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How I value a business using different scenarios

Discussion in 'Investing Strategies' started by Libertarian, 28th Feb, 2010.

  1. Libertarian

    Libertarian New Member

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    Hi Everyone,

    I am a former Investment Banker and Hedge Fund trader who now invests his own capital. I intend to outline my value investing methodology. The first topic is 'How I value a business using different scenarios'.

    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:

    I also value a business using different scenarios because it will help stop me from collecting information about the business, and then make 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:

    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 will be to:

    Gather Evidence > Weigh and Evaluate Evidence (Predict Scenarios) > Decide[5]


    How I will 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 will 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 will 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:

    Much more to come....The Fallible Investor
     
  2. wdongli

    wdongli Well-Known Member

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    Hi Libertarian,

    I am very happy to read your post and very excited to read the wise words in "The Fallible Investor." After working in the market as a part time trader, I did find in 2001, the terrible failure to chase the hot, and red hot stocks in the market. I spent a lot of time to update my mind-set but not good enough.

    All of the topics in your post are basic ones and most of my failure in the market, in hindsight, are caused by the failure of the understanding of the basics of the economies, market sentiment, value and how to value, and philosophy(life logic and common senses) and their application in the market.

    'How I value a business using different scenarios'. I like the words, "different scenarios," very much. Who are we? Without matter if we realize, we are the decision makers. As a decision maker, you have to make the decision based on the possible scenarios of the consequences from your decision and accept the consequences in the future.

    Please allow me to think further based on your wisdom and the followings are mainly to sharpen my minds to mull the words from you:

    Value, a very important but elusive thing
    I read and know the importance of the value. But how to get it. Happy to see the words:
    1. the intrinsic value
    2. estimate by determining its expected value
    3. upside, central cases, and downside scenario
    4. probability of the scenario

    How could we determine the expected value rationally? I am happy to see some lights about it in your "The Fallible Investor." Do hope I could get the asset to give me more about the expected value from there.

    Yes, we can not predict anything exactly in the future. So we have to protect us and buy at lower price than the value, the minimum possible future value.

    I like the black swan theory from Taleb very much but do feel the difficulty to use it properly.

    A story or thesis

    It is great light to me. Do feel something wrong to put too much time to google for the data and information to support my own perception. We could not predict the future exactly and then the story about the future would wrong. We don't need the story but the intelligent data collection, wise judgment, and make the decision to get the best consequences with good enough probability.

    I like the quote from Montier very much. We need to be warned by analysis paralysis and fail to make the decision when we need. Thank you for the words, explanation-based decision making. Could you give more information about Montier's work?

    It is the lesson I should remember:

    Never try to

    Gather Evidence > Explain Evidence with a Story > Match Decision to Story

    Yes all of us have multiple options to move into the future and business should do the same. it is a good map that:

    Gather Evidence > Weigh and Evaluate Evidence (Predict Scenarios) > Decide

    ***
    Libertarian's post shows the deep thinking about the investment. "The Fallible Investor" is a mine of wisdom in the market and investment. I would put more and more time on it and hope I could contribute to this mine someday later.
     
  3. wdongli

    wdongli Well-Known Member

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    Libertarian has given some very good ideas how to value a business in practice even anyone if wants to apply them, has to overcome some barrier in knowledge.

    The probability to be true of each scenario

    In the early days of the market practice, we tend to follow the market sentiment with simple or complicated charts. We calculate the probability in days if not in seconds. It needs tough speed to react instinctively by around the stop loss. The loss is the target not the profit.

    You could trade but you have to evaluate your target for the future profit power in long enough. We could not predict the wind blips even we could tell generally about the weather in days. The problems are the high efficiency of the market for the available data make you have little chance to win enough.

    We need to get the probabilities based on the underlying business. We need to know the business and fundamental background enough. We need to be intelligent in trading and investment.

    Libertarian does or want to do:


    1. "outline the pros and cons for each ‘tentative’ probability estimate."

    2. ask himself "what arguments are there for why the estimate is reasonable, and what arguments are there for why the estimate is unreasonable."

    3. "find out what risks the business took to generate this success."

    Charlie Munger, Buffett's partner, likes to say inverting and never forget to know where you could be killed and never close to it.

