10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock

Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.

For many businesses, it is difficult to calculate this with a level of precision that has much utility.

Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.

Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.

The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.

In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.

A no-growth business also earning $1 million would be worth about 10 times earnings.

Business 1: $1 million / (10%-6%) = $25 million

Business 2: $ 1 million / (10%) = $10 million

As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.

Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.

You should carefully think about each of these and add them to your checklists for evaluating a business.

I’ve put Gurley’s characteristics in the form of a question.

1. Does the business have a sustainable competitive advantage (Buffett’s moat)?

2. Does the business benefit from any network effects?

3. Are the business’s revenue and earnings visible and predictable?

4. Are customers locked in? Are there high switching costs?

5. Are gross margins high?

6. Is marginal profitability expected to increase or decline?

7. Is a material part of sales concentrated in a few powerful customers?

8. Is the business dependent on one or more major partners?

9. Is the business growing organically or is heavy marketing spending required for growth?

10. How fast and how much is the business expected to grow?

Gurley’s post: All Revenue Is Not Created Equal: The Keys To The 10X Revenue Club.

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12 thoughts on “10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock

  1. Elie Rosenberg

    Interesting post. It seems like most of the criteria are focused on gauging growth potential. Do you consider downside risk as part of the appropriate multiple/discount rate or as a separate factor? From how Schroeder describes Buffett’s process it sounds like he does the latter. There is a certain level of cat risk that will negate the investment for him at any price.

    Reply
  2. Greg Speicher Post author

    Elie, I think you make a valid point. I do not view this checklist as exhaustive; it is simply another tool to use when thinking about a business. Most of them – 1, 2, 3, 4, 5, 6, 7, 8, and 9 – are important considerations regardless of the growth prospects of the business.

    Reply
    1. Greg Speicher Post author

      Andrew, this model does not work with a growth rate that exceeds the discount rate. In this case you could use a two tiered model with 12% growth for x number of years and then a terminal value calculation. See http://gregspeicher.com/?p=53 for an example.

      Reply
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