimation and valuation of the provisions of divine grace will necessarily be modified in proportion as we modify the need it was meant to meet.

Third, the idea that venture capitalists get into deals on the strength of their brands can be exaggerated. A deal seen by a partner at Sequoia will also be seen by rivals at other firms: in a fragmented cottage industry, there is no lack of competition. Often, winning the deal depends on skill as much as brand: it’s about understanding the business model well enough to impress the entrepreneur; it’s about judging what valuation might be reasonable. One careful tally concluded that new or emerging venture partnerships capture around half the gains in the top deals, and there are myriad examples of famous VCs having a chance to invest and then flubbing it.[6] Andreessen Horowitz passed on Uber. Its brand could not save it. Peter Thiel was an early investor in Stripe. He lacked the conviction to invest as much as Sequoia. As to the idea that branded venture partnerships have the “privilege” of participating in supposedly less risky late-stage investment rounds, this depends from deal to deal. A unicorn’s momentum usually translates into an extremely high price for its shares. In the cases of Uber and especially WeWork, some late-stage investors lost millions. Fourth, the anti-skill thesis underplays venture capitalists’ contributions to portfolio companies. Admittedly, these contributions can be difficult to pin down. Starting with Arthur Rock, who chaired the board of Intel for thirty-three years, most venture capitalists have avoided the limelight. They are the coaches, not the athletes. But this book has excavated multiple cases in which VC coaching made all the difference. Don Valentine rescued Atari and then Cisco from chaos. Peter Barris of NEA saw how UUNET could become the new GE Information Services. John Doerr persuaded the Googlers to work with Eric Schmidt. Ben Horowitz steered Nicira and Okta through their formative moments. To be sure, stories of venture capitalists guiding portfolio companies may exaggerate VCs’ importance: in at least some of these cases, the founders might have solved their own problems without advice from their investors. But quantitative research suggests that venture capitalists do make a positive impact: studies repeatedly find that startups backed by high-quality VCs are more likely to succeed than others.[7] A quirky contribution to this literature looks at what happens when airline routes make it easier for a venture capitalist to visit a startup. When the trip becomes simpler, the startup performs better.[8]

W.A.C. Bennett grew tired of the company’s obstinance. In August 1961, after rumors of a potential takeover had circulated within the province for months, Bennett introduced the Power Development Act into the legislature in order to confiscate BC Electric for C$111.0 million. The bill passed unanimously, allowing the government to seize control of the utility. The move was highly controversial, sparking an uproar within the business press, with some overly dramatic papers even labeling Bennett a dictator. In an unfortunate coincidence, the head of British Columbia Power and BC Electric, A.E. “Dal” Grauer, had passed away a few days earlier, and his funeral transpired on the very same day the government took over the company he had led.184 In addition to taking BC Electric, the bill offered to buy the rest of BC Power for C$68.6 million, with interest accruing on this amount until the offer expired at the end of July 1963. Combined with the C$111.0 million paid for BC Electric, this offer would result in a total payment for all of BC Power’s operations of C$179.6 million—or the equivalent of C$38.00 per share. Bennett justified this price by highlighting that the proposal was a premium to the C$34.75 price the shares sold for the day before the expropriation.185 While the combined price of C$38.00 per share was reasonable, the valuation for the constituent parts was peculiar. The C$111.0 million price for BC Electric matched its paid-in capital but ignored the other C$28.6 million of common book equity. And this amount sidestepped the debate over whether book value was even an appropriate methodology for the utility in the first place. The C$68.6 million price for the rest of BC Power’s assets was even odder since these remnant assets generated no income and were carried on the balance sheet at only C$4.0 million. This was a clear overpayment for the holding company’s assets, proposed to entice it into consenting to the BC Electric takeover.186 Predictably, BC Power did not stand idly by. After preliminary attempts to negotiate a higher price were thwarted, the company took action in the Supreme Court of British Columbia on November 13, 1961. BC Power sought rulings on the validity of the initial Act, the right to additional compensation, and the convertibility feature of debentures issued by BC Electric (more on this last point in the next section).187 While the parties awaited trial, the government took additional steps to further entrench the takeover. At the end of March 1962—nearly eight months after the original seizure—the British Columbia legislature passed two new statutes. The first was the province’s amendment of the Power Development Act, which paid an additional C$60.8 million to BC Power for BC Electric and eliminated the offer for the rest of the parent company’s assets. Table 1 shows that the amendment didn’t significantly alter the total compensation. But the new consideration was a more realistic number for BC Electric and solved for the peculiar offer for the remaining assets, which BC Power would now have to sell themselves.

