How to valuate a company

There are few things more interesting to me than how we spend our money. Money is the clearest, easiest way of valuing things. If you spend $10 on a thing, you value it more than the thing you weren’t willing to spend $10 on. There isn’t necessarily a deep meaning to this, because there’s a million different ways in which we spend and use money, or, to use the terms of Wittgenstein, “money games”. However, you can also translate it to time, which is also how we can measure our life. If you spend $10 on something, and you make $10/hour, you value something at 1 hour of your time, or some small fraction of your life.

In general, spending money is not an easy thing to think about logically or philosophically. You end up with strange comparisons, like poor people value a Big Mac at more hours of their life than rich people. Some people find buying a boat and keeping it in their garage worth a year of earnings, while other people aren’t willing to spend that same amount to keep themselves alive. It’s unclear how far we can go, therefore, just talking about how people spend their money.

However, we can certainly compare spending money in one specific circumstance. One of humanity’s favorite pastimes is spending money to make more money. Whether it’s gambling, investing, or trading, it’s easy to make an “apples-to-apples” comparison. Whichever strategy consistently ends up with the most money is the right strategy.

Of course, we still have the entirety of Hume’s problem of causation. We’re asking what strategy causes us to make the most money, and it can be quite tough to see if there’s a necessary connection or not. We can try to solve it in our normal ways, like with Popper’s method, but at the end of the day, it’s a difficult problem to solve.

But, putting that aside for now, I want to talk about one specific way of using money to make more money: by investing in companies. This is how a significant portion of America (and an even more significant portion of America’s money) spends its day. We can argue about how useful it is to have so much of America focused on allocation of capital, to use the economic term, but for now let’s just look at how it’s done.

The most interesting thing about investing in companies is how much smart people disagree about how to do it. Unlike medicine, engineering, or research, investing is a field with many fundamental disagreements about how it’s done. This is because it’s particularly hard to see the relation between cause and effect in investing. It’s possible to make or lose a lot of money accidentally, just by buying a certain stock. In medicine, it’s quite hard to accidentally cure a person, and in engineering, it’s quite hard to accidentally build an airplane, but it is entirely possible in investing for a random guy off the street to achieve the same results as an expert.

I want to examine two strategies for investing in companies. Traditionally, they’d probably be divided into “value” and “growth” strategies, with the idea of buying shares in a company because it’s cheap vs. buying shares in a company because it’s likely to grow. However, I think there’s also a philosophical division between them, which should become obvious once we go through them.

The first strategy, the “value” strategy, is the “intrinsic value” strategy of Warren Buffett, the famous “Oracle of Omaha”. This strategy is based a lot on past trends and examining a company’s financials. Without going too much into detail, Buffett believes that there are three components to determining the value of a company: the business the company is in, the financials of the company, and the management team.

First of all, Buffett tries his best to understand the business. His specialty is insurance companies. When he’s looking to buy an insurance company, he’ll look at the specific metrics for that company that matter for insurance, like premiums and payouts, and compare them to the industry as a whole. He’ll also consider the long term prospects of the entire industry, and see if there are any trends to watch out for. Buffett refuses to invest in industries that he doesn’t understand and can’t perform this sort of analysis on.

Second, Buffett looks at the financials of the company. He cares about how money moves around the company and what it’s used on. Cash, in the long run, is the lifeblood of any company, and a company’s ability to grow and respond to changing market conditions depends on the cash that it has and can use. Also, as an owner of the company, which a shareholder is, cash is what you ultimately want to get out of the company. It’s fun to own a share of Coca Cola, but you also need to pay your rent at the end of the month.

Thirdly, Buffett looks at the management team. He sees how intelligent they are at using cash, how honest they are, and how emotionally stable they are. A good management team should know when and how to use cash, including when to give it to shareholders. They should also always be honest with shareholders, especially when admitting mistakes. Finally, they should be able to resist bad decisions, even if the rest of their industry is doing it.

