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How to value a company

By Michael O’Connor, theislandinvestor.com
Every company valuation is simply numbers from today multiplied by a story about tomorrow.
You have financial statements that give you an insight into how the company is performing at a specific moment in time, but it will be the future growth projections from management and market analysts that ultimately determine the price.
Take Tesla, for instance. Revenue and cash flows provided insight into the company’s performance, but it was predictions about future automated driving capabilities, battery production capacity and a world pivoting towards electronic vehicles that drove the company to its trillion-dollar valuation. Today, the revenue and cash flows are better than they have ever been, but the story about tomorrow has faded, and the company is down almost 60%.
While the numbers from today can be quantified, the story is driven by the future growth possibilities of the company. These future growth possibilities can seem rational at any one moment, but as the economy and company performance change, so do the growth possibilities.
Be careful how much weight you put on the stories the market is telling you about specific companies. As the information changes, so too will the story.
To quote Morgan Housel
“We can use historical data to assume a trend will continue, but that’s just a story we want to believe in a world where things change all the time”
Valuation tips
When valuing a company, you need to listen to the story being told by the company’s management team and assess whether this story is economically viable.
Here are three areas to focus on and some questions you should always ask yourself when valuing a company.
Current Cashflows
Is the company generating the profits needed to fund future business? Are the gross and net margins of the company competitive? How stable has the revenue generation been over time? Has the ROE from management been competitive?
Growth Potential
What has the revenue and earnings growth rate been over time? Are there potential revenue streams not currently being accounted for? Does the company have operating leverage that will help drive future profit margins? Does the company have a durable competitive advantage?
Future Risk
Who are the major competitors in the space, and does the company have an established moat to protect its market share? At what point will the company saturate the market, inhibiting future growth? Is the story currently being told by management viable if economic conditions changes?
Stock Picking is Hard
Since the 1940s, the phenomenal return of the S&P 500 has been generated by just 7% of the companies within the index. That is to say, 93% of the companies that made up the index reported flat or negative returns over time.
Remember, while the stock market has historically provided positive returns, picking individual names remains a difficult feat, with the odds very much stacked against you.
For those who get it right, financial elation awaits. But beware, information is constantly changing, so the probability of success can be lower than you think, no matter how strongly you believe in the future story you tell yourself.
If you have any investing questions, scan the QR code above and reach out. Always happy to help.