So not only were the liabilities from Allied’s bankruptcy becoming defined, but the core business was not showing any signs of stress from the scandal. That left valuation. At his $40 per share purchase price, and in contrast to most of the stocks discussed in this book, American Express did not sell for an obvious bargain price. With a $178.4 million market capitalization and $124.1 million enterprise value, the stock sold for 15.8x 1963 earnings, 7.8x EV/1963 EBIT, and 2.3x P/TB. It didn’t look that cheap, and this valuation didn’t include an adjustment for the cost of the salad oil settlement.270

The valuation analysis was simple—anyone could see the stock was incredibly cheap. But it had been traded below net cash for several years before the company distributed cash to shareholders. Returning the cash was the critical factor in driving excellent returns. Assuming Buffett bought the stock in 1954 at $35 and sold in 1957 (having received the $50 per share distribution and a few dollars extra in dividends) when it traded between $20 and $28, he would have more than doubled his money and earned around a 30% IRR.135 The stock didn’t work because it was cheap—it worked because management returned capital to shareholders. The other securities discussed in this book were also incredible bargains—but it took action to drive wonderful returns for shareholders.

His biggest hit so far is making the first investment in Pinterest, the popular social network used to share photos, organized as collections of pictures on a pin board. Launched in March 2010, it has become one of the most visited sites, with 23 million users in 2012 and a valuation of over $1.5 billion. Pinterest was founded in Palo Alto, Silicon Valley, by three youngsters under 30. “I helped them start and guided them as a mentor to become what they are,” says Cohen. “With this single investment I’m done. As soon as I get my liquidity event I will party like there’s no tomorrow.” All the angels dream of “the big hit,” says Cohen, who has written a book on the subject.[24] They are the ones providing 90% of startup capital, by writing checks out of their own pocket. But they don't do it just thinking of financial returns. “I think we do it because it’s fun. There’s no question that everyone thinks he or she is smarter than everyone else,” the Chairman of the New York Angels says half-jokingly. “In reality no one makes money, although some are luckier and hit the jackpot. Then there is the fashion factor. Everyone today wants to be an angel because it is cool. In other words, we are the prima donnas; we have a big ego. But there is also the idea of doing good, to have the satisfaction of helping start new emerging companies.” The pleasure of giving back: an important part of Jewish culture, and of American culture in general.

The right price: Great growth companies can be bad investments at the wrong price. While multiples such as PEG ratios have their limitations, use them (low PEG ratios) to screen for companies that are cheap.

When a company is paying out more in dividends, it is retaining less in earnings; the book value of equity increases by the retained earnings.

Persson did not create Minecraft because he wanted to create a billion-dollar company; he loved video games and kept his day job while developing it. When the game soared in popularity, he started a company, Mojang, with some of the profits, but kept it small, with just 12 employees. Even with zero dollars spent on marketing and no user instructions, Minecraft grew exponentially, flying past the 100 million registered user mark in 2014 based largely on word of mouth.2 Players shared user-generated extras like modifications (“mods”) and custom maps with each other, and the game caught on not only with children but their parents and even educators. Still, Persson avoided the valuation game, refusing an investment offer from former Facebook president Sean Parker. Finally, he and his co-founders sold Mojang to Microsoft for $2.5 billion, a fortune built on one man’s focus on creating something that people loved.3 On the other end of the spectrum is Zynga, one of the fastest startups ever to reach a $1 billion valuation.4 The social game developer had its first hit in 2009 with FarmVille. Next came Zynga’s partnership with Facebook that turned into a growth engine. The company began trading on the NASDAQ in December 2011 and had 253 million active users per month as late as the first quarter of 2013.5 Then the relationship with Facebook ended and the wheels started coming off. Flush with IPO cash, Zynga started exhibiting all the symptoms of ego-driven, grow-at-any-cost syndrome. They moved into a $228 million headquarters in San Francisco. They began hastily acquiring companies like NaturalMotion, Newtoy, and Area/Code. They infuriated customers by launching new games without sufficient testing and filling them with scripts that signed players up for unwanted subscriptions and services. When customer outrage went viral, instead of focusing on building better products, Zynga hired a behavioral psychologist to try to trick customers into loving its games.6 In a 2009 speech at Startup@Berkeley, CEO Mark Pincus said, “I funded [Zynga] myself but I did every horrible thing in the book to just get revenues right away. I mean, we gave our users poker chips if they downloaded this Zwinky toolbar, which . . . I downloaded it once — I couldn’t get rid of it. We did anything possible just to just get revenues so that we could grow and be a real business.”7 By the spring of 2016, Zynga had laid off about 18 percent of its workforce and its share price had declined from $14.50 in 2012 to about $2.50.

conventional energy sources (while nonrenewable) will continue to be used for at least 50 years. Thus, if our definition of sustainable goes to 50 years in the future, conventional energy sources are sustainable. Indeed, because of the effects of financial markets, as the cost of conventional fuel increases because of its depletion, we can anticipate that its extraction will slow as it is replaced by renewable energy sources. Thus we can readily see the continued use of conventional fuels for the next 100 years—barring some type of unexpected scientific breakthrough.

