Two uncertainties of valuing a business- risk & earnings

September 29th, 2008

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In our previous article, Measuring the value of an investment, we learnt about the theory and mathematics behind the valuation of a business under artificial conditions that are clearly defined. Under such conditions, we know exactly the business’s future earnings and its risk relative to government bonds. Therefore, valuing artificial businesses is easy and straightforward. But in the real world, earnings and risks are the very things that cannot be so easily and clearly defined and quantified. As we said in that article,

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ?art? of investing.

Thus, we should not be under the impression that the dollar number that is produced from the valuation of a real-world business is a scientifically precise number. Rather, no matter how precise that number is, it is just an estimate. And it is far more important for that number to be accurate than for it to be precise. If you are confused with what this means, we suggest that you read our previous article, Confusion between precision & accuracy and Example of precisely inaccurate information.

First, we will discuss the earnings of a business. Stock analysts spend a lot of effort trying to divine the future cash flows of the business that they are analysing. However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates. For some, they can even be unpredictable or volatile. To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates. We will explain the characteristics of businesses that favour accurate earnings estimates in future articles.

Next, we will discuss the risk of a business. The mainstream finance uses volatility of prices to define risk. As we said before in How do you define risk?,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time.

But we see risk differently. As we explained before in Measuring the value of an investment, the risk in value investing is a relative concept. The payments of government bonds are assumed to be completely risk-free whereas the earnings of a business are not so certain. Risk relates to how secure the future earnings of a business is. To illustrate this concept, let’s suppose there are two different businesses with identical earnings estimates. One is located in a geologically stable place (e.g. Singapore) while the other is located in an earthquake prone area (e.g. Tokyo). We can say that the latter one carries more risk because its earnings can be cut due to an earthquake. Therefore, it will carry a higher discount rate.

Between earnings and risk, the latter is the most subjective of all in the business’s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness. For earnings, all we have to do is to compare earnings estimates with the actual earnings to have a gauge of the estimate’s accuracy. But you cannot do so for the discount rate. Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts.

Bear that in mind when you look at analyst reports on the price targets of stocks.

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  • Pete

    Thank you, and I like the 2nd last paragraph “Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts” ๐Ÿ™‚

    I find it interesting that often analysts predicting “value” of a company (eg BHP) use the notion of projecting the current or past situation, into the future (much like real-estate speculators). For instance, saying “wow BHP had an excellent 07/08 financial year, and we see their value increase due to the potential profits from their commodities/resources”. Which is nice, but unless they are looking at the global economy and considering huge potential slowdowns AND share price volatility due to leverage (credit crisis), then I don’t see their valuation as any use whatsoever, other than to suggest a nice valuation for a perfect world.

    Even though I am probably missing half the point of this article, I think that there is a level of non-responsibility when it comes to valuations and the impact of global economics – I mean, if you are in charge of a company valuation, you will give one based on the current situation, because you don’t get extra points for speculating on the future, right? And then you can hardly be blamed for global forces out of your control forcing your valuation to be skewed.

    I’m probably losing the plot again ๐Ÿ™‚

  • Pete

    Thank you, and I like the 2nd last paragraph “Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts” ๐Ÿ™‚

    I find it interesting that often analysts predicting “value” of a company (eg BHP) use the notion of projecting the current or past situation, into the future (much like real-estate speculators). For instance, saying “wow BHP had an excellent 07/08 financial year, and we see their value increase due to the potential profits from their commodities/resources”. Which is nice, but unless they are looking at the global economy and considering huge potential slowdowns AND share price volatility due to leverage (credit crisis), then I don’t see their valuation as any use whatsoever, other than to suggest a nice valuation for a perfect world.

    Even though I am probably missing half the point of this article, I think that there is a level of non-responsibility when it comes to valuations and the impact of global economics – I mean, if you are in charge of a company valuation, you will give one based on the current situation, because you don’t get extra points for speculating on the future, right? And then you can hardly be blamed for global forces out of your control forcing your valuation to be skewed.

    I’m probably losing the plot again ๐Ÿ™‚

  • Hi Pete!

    I find it interesting that often analysts predicting ?value? of a company (eg BHP) use the notion of projecting the current or past situation, into the future

    Yes, you’re right. Analysts have no choice but to project the current into the future in order to come up with a number. Fund managers really need that number to do their planning, money management,etc.

    That reminds us of a story: A US general in charge of planning for D-Day asked a weatherman what the weather will be like in 1 year’s time. Of course, the weatherman cannot forecast what the weather will be like that far out into the future. But the general said, “But I need a forecast so that I can do my planning!” And so, the general got his forecast that he wanted in order for him to do his planning. Not sure whether this is a true story or not though.

    Your comment fits in very well with Should value investors be ?bullish? in a bear market?.

  • Hi Pete!

    I find it interesting that often analysts predicting ?value? of a company (eg BHP) use the notion of projecting the current or past situation, into the future

    Yes, you’re right. Analysts have no choice but to project the current into the future in order to come up with a number. Fund managers really need that number to do their planning, money management,etc.

    That reminds us of a story: A US general in charge of planning for D-Day asked a weatherman what the weather will be like in 1 year’s time. Of course, the weatherman cannot forecast what the weather will be like that far out into the future. But the general said, “But I need a forecast so that I can do my planning!” And so, the general got his forecast that he wanted in order for him to do his planning. Not sure whether this is a true story or not though.

    Your comment fits in very well with Should value investors be ?bullish? in a bear market?.