Developments that shall unfold

Bottom up valuation is one of my favorite way to understand where to catch the growth of a business.

Illustration only – hypothetical valuation.  Bottom up valuation is one of my favorite way to understand where to catch the growth of a business.

I remember one of the first thing when I read what Philip Delves Broughton wrote about finance in his book “What They Teach You at Harvard Business School” was that finance is all about valuation, not quite exact his word, but that was the central idea.  It took me 4 years with many practices across various different financial markets, from local to global and back to unlisted local markets to get what that sentence really means.  The true meaning of that sentence is the hidden relationship between value and price.  Of course, to my opinion, it’s not the central of finance, but the central of investment.  But let’s spare the wording, there is no any more important relationship in investment that stands higher than the relationship between value and price.  Price is what people pay for an asset, value is what people will receive with that asset now or in the future.

Because It is both so troublesome to identify any side of the equation, the price and/or the value of something, investment have been so difficult a subject. Price is the less hidden object comparing to value.  However, because price is more obvious doesn’t mean it is less complicated given price is the central point of bargain between any buy-sell relationship in a dimension that is more likely to be a zero sum rather than a win-win.  That’s why price has been the focus of various fields from macro to micro.  In capitalism theory, price is one of the key determination for profit and hence, in turn, a key determination for one to jump into the business and compete, competition will reduce price and cost gap and in the long-run will push profit margin down to average level.  In strategy and finance, gross profit margin of product speaks how powerful that company is to set the price comparing to industrial peers.  Demand and supply from microeconomics have various pricing strategies, including price discrimination that will, in theory, lead to highest profit margin that aviation companies often employ.  We have 4P of marketing.  Cost-plus pricing method of managerial accounting.  Black-Scholes-Merton in European-style derivative pricing.  To complicate the matter, in investment world, pricing is not the only dimension that label how much investor pay for one company.  Going along with the price there are the deal structures and term sheets that include various options that might be very powerful when time comes and the options are exercised: investors can’t always price some adverse events into the asset, but they can structure against them, that makes the terms and options can be a game changing point to protect the buyer/seller from the downside (with the damage goes into the other party).

However, to me, value is the much more troublesome side because you never really know if you overpay something.  The reason is there are various dynamics are evolving around and many of them are out of control of the investors such as a macro economic shocks (the case of 1997 in Southeast Asia, 2007 from the US, EU debt crisis), structural changes (motorbike helmet enforcement in Vietnam, financial deleveraging – everywhere), or a shift in technology (CD music playing devices, tapes, and now traditional newspapers).  From my limited experience, one of the most effective way to catch the value of a business is to identify the developments of the company/sector that shall unfold when time comes and that unfolding will bring a much higher value comparing to the price that the market is offering.  So that the investment game has become a value hunting business.  In order to find those hidden developments, the investor has to understand the business and the market deep enough to see those ahead of other (or others will buy the business before her and push up the price).  The developments come from as macro as mega trends of a society toward hygiene food, urbanization, health awareness, a rush to the universe (true story: I have a friend who is applying to be a Mars citizen), or as micro as a strong management team with a correct vision, R&D developments, or even as external as a failure of a key industrial rival due to its self-destructive investments (the case of Mai Linh vs. Vinasun, the case of Long Chau animal feed distributor in early 2000s).  These developments are called drivers, and we not only need to know what drivers lead to the growth of the business but also need to be able to quantify it down to a single valuation number and structure the investment that in our favor when the drivers go wrong.  Needless to say, the price, then, must be justified with the valuation before the investment is made.

I can’t stress enough how difficult that work is.  Each industry has a unique way of behaving and rules.  Value may stay concentrated or scattering around everywhere.  Top businesses in the industry may have already been pricing too high.  Middle tier businesses may not have a good enough competitive position to offer great growth.  Early businesses with potential ideas, clearly risky, may be managing under the hands of too inexperience entrepreneurs.  A star business may be diversifying into non-core businesses of real estate and stock investing (oops!).  A top position business may, and often, not need equity cash.  An attractive business may being bidden too aggressively between buyers.  Macro conditions may be changing (I have been into a business that when we got into the business the commodity price of what we are offering failed 50% globally the following years).  Building a diversified portfolio sounds a sexy idea, but the portfolio itself may have been overpaid, stock selection and timing risks are still, and the diversity is not complete enough to eliminate all business specific risks.

But because the real and valuable developments are so hard to find, it does offer room to protect the micro-business-specific risks and even some of macro risks, prevent over-trading from short-term market whipsaws, eliminate some emotional attachments and biases to the business,  and more importantly serve as an important thesis to support the notoriously difficult thing to do in investment: when to enter and when to exit.  Finally the question of why is the most difficult question to answer in investment world.  Looking into drivers and unfolded developments may be one of the approaches that work.

4:46 PM – May 25th 2013, Bitexco Financial Tower

Tri Ton

Businessperson with private equity expertise. Interested in strategy and investment.

2 Comments:

  1. Huynh Phu Than

    amazing but really deep thinking… Tks Trí 🙂

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