The three main methods people use to value stocks and make investing decisions–Technical Analysis, Ratio Analysis, and Fundamental Analysis. Most pundits and gurus make the topic of valuation much harder than it needs to be, in my opinion. The heart of any business is, after all, a simple transaction–one party provides a good or service in return for payment from another party. When thinking about investing, it’s helpful to keep in mind that no matter how large or complex a modern firm might be, at its root, it is only a collection of these very simple transactions.
The Golden Rule of Valuation
Assessing value should be straightforward. My own valuation axiom can be expressed in a single sentence:
The value of a company is the sum of the cash flows it creates on behalf of its owners over its economic life.
The value of a company does not depend on its present EV-to-forward-EBITDA multiple, its 50-day moving average, or its quarter-over-quarter gross margin expansion, it is, quite simply, the cash that it can create for its owners over time. To see proof of this, there’s no need to pour through academic articles regarding stock market returns–just look around you. All the conveniences and products we take for granted in our modern lives are a result of this axiom. None would exist if entrepreneurs and their investors did not realize they could create value by investing time and capital in a new project.
My axiom focuses on cash for one main reason: Cash is easy for accountants to count and hard for management teams to fake.
The Valuation Drivers
In order to create cash flows, a company has to do a few things:
The focus of any valuation analysis should be on assessing these drivers and can ignore most everything else.