some quick thoughts on valuation

The more investments I make and the longer I spend thinking about this game, the less emphasis I place on valuation. This may sound counterintuitive given I place myself firmly in the value investor camp. So, let me clarify:

 

Firstly, I think setting price targets and determining exact valuations is naive, unnecessary, and dangerous. Believing that you can consider the entire spectrum of future outcomes and discount them back to today at an appropriate rate is arrogant. No one can tell the future. Not at the macro or micro level. Therefore, it is impossible to determine an exact intrinsic value for any business.

However, determining a precise valuation for a business is not required to be a successful investor. John Maynard Keynes once said, “it is better to be roughly right than precisely wrong.” This is how I approach the valuation aspect of investing. Once I find a company that I like, I don’t perform a discounted cash flow analysis and set a level at which I would buy it. I try and work out at what price I wouldn’t be overpaying for the business. This is easier said than done and comes down to multiple factors. But the basic idea is that the investment opportunity should hit you over the head. The discrepancy between what the business is currently selling for and what it could be worth should be so large and so obvious, that it becomes a no-brainer.

Setting firm valuations and target prices for investments can also have side-effects. The most dangerous of which, is anchoring. Once you’ve set a target price you subconsciously anchor to the number and it can cause you to make poor decisions. An example would be: you purchase a stock at $1 and set the target price at $2. The business performance begins to deteriorate because of a new entrant in the market and the stock declines to $0.75. By setting the initial target price, you anchor to the number and argue that the issues are transitory and now the company is trading at an even more attractive price. This may be correct. However, anchoring to the initial “upside” may cause confirmation bias to set in, where you block out new information that would otherwise alter your view.

 

The second major point on why I place less emphasis on valuation than I did when I first started investing is because I don’t believe superior valuation skills are the key driver of successful investing. To make money investing in common stocks, you need to have a non-consensus view and be correct – variant perception. There’s a quote by Ron Rimkus that illuminates this point. He essentially says that too many analysts/investors spend their time trying to make precise forecasts about the future cash flows of a business. “The game is about our ability to distinguish our perceptions from the market’s and successfully bet when there is a material difference.” This is where the money is made.

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