Alibaba took its IPO to investors in a roadshow, having priced the offering at between $60 and $66 a share. This could value the Chinese e-commerce firm at around $160 billion when it lists in New York, which is close to Amazon’s current market valuation. With reports that its order book is already full, Alibaba is likely to raise $20 billion or more on its stockmarket debut, and possibly be the most lucrative IPO ever.

Table 3.7 Estimating Sustainable Growth Growth in earnings How much are you reinvesting? How well are you reinvesting? Operating income = Reinvestment rate × Return on capital (ROIC) Net income = Retention ratio × Return on equity (ROE)

In relative valuation, you price an asset based on how similar assets are priced in the market. A prospective house buyer decides how much to pay for a house by looking at the prices paid for similar houses in the neighborhood. In the same vein, a potential investor in Twitter's IPO (initial public offering) in 2013 could have estimated its value by looking at the market pricing of other social media companies. The three essential steps in relative valuation are: Find comparable assets that are priced by the market; Scale the market prices to a common variable to generate standardized prices that are comparable across assets; and Adjust for differences across assets when comparing their standardized values. A newer house with more updated amenities should be priced higher than a similar-sized older house that needs renovation, and a higher growth company should trade at a higher price than a lower growth company in the same sector. Pricing can be done with less information and much more quickly than intrinsic valuations, and it is more likely to reflect the market mood of the moment. Not surprisingly, most of what passes for valuation in investment banking and portfolio management is really pricing.

The differences in value between discounted cash flow valuation and relative valuation come from different views of market efficiency or inefficiency. In discounted cash flow valuation, we assume that markets make mistakes, that they correct these mistakes over time, and that these mistakes can often occur across entire sectors or even the entire market. In relative valuation, we assume that while markets make mistakes on individual stocks, they are correct on average. In other words, when we value a new software company relative to other small software companies, we are assuming that the market has priced these companies correctly, on average, even though it might have made mistakes in the pricing of each of them individually. Thus, a stock may be overvalued on a discounted cash flow basis but undervalued on a relative basis if the firms used for comparison in the relative valuation are all overpriced by the market. The reverse would occur if an entire sector or market were underpriced.

A good valuation is a bridge between stories and numbers, connecting a story about a business to inputs into a valuation, and by extension, to value.

As you craft a business story for your company, it is worth reminding yourself that you are not a creative novelist and that you are creating a foundation for a valuation. Consequently, you should aim to do the following: Keep it simple: When telling business stories for companies, it is easy to get distracted by strands of these stories that may be interesting but that have little relevance for value. The most powerful business stories in valuation tend to be compact, boiling the company down to its core. In our valuations of Amazon from 1997 to 2012, our core story for Amazon was that it was a Field of Dreams company, built around the belief that if you build it (revenues), they (profits) will come, and in our valuations after 2013, the story shifted to that of a Disruption Machine, a company that would go after any business that it felt had soft spots that could be exploited by a more efficient and patient player. Keep it focused: No matter what business you are valuing, the end game, for it to be valuable, is that it must make money. In short, a business story, even if it is not money making now, must include pathways to make money in the future.

Once you have constructed a business story for your company, you must stop and check to see whether your story passes what we call the 3P test, i.e. Is it possible? Is it plausible? Is it probable? We capture the differences between the three tests in Figure 5.2. As you go from possible to plausible to probable, you are making the tests more stringent, requiring more compelling explanations or more data from the storyteller. The “possibility” test is the weakest of the three, requiring only that you show that there is some pathway that exists for your story to hold and that it is not a fairy-tale. The “plausibility” test is stronger and requires evidence that you have succeeded, at least on a smaller scale (a market test, a geography), with your business. The “probability” test is the most difficult one since you must show that your business story can scale up and that your barriers to entry work.

For a story to become part of a valuation, you must convert its parts into valuation inputs. If you have a valuation model with dozens of inputs and complex output, this will become difficult, if not impossible, to do. One reason that we believe valuations should be parsimonious, with as few inputs as possible and limited output, is because they lend themselves much more easily to story connections. In Chapter 3, we introduced the basics of valuation and argued that you can tie the value of a company to a handful of inputs, and we summarize those in Figure 5.3.

Thus, to connect a business story into value, you must consider which of these inputs to change to reflect that story. Thus, if the key selling point of your business story is that it has a large potential market, it is revenue growth that will best reflect that belief, whereas if it is that your company has significant advantages (technological, brand name, patent protection) over its competition, it will show up as higher market share.

