“If it’s close, we don’t play.” - Ben Graham
Value investing- at its core, possesses impenetrable logic; find a great business, figure out its true value, and pay significantly less than it’s worth.
However, like anything worth doing, valuing a company is an extraordinarily difficult task.
I believe the purpose of fundamental analysis is wildly misunderstood, which I’ll address in a bit. But, before we judge too harshly, consider a few of the complexities that is involved in calculating the true value of a firm:
- Defined benefit (pension) accounting allows management to make significant, often unrealistic assumptions which can be really damaging to a business (think GE).
- Companies use off balance sheet financing to mask their debt levels. Analysts have to make adjustments for operating leases (which don’t show up on the balance sheet) to give a true sense of a firms future obligations.
- Management quality and shareholder governance is very difficult to measure.
- Analysts must make adjustments to financial statements for international subsidiaries, whose currency fluctuations will cause changes to the parents financial statements. For independent subsidiaries, changes in currencies by pass the income statement and are found in the equity portion of the balance sheet (having fun yet).
- Changes in consumer preferences and industry structure
- Adjusting financial statements from LIFO to FIFO to compare apples to apples.
- What valuation method is appropriate? Absolute valuation, i.e discounting dividends or free cash flow versus relative valuation i.e P/E, ROE, EV/EBITDA.
- How a company is financed, debt/equity and their respective costs.
- There are items that bypass the income statement (aren’t reflected in net income) such as unrealized gains and currency re-measurements.
- Fair value of goodwill is very subjective.
- Untangling accrual accounting such as deferred revenues and accounts payable.
- Which measures of profits/cash flows to look at: EBIT, EBITDA, net income, CFO.
- Determining the required rate of return, which is a function of constantly changing risk-free rates and the equity risk premium.
- And finally, the million dollar question, what are people going to pay for these companies.
So yes, determining a fair value for a business is extremely challenging, however, I think naysayers are missing the bigger picture. Fundamental atheists wrongfully assume one needs to be extremely precise to make money. This could not be farther from the truth. Warren Buffett said ; “you don’t pinpoint things. If somebody walks in this door and they weigh between 300 and 350 pounds, I don’t need to say they weigh 327 to say that they’re fat.”
Fundamental analysis can no more tell you what the price of a stock should be than technical analysis can tell you where a stock is going. The truth is, fundamental and technical analysis- although derived differently, are both all about probabilities and risk/reward.