The only way to value companies
In the investment industry we tend to get a lot of research and sales material. Some of it is good, some of it is terrible.
Most recently an email arrived professing a start-up valuation model which revolved around considering what would be a fair price-to-sales ratio in 5 years, then discounting that ‘price’ back to the present.
If you think about it that approach is completely in the seller’s interest. It’s almost saying ‘this is what I would love to receive in 5 years from some buyer of my business, you could get it today at the present value of that number.’
Leaving aside the incentives for the business builder, the valuation approach is simply wrong. Sales are great, in fact a sale is the most basic building block of a business, however it is the growth in purchasing power that makes a business valuable to us as an investment.
At its heart the right way to do a corporate valuation is very simple. The present value of all the future cashflows the business generates which could be paid to the owners. The investment community has known this simple truth for many decades.
There is some science and art required. What are the cash flows (which includes working out the business will be around for many years yet!) and the right discount rate are two key questions to ask. In the loosest possible way we can think of a good equity investment like a perpetual bond, with a growing coupon.
Balmoral’s approach is to get these things roughly correct and then rely on a margin of safety approach to make up for any lack of precision.