I estimate the intrinsic value of a business by determining its expected value. I estimate its expected value by determining an upside, central case, and downside scenario for the business and attaching probabilities to each of these scenarios.
Why I use different scenarios to estimate a business’s value
I value a business using different scenarios because I cannot predict the exact future of a business. As Taleb points out:
“The Sceptics’ main teaching was that nothing could be accepted with certainty, conclusions of various degrees of probability could be formed, and these supplied a guide to conduct.”[1]
I also value a business using different scenarios because it helps stop me from collecting information about the business, and then making up a story or ‘thesis’ to explain this information. The problem with making up a story about the business is that I am likely to make an investment decision based on this story, not on the original decision.[2] As Montier explains:
“In a rational world, we would all go around gathering the evidence, and then evaluate it and weigh it before reaching a decision. However, real-world behaviour is a long way from the rational viewpoint. We collect evidence (usually in a biased fashion), and then we construct a story to explain the evidence. This story (not the original evidence) is used to reach a decision. Psychologists call this explanation-based decision-making.”[3]
If I do not value a business using different scenarios there is a major risk that I would use the following process:
Gather Evidence > Explain Evidence with a Story > Match Decision to Story[4]
Predicting an upside, central case and downside scenario for a business, and attaching probabilities to each of these scenarios, is likely to prevent me from coming up with a story about whether I should buy the business. This is because I am forcing myself to predict more than one future for the business. By predicting scenarios, my process is to:
Gather Evidence > Weigh and Evaluate Evidence (Predict Scenarios) > Decide[5]
How I estimate the probability of each scenario
Estimating the probability of these scenarios is difficult because the future of a business is hard to predict. One technique I use is to outline the pros and cons for each ‘tentative’ probability estimate. In other words, ask myself what arguments are there for why the estimate is reasonable, and what arguments are there for why the estimate is unreasonable.[6]
How I estimate the downside scenario
If a business has been successful, it is critical that I find out what risks the business took to generate this success. As Taleb points out, you can often underestimate what these risks were. He says:
“Unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. Very rarely is the generator visible to the naked eye…We see the wealth being generated, never the processor, a matter that makes people lose sight of the risks….”[7]
Much more to come….thefallibleinvestor.com
[1] P184, ‘Fooled by Randomness’, Nicholas Taleb, 2001.
[2] As Montier also points out: “when we believe something to be true, we tend to throw logic out of the window, preferring to judge by our belief rather than by analysis.” Montier goes on to say: “People accept things that are not logically valid when they believe in them, and refuse to accept things that are valid but not believable. This is clear evidence of a belief bias: logic goes out the window when beliefs are strong.” P524, ‘Behavioural Investing’, James Montier, 2007.
[3] P53, ‘Behavioural Investing’, James Montier, 2007.
[4] See P191, ‘Behavioural Investing’, James Montier, 2007.
[5] Ibid.
[6] When determining the probability of these uncertain scenarios I can use some form of qualitative measurement. For example, qualitatively I can say one rock is harder than another (I do not have to put an exact figure on it). Also if I am unsure of the probability of a scenario I can widen my probability range until it reflects what I do know. See P17, ‘How to Measure Anything: Finding the Value of Intangibles in Business’, Douglas Hubbard, 2007.
[7] P29, ‘Fooled by Randomness’, Nicholas Taleb, 2001.
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I discovered your blog at Simoleon Sense. Very well laid out and informative blog. I believe the more simple and investing strategy is the less likely someone is get confused by noise.
I am interested in one of your concepts. That is the idea of assigning a probability to the various investment scenarios. I know Pabrai also has a similar kind of idea. Here is my problem. Can we really calculate probability on such complex inputs that is the world of investing? Are we not in a sense substituting a numerical story for the narrative story that can lead us to abandon rationality. This is not meant as a criticism. I am genuinely wrestling with this concept. And would love to know how to translate pros and cons into probability.
Thanks in advance for your response.
I think this is an excellent question. My answer is that I am not sure that we can calculate probability on such complex inputs. But what is the alternative! If the alternative is making a decision based on a story or narrative I will take the risk that I am wrong.
[...] As previously discussed, I estimate an upside, central case and downside scenario for a business depending on what I think are the major risks for the business, or upside factors likely to affect the business. I do not include the risk of a recession, a change in commodity prices, or where the business is in its product life cycle, as risk or upside factors. I do this because I think it is easier to deal with these risks when normalising the business’s earnings. [1] I use this normalised earnings estimate in my valuation to estimate the ‘central case’ value for a business. [...]
[...] qaitutalive measure of our health. For more on evaluating your overall health see my prior post 25 Scenario Checklist To Identify If Your Business Is In Trouble. Posted in: State of [...]