Measuring the shonks – or how to value a company

Founder and Chief Investment Officer of Montgomery Investment Management
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There are many skills that can help investors arrive at sound investment decisions. A good grasp of topics like strategy, finance, accounting and valuation is clearly high on the list, as is an ability to put together disparate pieces of information to form a cohesive picture of what is happening in an industry.

One skill that we think is highly relevant, but which doesn’t get quite as much attention, is an understanding of how probability and statistics affect investment calculations. We humans have highly developed instincts that have helped us survive countless generations of natural selection, but when it comes to probability, we sometimes get the wrong end of the stick. In some cases, the answer that feels right may be very wide of the mark.

Lies and statistics

Let’s look at an example. Suppose we have identified what we think is an excellent business, with an ability to raise prices year after year without impacting demand. What’s more, let’s suppose that we find this business trading in the market at a significant discount to our estimate of its intrinsic value. We think the company is worth $1.50 per share, but the share price is only $1.00.

There’s just one problem: we have an idea that the CEO may be a shonk, and even though we think it’s a good business, we clearly are reluctant to invest in a company where CEO shonkiness is likely.

Happily, we can go about our work on the basis that CEO shonkiness is a fairly uncommon problem – for argument, let’s say that around 5% of CEOs fall into this category. However, our new company analyst has recently spent some time meeting with this particular CEO and, after reviewing the accounts, has a bad feeling about this one. Our analyst doesn’t have decades of experience in the financial markets, but he studied Enron at university, and he knows a thing or two about accounting standards. We think he has an 80% success rate in spotting dodgy numbers, and in this case, he’s satisfied that the books are being cooked. If he’s right, we estimate that the value of the company will quickly halve to around $0.75 per share.

There are several dimensions to this problem, including questions of risk and ethics, but let’s start with a relatively straightforward dimension – value. What do we now think this business is worth?

Finding a helpful valuation

Before we continue, think about how you would ascribe a valuation in this case. A helpful approach is to think in probability-weighted terms, but what probability-weighted value would you place on this company?

It’s tempting to say that the business has an 80% chance of being worth $0.75 per share, and a 20% chance of being worth $1.50 per share, which gives a probability-weighted valuation of $0.90/share. At this level, we clearly would have no interest in paying $1.00 a share to own it.

However, this analysis is missing something. Even if our analyst has an 80% success rate at picking shonks, we need to keep in mind that CEO shonkiness is a rare problem, affecting only 5% of the corporate population.

If our analyst is right 80% of the time, then he’s wrong 20% of the time. Think about what happens when he visits the 95% of companies where the CEO is entirely sound. If he calls “shonk” on 20% of these companies, then 19% of the total corporate population will be unfairly categorised in this way.

When he visits the 5% of companies where hornswoggling is rife, he will correctly raise the alarm for 4%, and incorrectly give a clean bill of health to 1%.

What this means is that across the population of companies, our analyst will call shonk 23% of the time.

He will get most of these wrong (19 out of the 23).

Conclusion

Taking into account the relative scarcity of shonky CEOs, we estimate that there is only a 17% likelihood that our particular CEO is a problem (four out of 23 such calls will be correct). On this basis, the valuation of the company can be estimated as 17% x $0.75 + 83% x $1.50 = $1.37.

This is not to say that we necessarily want to leap in and buy this particular company. The other dimensions of the problem require some careful thought. However, having thought about the analysis a bit more carefully, we now have a more accurate starting point in terms of value.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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