Valuations are done using quantitative data (like Income Statement, Balance sheet, Cash Flows etc) from the Annual Reports. Think about preparing a Financial Model of a company and applying valuation tools like Discounted Cash Flow, Relative Valuation tools like PE, EV/EBITDA etc,to value the company. However, there are other “not-so-tangible” factors which also impact the valuation of the business.
In this article, we will look at the qualitative factors in valuation in detail.
- What do we mean by qualitative factors in valuation?
- Top 10 Qualitative Factors in Valuation
- In the final analysis
1) Investment Banking Tutorials 99 Course Bundle, 500+ hours
2) Business and Financial Modeling (University of Pennysylvania)
3) Introduction to Finance: Valuation and Investing (University of Michigan)
4) Excel to MySQL: Analytic Techniques for Business (Duke University)
5) Mastering Data Analysis in Excel (Duke University)
What do we mean by qualitative factors in valuation?
Qualitative factors are the factors in business valuation which are almost impossible to quantify for business. Or we can say that these are the factors in business valuation which can’t be directly quantified. But they are equally, if not more important than quantitative factors in valuation. And at the same time, no company can ignore these less tangible factors because they really matter in valuing a company.
Numbers are not the only thing that matters when you think about evaluating a business. There are other factors as well that may skip your mind as an investor.
In the next section, we will go into the meat of the article which will help you make smarter business decisions and you will be able to think through a completely different perspective before ever spending a buck on a stock.
What are the qualitative factors in valuation?
#1 – Company’s Core Business
As an investor, your first concern should be – “How a business makes money?” Yes, according to a recent definition of business, money-making may not be the sole ingredient of a good business. But as an investor, you should invest into a stock which will make you money. That’s why it is important to peep through their revenue model and find out whether it will really work in the long run.
For example, if you look at the business model of KFC, we will see that they sell delicious chicken burgers, chicken roasts, many varieties of mouth-licking chicken and veg recipes and their business model is very easy to follow. As an investor, you know that this is how KFC makes money.
Similarly, before ever spending a penny on any stock, know the business model of a company. Do your own due diligence. Find out its history, revenue generation model, how it got started, how long they are in the market, what is the revenue and profit margin they have been maintaining as of now. And then go for business valuation.
As seen in the below Facebook business overview, it provides us information on how the revenue is generated. Facebook generates all of its revenue from selling advertisement placements to marketers.
source: Facebook SEC Filings
#2 – Quality of Management
The second factor is the quality of the management in the company. If the management is motivated enough to steer the company toward its summit, the company would be a gigantic force and it would always find a way even amid greatest economic turndowns.
So before you invest into a company, having a check on the management quality is of utmost importance. Having a greatest business model will not serve unless the management quality of the company is at par.
So what would you do?
Every company, now-a-days, has a website where they mention their “teams”. Go through the page, find out who are the promoters of the company, filter out their background on different levels and find out what experiences they have in the similar industry.
This will give you a brief overview about the company. But that is not all. You need to dig deep and see for yourself what the management is really up to.
- History of performance: Results don’t lie. And when a company brings in astounding results that means there is a hand behind the management in it. Now go through the performance histories of top executives in the last decade and you will get a reasonable idea about whether it is prudent to invest into the company.
- Management Discussion & Analysis (MD&A): Every public company needs to produce an annual report as per 10-K filing. Look at the annual report. In the beginning section, you will find something like MD&A. In that section, you will get all the ideas about what worked for the company and what didn’t. Which division fetched the maximum output in the last year? And you will also able to have a glance at the financial statements of the company. Below is a snapshot from Facebook Management Discussion and Analysis.
source: Facebook SEC Filings
- Look for insider’s information: If you are researching about a company, you need to make a “one plus one equals two”. A company that is doing outstanding because of someone’s effort. For his/her effort, company is compensating him/her in a reasonable way. Look for stocks. How many stocks are given to a top executive and why? Why s/he has been given the stocks? What performances s/he has had in the past?
#3 – Customers and Geographic exposure
There are two basic things you need to check out, if you want to penetrate the actual picture of the company.
First, you need to find out about the customers of the company. Do the company have few big customers or many small customers? Do the company serve only businesses or end customers as well? Do their focus revolve around niche market or do they cover all segments of customers? To understand a company, getting answers to above questions are important. Because then you will understand where the company stands as per the customers’ mind-map.
Second, you need to find out the geographical exposure of the company. Do the company only operate in certain territories? If yes, why? Do the company cover only urban or rural areas? What is their sales-break-down as per each territory? Where they sell more and why? Asking yourself these questions and searching for answers will help you know the company well and make wiser choices at the end of the day.
In its 10K filings, Facebook has provided us with Geographical information. We note that United states is the major contributor to Facebook’s revenue. Rest of the world share is seeing a rapid rise and thereby diversifying geographical risk.
source: Facebook SEC Filings
#4 – Competitive Advantage
Before you ever evaluate a company in quantitative terms and judge the company based on figures, you need to find out what’s the competitive advantage of the company. Competitive advantage is a term coined by Michael Porter. He says there are few factors that are important for a company to have, to be called as competitive advantage –
- The competitive advantage of a company is a unique ability which can’t be emulated by other companies easily.
