Two Types of Valuation

Ultimately, two types of valuation exist: Intrinsic and Relative.

In intrinsic valuation, the price of an asset is determined by "the cash flows you expect that asset to generate over its life and how uncertain you fell about these cash flows."1.

In other words, you want an asset that delivers consistent, steady cash flows so those future cash flows so that an accurate valuation may be formed.

Chart 1.1 for example represents the cash flow of asset to the income column. A) Cash flow must exist and B) in order to form a reasonable valuation they must be strong and steady.

Chart 1.1 The Picture of Cash Flow

You can see this valuation at work in the Warren Buffet model of valuation ...

Intrinsic Value, The Earnings Approach ... Same Thing

This method is closest to how Warren Buffett values a stock investment. In this approach, the average earnings from the past three to five years are divided by a capitalization rate, typically the rate of return expected from the investment. Average earnings of $100,000 divided by a cap rate of 20 percent gives you a business value of $500,000. The $500,000 investment provides a 20 percent rate of return. Cap rates are typically bucketed off into different classes based on the size and type of business.⁴

1. 10 to 15 percent—large-sized businesses, over $10 million in sales.

2. 15 to 20 percent—medium to large-sized businesses with $2 million to $10 million in sales.

3. 20 to 30 percent—small to medium-sized businesses with $500,000 to $2 million in sales.

4. 30 to 50 percent—small-sized retail or service businesses.

With an existing business, ask for the income tax returns, ideally, 10 years’ worth.

The second approach, relative valuation is the same method used to value a house in which a Realtor pulls a list of similar houses that have sold recently and adjusts the selling price of the house in question up or down based on inferior or superior features. With a stock, this means comparing pricing to similar stock using the price to earnings ratio. A stock trading at 40 times earnings compared to a peer group that trades around 20, for all intents and purposes, appears overvalued.

1. The Little Book of Valuation, Aswath Damodaran, p. 4, John Wiley and Sons,2011

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