Let us assume that you have a story for your company and you have made sure that the story passes the 3P test, converted the story into value inputs, and valued the company. As you celebrate, it is worth reminding yourself that this is not the value for the company but your value, reflecting your story and inputs, and that you will be wrong. That is why it so critical to keep the valuation process open for feedback, especially from those who disagree most strongly with you. As you read or listen to their critiques, rather than react defensively, you should consider using their arguments to strengthen and solidify your story.

With more mature companies, there is less room for stories to diverge, and you will find more consensus on their valuations. Since the payoff in investing comes from being less wrong than others looking at the same company, it adds credence to the argument that the payoff to doing valuation is greater at young companies, where there is more disagreement about value, than in more mature companies.

It is to cover this default risk that lenders add a default spread to the riskless rate when they lend money to firms; the greater the perceived risk of default, the greater the default spread and the cost of debt. To estimate this default spread, you can use a bond rating for the company, if one exists, from an established ratings agency such as S&P or Moody's. If there is no published bond rating, you can estimate a synthetic rating for the firm, based on its ratio of operating income to interest expenses (interest coverage ratio); higher interest coverage ratios will yield higher ratings and lower interest coverage ratios. Once you have a bond rating, you can estimate a default spread by looking at publicly traded bonds with that rating. In July 2023, S&P gave KHC a BBB rating, and the default spread for BBB-rated bonds at the time was 1.89%, which when added to the risk-free rate of 3.80% yields a pretax cost of debt of 5.69%. Incidentally, if KHC had not had a rating, we could have computed an interest coverage ratio for the firm: With this coverage ratio, we would have obtained a synthetic rating of A–, translating into a default spread of 1.54% and a pretax cost of debt of 5.34%, in July 2023.

If historical growth and analyst estimates are of little value, what is the solution? Ultimately, for a firm to grow, it has to either manage its existing investments better (efficiency growth) or make new investments (new investment growth). In the special case where a company's margins are stable and there is no efficiency-driven growth, you should look at how much of its earnings a firm is reinvesting back in the business and the return on these investments. While reinvestment and return on investment are generic terms, the way in which we define them will depend on whether we are looking at equity earnings or operating income. With equity earnings, we measure reinvestment as the portion of net income not paid out as dividends (retention ratio) and use the return on equity to measure the quality of investment. With operating income, we measure reinvestment as the reinvestment rate and use the return on capital to measure investment quality.

Multiple Companion variable Mismatch indicator for undervalued company PE ratio Expected growth Low PE ratio with high expected growth rate in earnings per share P/BV ratio ROE Low P/BV ratio with high ROE P/S ratio Net margin Low P/S ratio with high net profit margin EV/EBITDA Reinvestment rate Low EV/EBITDA ratio with low reinvestment needs EV/Capital Return on capital Low EV/Capital ratio with high return on capital EV/Sales After-tax operating margin Low EV/Sales ratio with high after-tax operating margin

There are four basic inputs that we need for a value estimate: cash flows from existing assets (net of reinvestment needs and taxes), expected growth in these cash flows for a forecast period, the cost of financing the assets, and an estimate of what the firm will be worth at the end of the forecast period. Each of these inputs can be defined either from the perspective of the firm or just from the perspective of the equity investors.

Market value of equity: The price per share or market capitalization. Market value of firm: The sum of the market values of both debt and equity. Market value of operating assets or enterprise value: The sums of the market values of debt and equity but with cash netted out of the value. When measuring earnings and book value, you can again measure them from the perspective only of equity investors or of both debt and equity (firm). Thus, earnings per share and net income are earnings to equity, whereas operating income measures earnings to the firm. The shareholders' equity on a balance sheet is book value of equity; the book value of the entire business includes debt; and the book value of invested capital is that book value, net of cash. To provide a few illustrations: you can divide the market value of equity by the net income in order to estimate the PE ratio (measuring how much equity investors are paying per dollar of earnings) or divide enterprise value by EBITDA (earnings before interest, taxes, depreciation, and amortization) to get a sense of the market value of operating assets relative to operating cash flow. The central reason for standardizing, though, does not change. We want to compare these numbers across companies.

All Valuations Are Biased You almost never start valuing a company or stock with a blank slate. All too often, your views on a company or stock are formed before you start inputting the numbers into the models and metrics that you use and, not surprisingly, your conclusions tend to reflect your biases.

Your best estimates for the future will not match up to the actual numbers for several reasons. First, even if your information sources are impeccable, you must convert raw information into forecasts, and any mistakes that you make at this stage will cause estimation error. Next, the path that you envision for a firm can prove to be hopelessly off. The firm may do much better or much worse than you expected it to perform, and the resulting earnings and cash flows will be different from your estimates; consider this firm-specific uncertainty. When valuing Cisco in 2001, for instance, we seriously underestimated how difficult it would be for the company to maintain its acquisition-driven growth in the future, and we overvalued the company as a consequence. Finally, even if a firm evolves exactly the way you expected it to, the macroeconomic environment can change in unpredictable ways. Interest rates can go up or down, and the economy can do much better or worse than expected. Our valuation of Marriott from November 2019 looks hopelessly optimistic, in hindsight, because we did not foresee the global pandemic in 2020 and the economic consequences for the hospitality business.

