Introduction:TheQCulture xvThe next inquiry is what to loo kfor, within your circle of com-
petence. The main question is the certainty with which you can
evaluate the long-term economic characteristics of a business. A
greater degree of confidence may be necessary for rookies, less for
vintage companies, and least for classics; but in all cases, assessing
the long-term characteristics of business performance is crucial.
Obtaining the necessary degree of confidence in valuation entails
just a few quantitative inquiries. You’ll see in the second part of the
boo kthat financial statements must enable you to answer three
questions about a business:
- How likely is it the business will be able to pay its debts as they
come due? - How well is management running the business?
- What is it worth?
These questions can be gauged with a sufficient degree of con-
fidence by a basic familiarity with key business ratios relating to
working capital and debt, management of inventory and other short-
term assets, returns on equity, and the future outloo kfor earnings.
Just as each investor’s circle of competence will vary, so too will
the assessment of these financial characteristics. Ultimately, the
value of a business is the present value of all the cash it will generate
for its owners over future time. Because no one can know the future
with certitude, coming up with that number requires the right set
of tools and good judgment.
Equipped with these tools and working within your circle of
competence, you can determine how much and what sort of evi-
dence is required to be comfortable with a valuation estimate. Yet
there is no single reliable tool to pinpoint the value of a business,
so intelligent investors must observe Benjamin Graham and Warren
Buffett’s cardinal rule of prudent investing: getting a margin of safety
between the price you pay and the value you are paying for.
In your pursuit all these inquiries, reported figures must be
treated with a healthy skepticism. Accounting conventions and judg-
ments can distort business reality. For example, working capital fig-
ures can be distorted by accounting rules relating to inventory and
receivables collection. Some fixed assets that are outmoded or non-
competitive may have an actual scrap value way less than the re-
ported figure.