- Competitive advantage helps the company to produce more profits, more revenue, efficient systems and processes.
- Competitive advantage helps all the activities of the company get aligned with the organizational strategy.
- Competitive advantage helps a company receive benefits usually for five-to-ten years.
For example, if a company sells online, their logistics can be their competitive advantage which can help them reach their customers superfast and deliver goods and products faster than their competitors.
As an investor, you need to think through about the competitive advantage or lack of it before investing into it. Because competitive advantage or lack of it is their sole ingredient of producing astounding or mediocre results!
#5 – Corporate Governance
In simple terms, corporate governance is the holy grail of a sustainable business. If corporate governance of a business is not in order, the whole business will crumble sooner or later. So, checking out the corporate governance of a company is of utmost importance as an investor.
You need to see three things –
- Are the rules of the company aligned with company’s mission and vision?
- Are the company serving each and every stakeholder well?
- Are they legally compliant with government’s policies?
If answer to the above three questions is “yes”, usually, the company is pretty good at corporate governance.
Below is the Corporate Governance guidelines of Facebook.
source: Facebook Corporate Governance
#6 – Industry Growth Trends
Doing your own due diligence doesn’t end at company level. You need to find out which sector the company is in and then see the industry under the researcher’s light. You should gather the data of last ten years and then use different tools to see whether you seem to find any pattern or trend or not.
In this case, quantitative factors may help you get idea about the qualitative factors. Look at different trends, analyses, experts’ forecasts and suggestions. But make sure that you decide on the basis of your own thinking and your knowledge of the data. Don’t put the industry on a higher rung because an expert says so.
Once you know the trends, you will have definite ideas about predicting future trends of the company.
#7 – Competitive analysis
Many investors skip this.
But if you want to know the right value of a company, look at their competitors and do an analysis.
Look at their strengths and compare it with the company you want to invest into. Look at their weaknesses and see how the company you have targeted are doing in those areas.
Doing competitive analysis will not only help you the position of a company, it will also help you discover similar companies to invest into, in near future.
The industrial analyses can’t be done with taking competition into account. Only comparison with similar companies can give you an overview of how a company is doing in the same industry.
Facebook is in competition with lots of players including Google, Snapchat etc.
source: Facebook SEC Filings
#8 – Disruptive technologies
Technologies can shape or break a company.
Look for disruptive technologies that have shaped the industry altogether. And then see whether the company you are evaluating using those technologies or not.
In this age of continuous advancement of technologies, only disruptive ones make ruckus of the industry. And before you ever invest into any company, look for the technological state of the industry first.
One disruptive technology for Facebook is Oculus. Oculus virtual reality technology and content platform power products allow people to enter a completely immersive and interactive environment to play games, consume content, and connect with others.
#9 – Market share
Company doesn’t need to have major share in the market especially when it has been in the market just for sometime. But what we need to look at as investors are whether it has a potential to grow or not.
You can use BCG Matrix or any other strategic tool to find out where this company belongs to and then evaluate it on the basis of that.
As an investor it is important to know that the company can grow in near future. If a company has reached its saturation point and there is limited or no growth (rather downward slope along the way), investing into it wouldn’t be a great idea.
#10 – Regulations
No company can be free of regulations. And when you attempt to evaluate a business, you need to see the regulatory factors as well.
For example, on pharmaceutical industries, FDA (Food and Drug Administration) has direct regulations. According to FDA, before any drug comes into the market, it has to go through a series of clinical trials before they reach the end customers.
However, not all industries have same regulatory constraints. So, as an evaluator, you need to see whether the company is following all the regulatory practices or not.
source: Facebook SEC Filings
The idea is to find out the regulatory factors that can have a direct impact on the bottom line (think net profit) of the company. To discover this, you really need to dig deep, read all the financial statements of the company and also go through the annual report.
Related Articles –
- PEG Ratio
- Price to Book Value Ratio
- EV to EBIT Valuation Ratio
- Sum of the Parts
- Financial Statement Analysis
In the final analysis
It is always easier said than done. Even the most revered investor Warren Buffett doesn’t invest in technological stocks. If you ask him why he would say that he doesn’t feel that he has expertise in that area.
Now that’s something the investors should think about.
It is not enough only to consider the qualitative and quantitative factors into account. It’s also important to build an area of expertise where you are more thorough and where you have better instincts.
And you would know that with experience.
Try out the above factors while evaluating a business and then see for yourself how they impact your overall computation of business value.
The above may seem easy on paper; but to implement these, you need to go through countless research papers, countless data, insurmountable amount of graphs, trends, analysis and an amazing number of books. It is not easy, but worth the effort.
When you will take these “not-so-tangible” factors into account, you will become a better investor and will be able to compute the right price of a company.