The future influences the present just as much as the past. – Friedrich Nietzsche
I’ve been thinking about valuations and how they work. And it’s not that easy to get your head around the kinds of things you need to value these days.
Take “traditional” businesses, for example. Ones that absorb capital – like building houses or setting up a factory.
There are only a few numbers that really matter. The price at which you sell. The rate at which you borrow. The margins you make. And the risk-free rate.
For example, let’s say you want to invest in a rental property. You have an income from the market rental value and an increase in value over time due to property price inflation. You need to put in a deposit and borrow some money and your return will depend on how these factors interact.
The important thing is that the yield you make, the total return over the investment in capital assets, is greater than your cost of capital under a stressed scenario. In that case, you’re in the black and will make money. Whether you’re happy with the final return you’re getting when it’s compared to the risk-free rate – long-term treasury yields, for example. The US 30 year treasury bond, for example, is at around 2% right now, so if you make 3% that’s good and if you make 1%, that’s not so good.
Anyway, the model itself is not important – because so many investments these days are not about capital but about potential.
Take yourself, for example. Is your value the salary you make or have made? Is a company’s value the money it has made?
When we look at past performance using easy to measure attributes like money we can write people and companies off because they don’t look good on paper. But perhaps that’s because we’re measuring the wrong things.
Let’s focus on companies for a second. Let’s say you want to build a venture capital portfolio, investing your own money in a set of early stage companies. What should you look for?
It’s tempting to ask for profits, for stability, for evidence of growth in the past. But a company that shows good profits may have helped to manage those numbers because they knew that was what you wanted. It’s easy to increase profits in the short term by raising prices and cutting costs to look good now – but that weakens your future, with customers and employees moving away when your changes bite.
Sometimes companies without profits are actually investing in their future, bringing in people and creating the capacity to do better work. In that case, despite the low profits now, you have a better foundation for future growth.
Which one would you prefer – a good looking now at the expense of the future or a less good now with a bright future?
Being able to recognize value comes down to being able to see your own beliefs and assumptions for what they are and ask the right questions. And have a framework where you can make mistakes without losing everything.
When you’re asked to look at the future and think about what needs to happen for a business to succeed – you can quite quickly come up with factors that matter. Are they working on something that customers are going to want – that solves a real pain? Does it grab your attention? What do they plan to do with the money they are asking for? And so on.
The point is that the past is priced in. The future is what you make of it.