The return on capital varies widely across firms in different businesses, tending to be lower in competitive businesses. The return on equity (ROE) examines profitability from the perspective of the equity investors by relating profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment and can be computed as:

The cash flow to the firm is the cash left over after taxes and after all reinvestment needs have been met but before interest and principal payments on debt. To get to cash flow to the firm, you start with operating earnings, instead of net income, and subtract out the taxes you would have paid if the entire operating income were taxable and then subtract reinvestment, with the latter defined exactly the same way it was to get to FCFF: Using our earlier definition of reinvestment, we can also write the FCFF as follows: The reinvestment rate can exceed 100 percent if the firm is reinvesting more than it is earning, or it can also be less than zero for firms that are divesting assets and shrinking capital. Both FCFE and FCFF are after taxes and reinvestment, and both can be negative, either because a firm has negative earnings or because it has reinvestment needs that exceed income.

In July 2023, the risk-free rate was set to the 10-year Treasury bond rate of 3.80 percent, the equity risk premium (ERP) was 5.67 percent, reflecting KHC’s revenue weighted geographic exposure, and the beta for KHC was estimated by looking at the business it operated in, which is food processing, as shown in Table 3.6. Table 3.6 Estimating a Beta for KHC Business Estimated value Proportion of firm Sector beta Food processing $30,146 100.00% 0.69 KHC as a firm $30,146 100.00% 0.69

The accounting income statement measures accrual income, based on the revenues and expenses associated with transactions during a period, but it does not include capital expenses during the period. As a consequence, a company's cash flows can be different from its earnings, and the statement of cash flows represents the accounting attempt to measure cash flows to and from a business. That statement has three parts to it, with the operating cash flow segment estimating how much equity investors derived as cash flows from operations, adding back non-cash expenses and subtracting out changes in non-cash working capital items, the investing cash flow segment looking at capital expenditures and cash acquisitions and the financing segment focusing on cash flows to and from debt financing (debt issued and repaid) and to and from equity investors (new stock issuances and buybacks). Figure 2.3 breaks down the statement of cash flows into its constituent parts:

Note that if KHC had been a multi-business company, we would have estimated a weighted average of the betas of the businesses it operated in, with the weights based on the values of these businesses. Adjusting this beta for the debt in KHC, since financial leverage magnifies business risk, results in a beta of 0.92 for the equity in KHC: The resulting cost of equity is 9.00 percent: While equity investors receive residual cash flows and bear the risk in those cash flows, lenders to the firm face the risk that they will not receive their promised payments—

Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative. In intrinsic valuation, we begin with a simple proposition: the intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows. Assets with high and stable cash flows should be worth more than assets with low and volatile cash flows. You should pay more for a property that has long-term renters paying a high rent than for a more speculative property with not only lower rental income but more variable vacancy rates from period to period. While the focus in principle should be on intrinsic valuation, most assets are valued on a relative basis. In relative valuation, assets are valued by looking at how the market prices similar assets. Thus, when determining what to pay for a house, you would look at what similar houses in the neighbourhood sold for. With a stock, that means comparing its pricing to similar stocks, usually in its “peer group.

The principles of present value enable us to calculate exactly how much a dollar sometime in the future is worth in today's terms and to compare cash flows across time.

To measure how well a firm is investing its capital, we can look at the after-tax operating income relative to the capital invested in the firm, where capital is defined as the sum of the book values (BV) of debt and equity, net of cash, and marketable securities. This is the return on capital (ROC) or return on invested capital (ROIC) and it is computed as follows:

Once you have estimated the costs of debt and equity, you estimate the weights for each, based on market values (rather than book value). For publicly traded firms, multiplying the share price by the number of shares outstanding will yield market value of equity. Estimating the market value of debt is usually a more difficult exercise since most firms have some debt that is not traded, and so many practitioners fall back on using book value of debt. Using KHC again as our illustrative example, the market values of equity ($44,756 million) and debt ($19,476 million), and our earlier estimates of cost of equity (9.00 percent) and after-tax cost of debt (4.27 percent), result in a cost of capital for the firm of 7.56 percent.

Intrinsic valuation provides a fuller picture of what drives the value of a business or stock, but there are times when pricing will yield a more realistic estimate of what you can get for that business or stock in the market today. While nothing stops you from using both approaches to put a number on the same investment, it is imperative that you understand whether your mission is to value an asset or to price it, since the tool kit that you will need is different.

