How to Identify the Value of a Business

Investment Perspective – August 2015

Peter Flannery CFP AFA

 

 

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

 

The trading price of direct shares is how much the market is prepared to pay for an investment on the market (and what the market spends a lot of time watching and analysing). 

The value on the other hand is what the underlying business is worth.

People often argue that price and value are the same thing. After all, they say… a willing buyer and a willing seller surely must represent what something is worth.

Well, it might, but does not necessarily. 

The reality is that price is set by the market which is usually driven by sentiment (fear of missing out, fear of loss, greed, anxiety…) and does not always reflect the fundamentals of the underlying business. 

To be clear, at WISEplanning we do not invest or speculate on the share price. We are not investing in a rising or a falling trading price. 

Sure… that is what many do (invest hoping the share price will be upwardly mobile). On the surface that appears a rather difficult way to invest because if we are investing in the price then we had better keep an eye on it. Sounds like a lot of work to me (with minimal certainty as well)! 

I prefer to allocate my time deselecting businesses with unfavourable business economics when it fits my schedule (The Time Zones). To me, that is more effective than chasing prices driven by random market sentiment – every waking moment.

 

Business Economics vs Business Financials

At WISEplanning we differentiate between business financials and business economics.

If we look closely at the difference between business economics and business financials, I explain it this way …

  • Business financials: This could be the ratios and the analysis that we use to understand how the business is performing. For example price to earnings ratio, net tangible assets, dividend yield, dividend payout ratio, return on capital, discounted cashflow. These are examples of business financials.
  • Business economics: At WISEplanning this revolves around the underlying business model (how do they make money) and things like the sustainable competitive advantage. IBM for example controls and services approximately 60% of corporate mainframe computers globally. That is a significant position. Customers of IMB are known to be “sticky”. In other words, business owners (I know how this works and I bet you do too if you are a business owner) are happy to use technology as an enabler but prefer to stay with existing systems that are working fine rather than change to a new one. That is because the costs of doing so including the disruption (another cost) can be significant. Another example would be Google that currently controls over 60% of the global search engine space. This is not to say that something might not come along and take over – things can change. However, Google’s balance sheet is comprised of approximately 46% cash. Google has a dominant position in the search engine space and has a significant war chest to defend its position and / or expand into other opportunity.

 

Business Economics and Managing Risk

By far the favoured approach by investors, fund managers and share brokers is to diversify to manage risk. 

Diversify to capture opportunity I say… and invest in good quality businesses to manage the risk.

Good businesses can sometimes stumble. However, good businesses are strong and likely to be more resilient. Their ability to adapt and manage change can help them to grow stronger, better, create more jobs and build more wealth for their shareholders.

It has been well documented over many years that whilst there is a massive industry around funds management and diversification, it appears that those who use diversification to manage risk may not fully understand the value of investing in the right business economics. 

Therefore they are forever at the mercy of market conditions… wondering, worrying what is coming next.

They see price variability as a measure of risk and are led, driven by or react to it. Their focus is on price… usually with minimal regard for the underlying business economics.

“You don’t know who’s swimming naked until the tide goes out.“

Warren Buffett 

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