The Business of Value Investing.pdf

92 The Business of Value Investing

the long run. These two variables alone represent the critical valuation

metrics of oil companies. While no two businesses can ever be valued

in identical fashion, when it comes to valuing any business, a large

portion of the valuation will hinge on a small handful of variables.

Does this suggest that investors should ignore the little details?

Absolutely not. Serious investment requires a keen knowledge of all

the information. One of the wonderful aspects of investing is that

you are constantly learning something new each day. One business ’ s

negligible data could be another ’ s relevant information. Back to our

oil analogy, in addition to the oil price and production level, you

would also pay attention to production costs. This is helpful as you

begin comparing different oil companies. When the price of oil is

artifi cially high, it would appear that all oil companies are extremely

profi table, thus making management look very competent to share-

holders. Excessively high profi ts based on the price of oil are beyond

the control of management. What management can control, how-

ever, are production costs. And when oil prices decline, oil com-

panies with the right blend of rising production levels and stable

production costs will benefi t while the undisciplined companies hurt.

The point of all this is to expand on the quote of Paul Clitheroe at

the beginning of this chapter: Business valuation is not that hard if

you train yourself to look at the important things over and over.

When the topic of business valuation is discussed in investing

circles, lots of words are thrown around, such as intrinsic value,

margin of safety, free cash fl ow, discount rate, and so on. These are

all very important concepts that are at the core of valuing a busi-

ness. Before getting started in valuing any business, it ’ s important

to have a true understanding of these terms and concepts.

Value Investing 101: Margin of Safety

Warren Buffett calls margin of safety the “ the three most important

words in all of investing, ”^1 and Benjamin Graham gave rise to the

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