The Worth Of Things
10 Jun 2024

Price and value is not the same thing – and everyone knows that. A little rubber washer is priced at less than a dollar – but the trouble it avoids is potentially worth thousands of dollars – if the water it holds back spills, covers the floor, damages goods, and renders the room functionally unusable for a period of time. A steak at home is cheap, in the restaurant it is expensive. People will say that $1.35 is too expensive to pay for a short story… but they might blow 3.50 or more on a latte without as much as a second thought. $350 is too expensive for a month’s worth of water at the home (all water, bathing, showering, washing, drinking, cooking etc), but a $5-8 bottle of water when one goes out, well, it’s worth it.

Services or products, determining the actual worth of something is relative, complicated, and far more involved than merely looking at a price, input costs or time to produce.

Valuing a business or a share is no easier – and yet valuing is a foundational principle of doing business. The simple answer is that a business is worth five times what it makes a year. But nearly no one will agree with such a valuation when their own personal particulars get involved – and there’s always someone’s personal particulars involved. When you are the owner, a business is worth whatever cash it generates in perpetuity. If you are the buyer of a business, then you say things like, now, now, let’s be reasonable…

Or take value investing. The very oversimplified crib notes version: Pay below Tangible Asset Value for a business within a healthy safety margin (that is, get it only on discount) and making money on your investment is virtually guaranteed.

Just how does one determine what a business or share is worth? Despite the fact that accountants wear suits, and calculators are whipped about boardrooms like lightsabers, and spreadsheets are classed as non-fiction – valuation is not an exact science. And in itself, there is a lesson there.

Some pretend methods include:

Price-to-Earnings (PE) Ratio – The Classic

If I make ten bucks and you make ten bucks, but I have a million in the bank and you only have five bucks in the bank, then you are a better buy because my bigger nest egg should in theory make me better at earning than you. So the PE Ratio is calculated by dividing the current market price of a share by its earnings per share. It’s a favourite go to because it’s simple. It’s easy to calculate and allows for quick comparisons between different companies in the same industry. On the flipside, earnings can be manipulated like everything else you read. It is a backward looking metric and doesn’t factor in future growth – so a high PE Ratio could mean either that the share is overvalued or that there are high growth expectations. And the typical PE Ratios vary between different industries, so what’s good for a utility company may not be good for a tech startup, and vice versa. Still, it sounds awfully sophisticated, doesn’t it? Why, it has the word RATIO right there at the end, which implies calculation, which means whoever says it loudest or first know what they are talking about. So it’s as reliable and likely to be used as ‘The Sultan’s of Swing’ is at a Devonport wedding reception.

Discounted Cash Flow (DCF) – The Crystal Ball

Much more suave and sophisticated, is the Discounted Cash Flow. This one involves very convincing guessing of the future cash flows of a business (pinky promise) – and then discounting them back to their present value using a discount rate. In a stable world with no surprises, compliant customers, passive competitors and no government screwups or scandals, it actually works pretty well. It takes the time value of money into account. Investors can adjust their discount rate based on how strong their stomachs are. And it is forward looking. It involves accurate, reliable and available data, slightly more complex calculations, and is vulnerable to the accuracy of all the myriad assumptions made in order to use it. But why not.

Price-To-Book (P/B) Ratio: Old Faithful

How much does the market say you are worth, vs how much are you worth if I sell you off piece by piece? You have book value – the number associated with your assets – and then the value of your shares. The narrower this gap, the safer the buy… good old value investment at its most prosaic. Divide the price per share by the book value per share. It’s based on actual assets (how novel), is typically more stable earnings, and providing that beloved margin of safety when you purchase an undervalued company (always provided, of course, that the management don’t continue with whichever shenanigans made them undervalued in the first place). Drawbacks are that it doesn’t take intellectual assets into consideration (and while I smirk at that too, IP can in reality be very substantial). Cross sector comparisons are notoriously hard. And finally, accounting practice means that book value is as much a guestimate as anything else, since the prices in the balance sheet and the worth of assets under control of the company are very often related only as very distant cousins.

