You can read the part 1 of this two part series here on what drives value

Lets review balance variables which impact valuation models

Past Prices

For a lot of cyclical companies – How they have been valued in past can help us guide on the band of multiples they can trade. However using a valuation model just based on past prices and multiples can be flawed, see the below diagram

As you can see past prices and even current prices are influenced by many factors, as long as business performance is driving prices up and down we can use past price in building current valuation model but that’s rarely the case

Apart from business performance, the stock price would be affected by

• Economic /business cycle
• Demand and supply (Mr Market’s mood)
• Perception of company and its promoters

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and there could be many more factors

Our inference

• For a cyclical company it would be an approximate view on how the company is priced (not valued) in various economic cycles

Always remember what Buffet wrote

It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now.

 

Net worth

Our inference

• Given all other things equal a company which dilutes equity continuously will be valued less than one which doesn’t in same industry
• A company which utilises its retained earnings effectively will be valued more than one which doesn’t in same industry

Here again Buffet has given us an easy way to ascertain if a company is using its retained earnings effectively, See below

it is our job to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value

You can also read this post to get a good grip on this subject

 

Return on Equity

As Buffet wrote,

Except for special cases (for example, companies with unusual debt‐equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital

ROE is perhaps is one of best economic indicators, however source of ROE is more important than ROE itself

Therefore ROE needs to be dissected – You can read a detailed post on this below

Our inference

• Given all other things equal a company which generates a higher ROE (not due to high debt) would be valued more than a company earning less in same industry

Now we have analyzed all input variables that impact the various valuation models used to value business, working on inferences can give you insights on why some companies are valued more than others in same industry

Champion investors can detect these very quickly although it takes years of practice and curious bent of mind but as many investors has shown this can be learned.

As an exercise jot down (or copy) all inferences and try and fit a business ,which you know is valued more than its peers. This will ingrain a very important construct in your brain whenever you will evaluate any business, Share with us in comments

Happy Investing

 

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