Renowned value investor Seth Klarman (Trades, Portfolio) has a simple framework for determining whether an investment is undervalued, fairly valued or overvalued. As he puts it, "To a value investor, investments come in three varieties: undervalued at one price, fairly valued at another price, and overvalued at still some higher price. The goal is to buy the first, avoid the second, and sell the third."
But to know which category an investment falls into, you first need to be able to accurately value the underlying business. So, how does Klarman go about valuing companies to uncover investment bargains? Throughout his storied career managing the Baupost Group hedge fund, he has relied on three core valuation methodologies.
Net present value analysis
The first technique Klarman utilizes is net present value analysis, sometimes called discounted cash flow analysis. This approach involves predicting what a company's cash flows will be in the future and then discounting them to the present to calculate their worth today.
DCF analysis requires developing a financial model to forecast the business' cash flows over a multiyear period, often five to 10 years out. Key inputs include revenue growth rates, profit margins, capital expenditures, depreciation and changes in working capital.
After estimating the future free cash flows, these are discounted back to the present using an appropriate discount rate, often the company's weighted average cost of capital. This yields the net present value - the amount an investor should be willing to pay today for the rights to those future cash flows.
Why use discounted cash flow analysis?
DCF has a strong theoretical basis and can provide the most accurate valuations when used properly. It is especially applicable for companies with stable, predictable cash flows that are expected to grow at steady rates.
The NPV approach directly values the business based on its underlying cash generation capacity. So, it allows investors to estimate intrinsic value rooted in fundamentals.
DCF works best for profitable, growing companies in steady industries; think consumer staples, utilities and telecoms. For Silicon Valley tech startups with wildly unpredictable futures, DCF has more limitations.
The art of projecting cash flows
The tricky part is accurately forecasting future cash flows, a task requiring experience and business acumen. Small changes in growth and margin assumptions can greatly impact value.
Conservative investors like Klarman build in a margin of safety by using lower growth estimates and higher discount rates. Still, DCF requires making educated guesses about the future.
An expert valuation professional can reasonably estimate cash flow projections and appropriate discount rates. But significant judgment is involved. DCF is as much art as science.
The beauty of discounted cash flow
Despite its complexity, DCF represents the most direct way to value companies with stable cash flows. And it intuitively makes sense - something is worth what it can produce. By discounting free cash flows, investors can derive the fair value of a business today.
While imprecise, DCF provides a methodology grounded in fundamentals. When used prudently by disciplined investors like Klarman, it can accurately value companies and identify distortion between price and value.
Liquidation value
The discounted cash flow model breaks down when applied to money-losing companies with bleak futures. So, how does Klarman value distressed or unprofitable businesses? Here, he turns to liquidation value.
The liquidation valuation method involves estimating what a company's assets would fetch if they were sold off today. It disregards any future cash flows and focuses strictly on balance sheet values.
Think of liquidation value as if the company went bankrupt and everything got auctioned off in a fire sale. What would the inventory, real estate, equipment, and other assets bring in this distressed scenario?
When to use liquidation valuation
Liquidation analysis is most appropriate for companies in financial trouble. Often "cigar butt" stocks trading below liquidation value offer low-risk investment opportunities.
Klarman has profited handsomely buying when irrational pessimism drives market prices far below net asset values. This strategy succeeds when fears of bankruptcy subside, and valuations revert to liquidation floors.
Liquidation value sets a baseline for how low valuations could go in a worst-case scenario. It provides a margin of safety for investing in distressed firms.
Net working capital and net-net stocks
For manufacturing and retail companies, net working capital (current assets minus current liabilities) is often used as a proxy for liquidation value.
Net-nets represent an even more stringent criterion - stocks trading at less than their net current asset value, discounting all long term assets and liabilities.
Benjamin Graham focused extensively on net-nets. While scarce today, they were prevalent during the 1930s. Klarman has uncovered occasional net-nets in distressed periods like the 2008 financial crisis.
Shortcomings of liquidation valuation
The problem with liquidation value is it assumes the worst-case scenario of a forced asset sale today. This creates a fire sale mentality and dramatically undervalues enterprise value.
Liquidation analysis only considers hard assets and ignores intangibles like brands, patents and human capital. It also fails to account for earnings power in ongoing operations.
Still, as a bedrock downside valuation check, liquidation value has a place in every value investor's toolkit. Klarman calls it the "ultimate reality check."
Sum-of-the-parts analysis
For complex businesses, Klarman employs a sum-of-the-parts analysis. This involves valuing a company's individual business units separately, then combining them to derive the whole company's worth.
Sum-of-the-parts works well for conglomerates, multi-segment companies or companies planning spin-offs. The approach recognizes that value may be obscured when lumping diverse businesses together.
Each unit can be analyzed on a standalone basis using discounted cash flow or peer comparisons. This often reveals hidden value not captured in the consolidated figures.
When to take a sum-of-the-parts approach
Sum-of-the-parts valuation is ideal when:
- A company operates disparate businesses under one roof.
- Different segments face unique market conditions.
- Certain units are dragging down others.
- A breakup or restructuring is underway.
Valuing the pieces to see the whole picture
The process involves first valuing components based on their distinct cash flows, growth and risk profiles. Business units can be compared against peers on metrics like price-earnings and enterprise value/Ebitda to benchmark value.
The separate unit valuations are then added up to derive the total enterprise value for the consolidated company. This aggregated value can be compared to the actual market capitalization.
Companies trading at steep discounts to sum-of-the-parts value present compelling investment opportunities if a breakup or spin-off event seems likely.
The limitations of breakup valuation
Like other approaches, sum-of-the-parts has drawbacks. It fails to account for synergies between business units that boost combined value. Corporate overhead makes direct comparisons to peers difficult.
Still, for complex businesses, valuing the parts often reveals insights obscured in consolidated financials. Taken together with other methods, sum-of-the-parts analysis contributes to a mosaic understanding of value.
The essence of business valuation
At its core, business valuation is not a precise science. Assumptions and projections about the future are invariably wrong to some degree. No model can exactly predict the intrinsic value of a dynamic organization made up of people.
But while imperfect, valuation remains essential for achieving the most basic aim of value investing - determining whether a stock is currently undervalued, fairly priced or overvalued relative to what the underlying business is rationally worth.
Klarman's threefold valuation framework provides a toolkit to make this assessment in a structured, reasoned way. While quantitative models alone will never grasp the full picture, they allow investors to value enterprises through alternate lenses and reach reasoned judgments about upside potential versus downside risk. In Klarman's words, "Business valuation is at best a rough art." Taken together, his pragmatic approaches provide a valuable starting point for finding bargains.