    In the market we are decision makers. We need to defend us first and offend second. If we could not defend us enough we would lose or lose the capability to offend.

    We come into the market originally since we see someone gets millions of dollars from something we could not see. "Very rarely is the generator visible to the naked eye." We need to update our minds to know the underlying processing to make the money. If we find a money maker for something like raining gold, we should not worry the market sentiment changes. Is it why Buffett always say he prefer to "pay the reasonable price for quality?"

    On to the earth, we should know when and under what conditions the quality could be sold in discount or on fire. I do feel if you don't know what the quality is you have to know when and where you could get something for discount.

    Of course it is better to get the quality but remember we want the profit not quality and if the price is too high we could not get the profit from anything.

    Please note all of the ideas in this post is from Libertarian and I just rewrote to fit my mind updating demand. A home work for the valuation and probability of the scenarios of the consequences.
     
  4. Tropo

    Tropo Well-Known Member

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    Value Investing:
     

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  5. wdongli

    wdongli Well-Known Member

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    Value, low, and lower

    Haha, thank you, Tropo! It is very fun to look at the picture you left!

    Hope all of us are not this kind of value investors: buy low and sell lower!

    In reality, often than not we want to buy low but find what we got turns to be lower. How to be sure we buy lower than the future low or low of the future high? It is more important than we call us as value or whatever investors.

    Are there the fake value investors? What difference between the fake and true value investors? I guess, too many who said they are value investors but don't know what the true value investors do.

    What would the true value investors do? Do they do the same as what Warren Buffett does?

    Not sure in details but just based on the reading about Buffett and B. Graham, the true value investors have to follow the followings as basics:

    ***
    1. Know roughly about what the intrinsic value is which should be very elastic and decided by some tangible and intangible matters of the business.

    2. How to know the tangible and intangible assets or matters? The true value investors seem to be some kind of business men or women in their circles. They should not the best otherwise they could not get the value right.

    3. So if a self-labeled value investor could not know the value, he would buy the low and sell lower. We are wrong and could not sustain the loss, what could we do?

    ***
    So Buffett said no loss, never no loss, and never forget no loss. I thought I want to be a true value investor. But I have to stop the loss regularly. My conclusion is I am not a value investor at least not true one.

    We, as retail market players, come into the market mainly because we want the quick money but we forget a basic logic, knowledge is power. We don't have enough knowledge about the financial statement to tell what's made and what paid, what's the earning trend and what's the future power...

    Besides of the lack of the knowledge, we are greedy since we are money hungry.

    So most of people would be very disappointed about the value investment. We want the quick money but it just don't make our money as we expect.

    Yes, Value investing: buy low and sell lower. It is never easy to make the money let along the big money. We want the big money but don't want to get the knowledge for this big money. So we hand out our fate to Mr. Market.

    ***
    Knowing buy low and sell high is not good enough. We could be wrong. So the true value investors have to leave big enough margin of safety for their capital.

    You want to offend to win but you have to defend yourself good enough. If you are defeated, you could not offend let alone the victory.

    ***
    Quality itself is not value. Everything has its value. You have to buy the value at much lower price in future or at least the time scope you would like to hold.

    Value is not a matter in the paradise. Value is sold on sale is rare. So when and where we could get the value in discount and great discount.

    ***
    I realized the above in 2006. But until now do feel I need to get a lot of knowledge about the economy, market, business leadership, management, accountancy, crowd psychology, and so on.

    A great market player must be a master about the market or in his circle. I am not sure if I could but I would try.

    I am reading the book, "The General Theory of Employment, Interest and Money" from Keynes. We need to know the economy good enough. We need to know what we don't know. We need just to play what we know for safety and extend our knowledge to keep playing what we know.

    To be a true value investor needs a long journey. Could we walk together for it.
     
  6. Tropo

    Tropo Well-Known Member

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    Decision based on imaginary value/fundamentals only, is a one way ticket to Disasterville.
    J.M.Keynes was a short term 'speculator'. His famous remark -“The market can stay irrational longer than you can stay solvent” is still valid today.