Philosophically speaking, Buffett’s investing philosophy is somewhat deductive, somewhat inductive, and a bit intuitive. He bases his idea of what financials should be on deductive assumptions, including mathematical calculations and logical assumptions about the way money is used. His knowledge of a business and what a good business should be is inductive, based on his familiarity with certain industries, like the insurance industry. His ideas of management are inductive, based on his experience with bad management, and deductive, based on logical ideas of how cash should be used, but they are also intuitive. They’re intuitive because reading people is always intuitive, in that it’s something almost all humans are born with, and those that aren’t (like autistic people), find it impossible to learn.

It’s also important to note that Buffett strongly believes in a “margin of safety”. Once he evaluates a company based on his three criteria, he comes up with an “intrinsic value” for the company, which is the amount he would be willing to pay for the company. To compensate for the assumptions that go into this intrinsic value, he discounts it, and the amount between what his calculations tell him he should pay for the company and what he will actually pay for the company is the margin of safety.

Now let’s look at our other model. Andreesen Horowitz is perhaps the most famous venture capital firm operating out of Silicon Valley right now. As a venture capital firm, they cannot rely on investing in businesses with a solid track record, or that are currently undervalued. Instead, they have to find businesses with the capability to grow. Their business model requires specifically for them to find businesses with the capability to grow rapidly. To use a baseball analogy, Buffett’s business model requires him to consistently hit singles and doubles. Andreesen Horowitz’s business model requires them to occasionally hit home runs.

A16Z, as they call themselves (see if you can figure out why), have 5 criteria that they look at when trying to choose companies to invest in. They look at leadership, ideas, market potential, monetization, and how the A16Z team can help the companies. Let’s take a look at each.

Leadership they divide into 3 categories: the ability to effectively direct people, charisma, and brilliance. While these are all easy enough to understand, they’re hard to describe directly in the way that Buffett can describe his management qualities directly. You can imagine people disagreeing over who is an effective, charismatic, or brilliant leader, although it’s possible to come up with examples for each.

For ideas and market potential, they just say they want “breakthrough” ideas and big market potential. This is sort of obvious, but what is frustrating is that they hedge this by saying ideas might not seem breakthrough at first, and market potential might not seem big at first, but they should be breakthrough and big eventually. In other words, if a company has already changed the world, A16Z says they’re classified as world-changing, which isn’t exactly a bold prediction.

The ability to make money is not important, according to A16Z, but it is important that the companies are in categories which the A16Z team can help with. Specifically, A16Z only invests in companies which rely on software, which A16Z believes is their core competence. Along with investing in software companies, A16Z helps them practically with expansion issues.

A16Z’s model is almost entirely intuitive. Without specific criteria of how to look at leadership, ideas, or market potential, A16Z relies on whatever seems to them to fit based on their feelings. The only part that’s inductive is how well the companies fit in with the A16Z team’s competencies, which is based on their experience developing previous software companies.

To compare the two models, while neither is scientific, Buffett’s comes much closer. Because Buffett assumes most of his predictions will come true, it’s possible to attack his model if his predictions tend not to come true. A16Z assumes most of their predictions will not come true, and only a few will succeed, which means it’s harder to know when their model no longer works.

Also, because Buffett’s model mostly relies on deductive and inductive thinking, it is much easier to teach it to others, and it can then be judged based on how well it performs in other’s hands (which would take away the possibility that it relies on Buffett himself, rather than the model). A16Z’s model relies on intuition, especially with regards to understanding the management team, which mostly cannot be taught. Therefore, it would be very difficult for A16Z to teach their model to others, and still harder to evaluate it.

This isn’t to say that A16Z’s model is useless, but philosophically speaking, it’s much harder to tell if their model is good. In a practical sense, if you’re interested in using money to make more money, and you’re looking to do so by investing in companies, I’d advise you to rely on Buffett’s model. If you’re skeptical, evaluate it for yourself by seeing how other people have done with it, or by forming hypotheses based on it and attempting to disprove them. It’s much harder to evaluate A16’s model, and therefore much more dangerous to rely on it.

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