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What You Need to Know About Business Valuation

What You Need to Know About Business Valuation

The business valuation of your company matters whether you’re a manager of a publicly traded company, a privately held company, a company that wants to be acquired, or a business looking for capital. While the value of your company’s stock is not the only metric of success, that value does provide a lot of information about how investors think about your company. As such, every manager should at least have a basic understanding of the two accepted approaches for analyzing the value of a company – the technical and fundamental analysis methods.

Technical Analysts

When you think the technical analysis of a business valuation, think of money manager Jim Cramer on the CNBC show Mad Money.  If you’ve ever watched Mad Money, Jim Cramer analyzes a stock’s value from multiple charts, looking at historical trends in the stock price, ratios compared to the industry and relationships to other economic indicators.  For example, Jim Cramer might compare the price of oil against an airline’s stock price, or compare interest rates to the stock prices of financial services firms or real estate companies to forecast how these companies stocks might perform. As a technical analyst, Jim Cramer will be focused on the Beta of a stock and how that stock’s potential return and risk might fit into his investment portfolio. Jim Cramer will consider a news release such as new disruptive technology into his buy, sell or hold recommendations, but as a technical analyst, Jim Cramer believes all financial information is already accounted for in the stock’s price.

Fundamental Analysts

A perfect example of a fundamental analyst is Warren Buffet.  If you’ve ever read Warren Buffet’s books, then you will know that when he invests in a company, he will focus on the fundamentals of the company; reading the financial statements starting in the back to the front. Warren Buffet will want to know all things about the balance sheet, cash flow, sources of revenue, the management of the company, the products, markets and clients, competitive advantages, and more.  He will spend significant effort comparing the fundamentals to the nearest competitors and will try to determine the company’s intrinsic value based on discounted future cash flow calculations – often resulting from the company being turned around.

Which Method Produces Better Results?

So where does that leave us? Although this is a generalization, technical analysis is better for short term “trading” of stocks, whereas fundamental analysis is better suited for a longer term and larger “investments.” It is very difficult for a portfolio manager to perform a fundamental analysis on 200 stocks in their diversified portfolio.

The difference between trading and investing is a gray line often based on a time horizon, but it does summarize the main differences between technical and fundamental analysis. Investing using the Jim Cramer technical method returns results in weeks, days or even minutes, whereas a fundamental investor like Warren Buffett may not see results for many years. Under Warren Buffet’s approach, a gain may not be realized until the stock’s market price rises to its “correct” value. This investing is called “value investing” and assumes that the short-term market is wrong, but the price of the stock will correct itself over the long term.

Therefore, there is no correct answer as to which method of business valuation produces better returns – or which method is valuing a company more accurately.  Both methods try to maximize returns against the risk being taken.  The higher the risk, the higher the potential return, and there are technical and fundamental investors on both sides that take more risk and sometimes have higher returns – or bigger losses.

Behavioral Finance

The main issue with both methods of business valuation is that the human aspect always gets in the way. What an investor is willing to pay for a stock; its market value may be very different to what it’s really worth (intrinsic value).  The explanation for this anomaly is based on behavioral finance.

Behavioral finance tells us that analysts and investors don’t always behave rationally.  Anchoring bias describes how we associate recent events as predictors of future events.  We would not be human if we didn’t learn from our past experiences, but while recent events can give us an idea of what to expect, this is in no way indicative of what the future will bring, especially given the volatility of markets.

Anchoring bias is an issue with the technical analyst who compares past charts and trends and sees patterns as a predictor of the future. Anchoring bias is also an issue with the fundamental analyst who believes they can predict future cash flows of a company based on multiple highly risky variable assumptions that cannot be controlled – competitor behavior, customer, and client buying patterns, operational improvements which may not materialize, and many more variables.

What Does This All Mean to us as Managers?

At any one point in time, you are going to have both types analyzing your company, and both the technical and fundamental data are important for a business valuation. As a manager, we need to understand why our stock is experiencing volatility when it’s increasing or decreasing in price.  Those movements in our stock price may give us external insight into our performance, our industry, or the market as a whole from the point of view that we may not see from the operational ground. We must also ensure that both types of analysts can easily understand our fundamental data like our strategy, competitive advantages and that our financials are attractive to the market.  Finally, as any financial analysts from either side will tell you, managing our cash flow and risk is the most important job we have because ultimately that is the basis of all business valuations.

Dr. Alfred Sanders is a professor of finance at the Jack Welch Management Institute, and a Partner, Capital Markets Consulting at Genpact.

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