It's always tempting to try out complex new valuation techniques. Don't!
When you follow the financial markets, a flood of numerical data comes your way. The data from annual reports, from online information services and from TV stations like Bloomberg or CNBC.
All this information is good, surely? And the more information you have, the better the investment decisions you make, right?
Well, I don't think so. Here's the problem. You could feel obliged to do something with all these numbers, such as collect them, collate them, and run statistical software over them. Supposedly that will give you an insight into share price movements and company valuations that ordinary investors do not have. But I'm not convinced that all this work will improve your investment performance.
Recently, I came across a piece of software to help value companies. It uses something called the "Gordon" model, which is named after Myron Gordon, a Professor of Finance at the University of Toronto. The Gordon model is taught in MBA programmes.
At first sight, the model looks complex and involves the use of a company's cost of capital, its future cash flows, its future growth rates and something called "the summing of an infinite series."
At second sight, it should be old hat to seasoned Foolish investors because it is strikingly similar to the discounted cash flow model of company valuation which has been discussed at length on The Fool.
At third sight, the model is mad. The valuation depends on accurately predicting a company's growth rate and cost of capital many years into the future. Besides, whilst the notion things can be "summed to infinity" might be interesting to mathematicians, it seems odd to apply it to investment where it's hard to know enough what might happen tomorrow, let alone at infinity.
These sorts of company valuation methods give the illusion of accuracy by appearing to be precise. In fact, they're neither accurate nor precise.
The vagaries of the business climate make precision impossible. The best that can be achieved is a reasonable approximation. This means that, when buying a share, your workings-out can only be a best guess. To protect yourself, make sure you pay as little as possible for that share.
In other words, the trick is to use a sufficient "margin of safety" to use Benjamin Graham's terminology. You could equally call this a "risk discount." Hence a FTSE-100 blue chip on a price-earnings ratio of 12 might look better value than a risky AIM-listed share on a p/e of 7.
Investors of an academic bent are lucky these days. The internet has made it possible to search for all sorts of information that used only to be available to the rarefied elite. Now, most information including arcane company valuation techniques are available to all.
But the precision offered by such techniques is a dangerous illusion that offers many opportunities to get things wrong. It's better to be roughly right than precisely wrong, as the saying goes. It's also worth remembering that people like Myron Gordon are academics not investors.
More: Valuation techniques from the MIT Sloan School of Management | Buffett, Screaming Value And The Discounted Cash Flow