Enterprise Value to EBITDA: Operational Purity

Here we compare the enterprise value to its earnings but BEFORE interest, taxes, depreciation, and amortization. Of course, companies that exist in reality have to deal with interest, taxes, depreciation and amortization. What it does do is give you a look at what’s happening on an operational level only. Divide the EV by the EBITDA and c’est viola. On the plus side, debts are taken into consideration so you don’t just look at the rosy bits. It’s all about cash flow and profitability. It even allows for comparisons across companies with different capital structures. Lo and behold, however, this method is as subject to accounting manipulation as much, if not more, than any other. So caveat emptor, as bloody always.

The Dividend Discount Model: The Steady Payment Potential

For those who crave the steady income – the Gordon Growth Model values a company based on the present value of its expected (read alleged) future dividends. Divide the dividend expected next year by the required rate of return minus the growth rate of dividends, and ker-ching. It’s all about the income… and a certain kind of company almost depends on paying out dividends steadily, so it can be more reliable than earnings (right up to that point where reality sets in). But not all companies pay dividends, some of the best growers don’t, and everything about the dividends, that they will be paid, that they will grow, is your assumptions.

Comps: Market Value Exemplified

In real estate, trust comps more than anything else (square footage, etc.). What does similar properties sell for on the open market? Use a variety of methods but the whole trick is to compare peers with each other. So if you want to look at the value of one share, in say, banking, compare it along multiple metrics with all the other banks. It seems obvious, for no share is an island… and yet, it’s not. It reflects current sentiment and conditions. It’s relatively simple. It’s widely used by… well what do you know… investment banks. But it’s not as easy to find companies that can really be compared (your grandpappa’s savings and loan is not like the latest digital only fintech). And taking sentiment into account might not be the best thing to do, considering how often the market is batshit crazy. Also, if you’re going to do comps, do it fast and move on it fast – because by next quarter, everything might change.

Sum Of the Parts (SOTP): Postmodern valuation

Best done on large conglomerates. Deconstruct the profit centres, divisions, departments or subsidiaries – and then establish a value for each. At the end, add them up and there’s your total sum. Obviously best used if you’re one of those come in, break down, sell bits and pieces all the while firing decent hardworking people along the way types. This can uncover hidden value in overlooked or undervalued segments. But it’s pretty much a vulture capitalist or private equity play… you wouldn’t bother with it unless your game is restructuring.

Real Options Analysis: Yoga For Valuation

Apply financial options theory to investment decisions. The result is that you get a picture of the flexibility and strategic choices available to management. This is about strategy and tactics, more than just value – meaning its more likely to be used, and more useful, for interventions or turnarounds or takeovers or change. The downside is you need to know options theory – generally – and then you need to know how to apply it in each particular case effectively (quite a tall order if you know most options theory practitioners).

Economic Value Added (EVA): Bottom Liner

Take the financial performance and subtract cost of capital from net operating profit, after taxes. So, how did we do if you account for how much it cost us to do what we did? It’s a very bottom line approach that cuts to the question: did we add any actual value here or are we just busy being and looking busy? This stimulates efficiency (what is measured improves) and promotes the efficient use of capital. It drives performance. But it requires detailed financial data and accurate knowledge of the cost of capital. Hard if you’re very leveraged and navigating several layers of restructured ingenuity by investment bankers.

Truth: What’s It Worth To You?

The real question isn’t what a product, service, company or share is worth – as if there is some objective underlying value that can be assessed and arrived at and judged. All financial decisions and realities are subjective. The only real answer and question is: what is it worth to you?

Some folks spend a grand on a glass of wine. Others spend that on gym supplements. Each might accuse the other of wasting their dough. Because folks value different things differently. From a company and share point of view – the company is worth something to one acquirer, and a different amount to a different acquirer. And if the seller and the acquirer can find a strike price that appeals enough to both – boom – the sale is made.

But a company’s worth can be judged by the people who work there, or the people that buy there – and these emotional, subjective truths may be equally valid – but simply irrelevant when it comes to exchanging the value of the company.

The owner gets to set the price.

I’m reminded of a sign outside a used furniture store. WE BUY JUNK, the top part read. WE SELL ANTIQUES, said the bottom.

In the final analysis, when it comes to the worth of anything, a key principle is never to overvalue what you do not have, and never to undervalue what you do.