    Interesting reading :
    http://jutiagroup.com/2009/02/17/wa...l-insider-trading-reveals-undervalued-stocks/
    Insider Trading with Warren Buffett: The embarrassing truth from a non-believer – Out of the Box - Strategy, Sales and Marketing
    Here I Go, Criticizing Warren Buffett -- Seeking Alpha
    The One-Arm Contrarian
     
  7. wdongli

    wdongli Well-Known Member

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    Hi Tropo, thank you very much for your appreciation and feel you work very hard to know the investment as deep as you could.

    The winning and learning need to learn from the Masters as that for us to learn martial art, which could lead us to make less mistakes and better results counted in time. We would still make mistakes but from the masters and Greats, we would learn how to correct our mistakes.

    In all of books I have read, I thought "The intelligent Investors" from B. Graham is one we have to read. I found very hard to read "the security analysis" which needs a lot of knowledge in accountant, management, and the understanding of the human psychology. All I do now is to get the basic knowledge to understand "the security analysis" good enough.

    These two books are the bible of the true value investors. I believe if we could not understand these two books we could not be good value investors.
    Graham separated the value investors into two types, one is passive and another is active.

    If we want to be passive we have to read "the intelligent investors" which is for the people who could not get enough time but want to be value investors. I do feel after you read "the intelligent investors" you would get the motives to go much far as you could.

    Don't know you age. If you are young or below 35, one word from Buffett would be very helpful: Learn from one Great which could make you excited and focus on to learn from this Great. Unfortunately I have got too much in my field and the transition from one field to another need more energy to get rid of the inertia frictions.

    How I would back to "the security analysis" once I have got enough relevant knowledge to understand it.

    Good luck and get your intelligent mental frame first if you could.
     
  8. Tropo

    Tropo Well-Known Member

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    wdongli,

    One of many books I do have is Graham's "Intelligent Investor" which I read long time ago...
    Unfortunately books like "One Up On Wall Street" by Peter Lynch or "Take On The Street" by Arthur Levitt, are not going to make anybody a successful investor.
    Those books like many others of this kind are good easy/entertaining reading.
    Without understanding human psychology, risk/money management and few simple investing/trading techniques, anybody's chances to become a successful investor are rather bleak. :rolleyes:
    It seems to me that you do have a long way to go...
    So...Happy learning! ;)
     
  9. wdongli

    wdongli Well-Known Member

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    Very happy to know you have go ahead of most of market players and me, which would give me more chances to get a intelligent mental frame for a profit in long run.

    Fully agree "without understanding human psychology, risk/money management and few simple investing/trading techniques, anybody's chances to become a successful investor are rather bleak.

    Having jumped into market for more than a decade I still act more often than not as a speculator. To be a successful value investor, my understanding is we have to understand the life logic and common senses and could adapt them into the ever-changed market environment first.

    I am still in my learning curve but do feel the benefit from the mind updating. I basically follow the cigar butt theory in my market practice with some adaption since 2004.

    Currently I try to:
    1. Buy for no loss and never think about stop loss as I used to do(good defending always is the first and then you could offend effectively)
    2. Get a trustful value evaluation method for roughly right since it doesn't exist of a constant value
    3. Cigar Butts or pennies have their value and some of them could be dollars.
    4. Get as much as you can from the winners to cover all of costs, needs, loss of the losers, and get enough profit after the deduction(get the value at great discount. Hope to get a dollar at penny price. To be a intelligent value picker)
    5. Patient to hold the winners if getting the faith for their future(to be intelligent speculator and stay at the place there will be black swans appears regularly)
    6. Lock the profit when they big enough(enough is enough and know what and when should be enough)
    7. Hope I could think independently and have inner peace for balance of the chances and risks(Hope be able to be a thoughtful market player. Play for money but not really for money even at last we have to get the money)

    Yes not easy but have to learn for a intelligent mental frame. To a good mind no money you would make money but to a bad mind, you could lose millions of dollars very easily.

    Thank you for your kind advice. I would keep to reading and pondering for a good market player.
     
  10. Tropo

    Tropo Well-Known Member

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    Happy Investing !!
     

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  11. tradeonauto

    tradeonauto New Member

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    Geee fellas, you seem to be making it awefully difficult.
    Remember being a hedge fund trader is not a big deal in terms of returns. Some of these guys - the so called good ones manage a whole 20 odd percent a year.
    I wouldnt get out of bed for that! And neither should you.