My Approach to Valuation

Abdullah Al-Rezwan is a young analyst who publishes some deep dive research on specific companies on his blog. In this piece, he shares his approach to valuation, a subject often misunderstood and misused. Abdullah brings out the limitations given the inexact nature of valuation as a science yet the importance of using it to improve the odds of generating returns. He starts off with the current state of valuation of technology companies and the difference between the west coast and east coast approach to valuations, both of which have their place under the sun. “…it’s this difference between a culture that says look, this product is so amazing, it will define its own category, and other investors saying, when you look at this in a spreadsheet, it just doesn’t work…. The east coast approach is likely to stop you from investing in companies that will eventually go to zero, but the west coast approach is likely to help you invest in the moonshots which can potentially not only recover all those zeros but also generate outsized returns.”
Before he shares his approach to valuation, he talks about Warren Buffet’s approach to valuation and how it sounds very simple, yet can only be implemented with a very deep understanding of the underlying business fundamentals.
“I come across arguments every now and then on twitter how Buffett/Munger never builds any excel model and how analysis paralysis leads to destruction of alpha. Analysis paralysis is real, and it is important to avoid it.
So, what does exactly Buffett do? “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
I think most people seriously underestimate the distance between our intelligence/skill and Buffett/Munger’s skills. They may act like two friendly grandpas, but can you sit for a while and think who are we talking about? We are talking about two nonagenarians who are somehow still intellectually capable of managing a ~$500 Bn market cap company. These are the people who made their greatest dollar return investment (Apple) in the History of investing at the very late stage of their lives. You and I would be lucky to speak a full intelligible sentence when we are 90 years old. Buffett reads 500 pages a day, and most of us will probably find it difficult to read 500 tweets every day. The more I read about him, the more convinced I am that people do not understand just how downright incredible these two guys are. What they do is certainly worth noticing, and perhaps even copying. But imitating bits and pieces and conveniently ignoring other important details can be potentially dangerous. Let’s not kid ourselves thinking that coming up with probability of losses/gains or the amount of gains/losses will be any less difficult or will work any better for us than building an excel model.
I build the model because it suits me. Not because I believe I am going to generate massive alpha by building beautiful excel models, but because I genuinely believe it helps me understand and visualize the business a little more than just by consuming 10-ks or earnings transcripts.
Here is my first and most important rule while building an excel model: Do not take your model too seriously. Anyone can make a DCF sing. And I also do not believe I have any special ability to come up with long-term forecasts for any company in any industry.
I would most certainly not make it a habit of buying/selling stocks because someone else on the internet is bullish/bearish on them. It’s certainly not a bad idea to borrow ideas from others, but if you do not do the work yourself, it is impossible to build conviction. Without conviction, you would be tempted to sell stocks at the first sign of turbulence. If that continues over your investing career, you are likely to generate subpar investment returns.  
My level of comfort, understanding of the business, competitive dynamics, management quality, their incentives, and capital allocation policies will eventually dictate weighting in my portfolio. These are more qualitative than quantitative process. Since I am an individual investor, I want to have a portfolio of 5-15 stocks (currently I have 11) so that I can actually follow these stocks and listen to their earnings calls. I try to initiate positions at 5-10% weights, with 10% typically implying more conviction than the one initiating at 5%.
As you can see, I do not come up with any price targets. I truly believe most of us will own the great businesses of our time at some point in our portfolios. Unfortunately, most of us will sell those fantastic businesses too soon.
We would be foolish to think we can come up with target prices for stocks with any level of accuracy over the long term, but I am more optimistic about our prospects of finding great businesses at reasonable valuation and then hold onto it unless fundamentals start deteriorating. Akre capital mentions three specific reasons for selling a business that they own:
“Even with the power of compounding firmly in mind, there may be times when we believe it is appropriate and necessary to sell. These include, but are not limited to, when a business (1) is no longer growing at an above-average rate, (2) has had its competitive advantage impaired, or (3) has had an adverse change in management.”
While I am not an esteemed member of the #NeverSell community, my approach is much closer to them than it is to hyper-focused valuation community. There is no perfect way to approach valuation, but we need to find one that suits us and an approach that we can stick to across different market cycles.”