When the stock-based compensation takes the form of options, analysts often use shortcuts (such as adjusting the number of shares for dilution) to deal with these options. The right approach is to value the options (using option pricing models) and reduce the value of equity by the option value.

What if the intrinsic value that you derive, from your estimates of cash flows and risk, is very different from the market price? There are three possible explanations. One is that you have made erroneous or unrealistic assumptions about a company's future growth potential or riskiness. A second and related explanation is that you have made incorrect assessments of risk premiums for the entire market. A third is that the market price is wrong and that you are right in your value assessment. Even in the last scenario, there is no guarantee that you can make money from your valuations. For that to occur, markets have to correct their mistakes, and that may not happen in the near future. In fact, you can buy stocks that you believe are undervalued and find them become more undervalued over time. That is why a long time horizon is almost a prerequisite for using intrinsic valuation models. Giving the market more time (say three to five years) to fix its mistakes provides better odds than hoping that it will happen in the next quarter or the next six months.

OSCAR WILDE DEFINED A CYNIC AS ONE WHO “knows the price of everything and the value of nothing.” The same can be said of many investors who regard investing as a game and define winning as staying ahead of the pack.

Always be honest about your biases: Why did you pick this company to value? Do you like or dislike the company's management? Do you already own stock in the company? Put these biases down on paper, if possible, before you start. In addition, confine your background research on the company to information sources rather than opinion sources; in other words, spend more time looking at a company's financial statements than reading equity research reports about the company. If you are looking at someone else's valuation of a company, always consider the reasons for the valuation and the potential biases that may affect the analyst's judgments. Generally, the more bias there is in the process, the less weight you should attach to the valuation judgment.

There are three reasons why a cash flow in the future is worth less than a similar cash flow today. People prefer consuming today to consuming in the future. Inflation decreases the purchasing power of cash over time. A dollar in the future will buy less than a dollar would today. A promised cash flow in the future may not be delivered. There is risk in waiting. The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the discount rate. The discount rate can be viewed as a composite of the expected real return (reflecting consumption preferences), expected inflation (to capture the purchasing power of the cash flow), and a premium for uncertainty associated with the cash flow. The process of discounting converts future cash flows into cash flows in today's terms. There are five types of cash flows—simple cash flows, annuities, growing annuities, perpetuities, and growing perpetuities. A simple cash flow is a single cash flow in a specified future period. Discounting a cash flow converts it into today's dollars (or present value) and enables the user to compare cash flows at different points in time. The present value of a cash flow is calculated thus:

There are three basic accounting statements. The first is the balance sheet, which summarizes the assets owned by a firm, the value of these assets, and the mix of debt and equity used to fund them, at a point in time. The income statement provides information on the operations of the firm and its profitability over time. The statement of cash flows specifies how much cash the firm generated or spent from its operating, financing, and investing activities.

How do accountants measure the value of assets? For most fixed and long-term assets, such as land, buildings, and equipment, they begin with what you originally paid for the asset (historical cost) and reduce that value for the aging of the asset (depreciation or amortization). For short-term assets (current assets), including inventory (raw materials, works in progress, and finished goods), receivables (summarizing moneys owed to the firm), and cash, accountants are more amenable to the use of an updated or market value. If a company invests in the securities or assets of another company, the investment is valued at an updated market value if the investment is held for trading and historical cost when it is not. In the special case where the holding comprises more than 50 percent of the value of another company (subsidiary), the firm must record all of the subsidiary's assets and liabilities on its balance sheet (this is called consolidation), with a minority interest item capturing the percentage of the subsidiary that does not belong to it. Finally, you have what are loosely categorized as intangible assets. While you would normally consider items such as brand names, customer loyalty, and a well-trained work force as intangible assets, the most encountered intangible asset in accounting is goodwill. When a firm acquires another firm, the price it pays is first allocated to the existing assets of the acquired firm. Any excess paid becomes goodwill and is recorded as an asset.

Even the simplest multiples are defined and computed differently by different analysts. A PE ratio for a company can be computed using earnings from the last fiscal year (current PE), the last four quarters (trailing PE), or the next four quarters (forward), yielding very different estimates. It can also vary depending on whether you use diluted or primary earnings. The first test to run on a multiple is to examine whether the numerator and denominator are defined consistently. If the numerator is an equity value, then the denominator should be an equity value as well. If the numerator is a firm value, then the denominator should be a firm value as well. To illustrate, the PE ratio is a consistently defined multiple since the numerator is the price per share (which is an equity value) and the denominator is earnings per share (which is also an equity value). So is the enterprise value to EBITDA multiple since the numerator and denominator are both measures of operating assets; the enterprise value measures the market value of the operating assets of a company, and the EBITDA is the cash flow generated by the operating assets. In contrast, the price-to-sales ratio and price to EBITDA are not consistently defined since they divide the market value of equity by an operating measure. Using these multiples will lead you to finding any firm with a significant debt burden to be cheap.

you cannot judge a valuation by its precision, since you will face more uncertainty when you value a young growth company than when you value a mature company. Another is that avoiding dealing with uncertainty will not make it go away. Refusing to value a business because you are too uncertain about its future prospects makes no sense, since everyone else looking at the business faces the same uncertainty. Finally, collecting more information and doing more analysis will not necessarily translate into less uncertainty, since the uncertainty does not just come from estimation mistakes but also reflects real uncertainty about the future.

