Q&A: Factoring Unknowns when Estimating Business Value
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Winter storm (“Winter Storm Uri”) in Texas in late 2020 caused havoc in the energy markets. Some of the problems that fed into the statewide power outages were predictable, but others may have been surprising or unknown. How can investors account for so-called “unknown unknowns” – risk factors you don’t even know exist, much less what degree of risk they pose – and the risk they create of potentially misvaluing an investment?
It's not a risk that can be entirely removed from the equation, but there are certain tricks to mitigate it.
One such trick is to identify industries that are relatively slow‑moving in the rate of change over time. Look at it today and look at it 30 years ago. If you see some relative consistency there, you can at least intelligently project that in the next 10 years, you're not going to have a huge swing. If you're doing it in an industry that has a high rate of change, it becomes even more important to do a lot of research and due diligence, down to understanding the company's culture and pinpointing details like how much they've been spending on research and development as a percentage of sales among other behaviors and measures.
Another trick is to look for companies that have a lot going on. They’re diversified. It’s okay if there’s some failure in that diversification, as long as there’s also substantial success. Google and Amazon may be examples here. They’re constantly trying a lot of different things, and they’re not always successful at everything, but I prefer a company like that as opposed to a “pureplay” company that is dependent on getting that one next product exactly right.
We also have to look at the trend line and how a business performs over time and figure out the direction in which trend line is moving. We can't just say the inherent value today is X and use that as our only data point. This can be a problem with investing methodologies that lean heavily on specific formulas or metrics. We mitigate the risk of unknowns by looking at multiple data points, over time, so we have as complete a picture as possible.
Ultimately, we can’t forget the bottom-line equation though: we want to buy a company with a lot of future potential at a price that’s lower than the company’s intrinsic value. Then, we let that value grow over time. Teasing each of those elements out – what is its intrinsic value? How much lower is its market price relative to that value? What is the company’s future potential for growth and value generation? – just takes a lot of information and research. There just aren’t any shortcuts here.
The best way to minimize the risk of unknowns is to reduce the number of unknowns by learning as much as possible about the company under consideration.
Finally, take a step back and consider the positives too. Unknowns count both ways. They could be unknowns on the upside where the market wasn't discounting it properly.