Our valuation approach

Much emphasis is made in academic circles and from nieve investors (both extremes of the spectrum) on valuation methods used to determine if an investment security is attractively priced, or not... We have little to add on this debate. Many of our clients know we use a simple, transparent process that places greater emphasis on understanding the business, rather than crunching the numbers. We have often mentioned our process requires the mathematical skills of an average 12 year old pupil, and tries to incorporate the most powerful tool humankind has developed: applying trial and error. A simple method that reduces the number of assumptions used helps achieve this more successfully, in our opinion. Not all companies can be valued using the below mentioned process due to the assumptions we must make. All models are a detachment from reality, the best we can do is determine when the model is more useful, than dangerous... 1. For certain companies it is easier to determine their stable, normalised earning power. Such companies have a sustainable, competitive advantage that can render this number relevant throughout the business cycle. We attack this number by understanding the companies market structure, demand and supply dynamics for their products/services, the source of competitive advantage, their cost structure, business model, and management behaviour, operational efficiency and capital allocation. 2. We apply a x15 multiple to this stable earning power 3. We ask ourselves if this company can increase their free cash flow generation in the next 3 - 6 years. Hence, if it deserves to trade at a premium to its current stable earning power 4. We consider to purchase the companies stock if it trades at a greater than 35% discount to our estimate of its fair business value For companies whose products are continuosly changing, as may be there market structure, this method can be useless. Stable earning power is non existent in many technological companies as the products they would be selling in 5 years time are likely to be different. There customers may be the same, but the distribution model may have changed, hence how they interact with clients will have changed. Such businesses are outside our scope of competence as we are not close enough to such companies to feel comfortable with how their businesses may look in 10 years time. Since we do not have the resources that compete with hedge funds, mutual funds etc that have an army of analysts doing continuous inventory checks, talking to well placed friends in these industries, may even hire detectives to get data etc, we are not foolish enough to compete with their network and capital resources to determine how a businesses results may evolve on a quarter to quarter basis. Our aim is to pitch for those investments that have a recognisable stable earning power, the potential to grow their fair business value through investing their free cash flow generating satisfactory returns on capital whilst, not being in a capital intensive business or having an over leveraged balance sheet, whilst competing in a market that has a favourable market structure, stable demand for their products over the business cycle (an essential item) with a product that is hard to substitute via technological change, and a competitive advantage(s) that generate high barriers to entry to keep supply in check. This may seem demanding. However, several events may create this opportunity: A market crash Recession & other macro fears A publically recognised operational error (when history suggests this is an exception rather than the norm) A recent bad investment (leading to writedowns and lossing faith in management) Litigation Poor management (leading to temporary poor usage of free cash flow generated) An over leveraged balance sheet Buying/selling an asset A corporate event (i.e. rights offering, spin off) Changing business model An underperforming business in the company that is publically discussed Technology change (whose impact is not fully understoof yet) This is not an exhaustive list. But indicates certain catalysts that allow the stock to trade at a greater than 35% discount to our estimate of the companies fair business value.