Success in investing comes not from being right but from being less wrong than everyone else.

Netting operating expenses and depreciation from revenues yields operating income, whereas the income after interest and taxes is termed net income.

Two principles underlie the measurement of accounting earnings and profitability. The first is accrual accounting, where the revenue from selling a good or service is recognized in the period in which the good is sold or the service is performed (in whole or substantially), and a corresponding effort is made to match expenses incurred to generate revenues. The second is the categorization of expenses into operating, financing, or capital expenses.

Cash flows that are riskier should be assessed a lower value than more stable cash flows. In conventional discounted cash flow valuation models, we use higher discount rates on riskier cash flows and lower discount rates on safer cash flows. The definition of risk will depend on whether you are valuing the business or just the equity. When valuing the business, you look at the risk in a firm's operations. When valuing equity, you look at the risk in the equity investment in this business, which is partly determined by the risk of the business the firm is in and partly by its choice on how much debt to use to fund that business. The equity in a safe business can become risky if the firm uses enough debt to fund that business.

Watching every tick up and every tick down is just wasting your valuable time. Do yourself a favor, and pick up a book or two about investing each month.

Those firms that do not update their investment processes within that time frame [over the next five years] could face strategic risks and might very well be outmanoeuvred by competitors that effectively incorporate alternative data into their securities valuation and trading signal processes.

Value creation is rather internal continuous process by a company but Valuation is ascribed to it by outsiders … Invariably these two never meet precisely.

By placing too low a discount on the future earnings of companies, investors ended up paying too much. The discounting error was widely acknowledged at the time. In early 1928, Moody’s Investors Services declared that stock prices had ‘over-discounted anticipated progress’.30 After the crash, Benjamin Graham and David Dodd wrote in their book Security Analysis that the late 1920s witnessed ‘a transfer of emphasis [in the valuation of stocks] from current income to future income and hence inevitably to future enhancement of principal value’.31 Or, as the market analyst Max Winkler memorably described: ‘The imagination of our investing public was greatly heightened by the discovery of a new phrase: discounting the future. However, a careful examination of quotations of many issues revealed that not only the future, but even the hereafter, was being discounted.

Lucent, Not Transparent In mid-2000, Lucent Technologies Inc. was owned by more investors than any other U.S. stock. With a market capitalization of $192.9 billion, it was the 12th-most-valuable company in America. Was that giant valuation justified? Let’s look at some basics from Lucent’s financial report for the fiscal quarter ended June 30, 2000:1 FIGURE 17-1 Lucent Technologies Inc. All numbers in millions of dollars. * Other assets, which includes goodwill. Source: Lucent quarterly financial reports (Form 10-Q). A closer reading of Lucent’s report sets alarm bells jangling like an unanswered telephone switchboard: Lucent had just bought an optical equipment supplier, Chromatis Networks, for $4.8 billion—of which $4.2 billion was “goodwill” (or cost above book value). Chromatis had 150 employees, no customers, and zero revenues, so the term “goodwill” seems inadequate; perhaps “hope chest” is more accurate. If Chromatis’s embryonic products did not work out, Lucent would have to reverse the goodwill and charge it off against future earnings. A footnote discloses that Lucent had lent $1.5 billion to purchasers of its products. Lucent was also on the hook for $350 million in guarantees for money its customers had borrowed elsewhere. The total of these “customer financings” had doubled in a year—suggesting that purchasers were running out of cash to buy Lucent’s products. What if they ran out of cash to pay their debts? Finally, Lucent treated the cost of developing new software as a “capital asset.” Rather than an asset, wasn’t that a routine business expense that should come out of earnings? CONCLUSION: In August 2001, Lucent shut down the Chromatis division after its products reportedly attracted only two customers.2 In fiscal year 2001, Lucent lost $16.2 billion; in fiscal year 2002, it lost another $11.9 billion. Included in those losses were $3.5 billion in “provisions for bad debts and customer financings,” $4.1 billion in “impairment charges related to goodwill,” and $362 million in charges “related to capitalized software.” Lucent’s stock, at $51.062 on June 30, 2000, finished 2002 at $1.26—a loss of nearly $190 billion in market value in two-and-a-half years.

