How to Appraise the Value of a Business - dummies

How to Appraise the Value of a Business

By Peter J. Sander, Janet Haley

Part of Value Investing For Dummies Cheat Sheet

Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you’d look for the following:

  • Income: Profits — and strong positive operating cash flows exceeding capital requirements — are a good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.

  • Income growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.

  • Productive capital investments: If a company is able to invest additional capital productively — at a greater return than it would get by putting it in the bank — that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.

  • Rising productivity and falling expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.

  • Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.

  • Steady or rising asset values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.

  • Favorable intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.