Today, in 2020, I cannot see the future, but my instincts tell me that we are going to experience a replay of the first Great American Depression of the 1930’s, and that it will happen before the 100 year anniversary of that last one. (Keep in mind the uselessness of such personal premonitions) (Update September 2020 in light of record setting stock market valuations (for some companies) while economies were still under water) The above made so little sense, it became possible to imagine that certain companies had a pipeline to free Federal reserve cash.

In the case of cultural goods, a particularly complicated equation determines value. The socially constructed nature of the valuation process in markets is most clearly visible in the creative and cultural industries because creative works such as art, books, music, and fashion have greater symbolic than material value. For example, readers value books not because of the physical materials (such as paper and ink) that go into the writing and publishing of a book but because of the ideas that the book symbolizes. Special knowledge is required to interpret, understand, and convey this symbolic value and to evaluate cultural goods; individuals need to understand something about art, the history of aesthetic movements in the art world, and the evaluation criteria for art (for example, originality, rarity, technique) to know not only why works by Raoul Dufy are valued but also why they are less valued (and therefore, also less expensive) than those by his contemporary, the abstract artist Pablo Picasso. Thus, the symbolism inherent to cultural goods—which distinguishes them from strictly utilitarian goods, such as, for example, paintbrushes—creates a barrier to their understanding and valuation.

bankruptcy and tax law, fixed-income and equity valuations, and credit analysis.

This focus on the short term is hard to reconcile with any fundamental view of investing. We can examine the drivers of equity returns to see what we need to understand in order to invest. At a one-year time horizon, the vast majority of your total return comes from changes in valuation—which are effectively random fluctuations in price. However, at a five-year time horizon, 80 percent of your total return is generated by the price you pay for the investment plus the growth in the underlying cash flow. These are the aspects of investment that fundamental investors should understand, and they clearly only matter in the long term.

Markets will always remain Imperfectly Perfect, the time you get to know correct valuation, the opportunity becomes out of reach, or vice versa.

Pair 3: American Home Products Co. (drugs, cosmetics, household products, candy) and American Hospital Supply Co. (distributor and manufacturer of hospital supplies and equipment) These were two “billion-dollar good-will” companies at the end of 1969, representing different segments of the rapidly growing and immensely profitable “health industry.” We shall refer to them as Home and Hospital, respectively. Selected data on both are presented in Table 18-3. They had the following favorable points in common: excellent growth, with no setbacks since 1958 (i.e., 100% earnings stability); and strong financial condition. The growth rate of Hospital up to the end of 1969 was considerably higher than Home’s. On the other hand, Home enjoyed substantially better profitability on both sales and capital.† (In fact, the relatively low rate of Hospital’s earnings on its capital in 1969—only 9.7%—raises the intriguing question whether the business then was in fact a highly profitable one, despite its remarkable past growth rate in sales and earnings.) When comparative price is taken into account, Home offered much more for the money in terms of current (or past) earnings and dividends. The very low book value of Home illustrates a basic ambiguity or contradiction in common-stock analysis. On the one hand, it means that the company is earning a high return on its capital—which in general is a sign of strength and prosperity. On the other, it means that the investor at the current price would be especially vulnerable to any important adverse change in the company’s earnings situation. Since Hospital was selling at over four times its book value in 1969, this cautionary remark must be applied to both companies. TABLE 18-3. Pair 3. CONCLUSIONS: Our clear-cut view would be that both companies were too “rich” at their current prices to be considered by the investor who decides to follow our ideas of conservative selection. This does not mean that the companies were lacking in promise. The trouble is, rather, that their price contained too much “promise” and not enough actual performance. For the two enterprises combined, the 1969 price reflected almost $5 billion of good-will valuation. How many years of excellent future earnings would it take to “realize” that good-will factor in the form of dividends or tangible assets? SHORT-TERM SEQUEL: At the end of 1969 the market evidently thought more highly of the earnings prospects of Hospital than of Home, since it gave the former almost twice the multiplier of the latter. As it happened the favored issue showed a microscopic decline in earnings in 1970, while Home turned in a respectable 8% gain. The market price of Hospital reacted significantly to this one-year disappointment. It sold at 32 in February 1971—a loss of about 30% from its 1969 close—while Home was quoted slightly above its corresponding level.*

A return to sanity. In April 1999, the P/E ratio had risen to an unprecedented level of 34 times, setting the stage for the return to sanity in valuations that soon followed. The tumble in stock market prices gave us our comeuppance. With earnings continuing to rise, the P/E currently stands at 23.7 times, compared with the 15 times level that prevailed at the start of the twentieth century. As a result, speculative return has added just 0.5 percentage points to the annual investment return earned by our businesses over the long term.