Applying value investing principles to Start-Up Investment
Very often in our lives we are presented with “investment opportunities” of colorful forms, whether they are public company stocks, bonds, a farm, real estate and in my case internet start-ups, etc. It is extremely important to learn how to evaluate each opportunity and adopt a disciplined process that will help you make the investment decision.
The process I have adopted to evaluate any investment is called value investing, which was fathered by Ben Graham at the start of the 20th century. Graham is famous for writing Security Analysis in 1934 and The Intelligent Investor, also known as the bible of value investing, and for being the mentor of great modern day investors like Warren Buffett. Value Investing is a pretty simple process, it is designed to help you select investments by estimating their intrinsic value or their real worth and if this intrinsic value is much greater than what you are paying for it then you are making a value investment, in simple terms buying $1 for $0.50. Value investing is most commonly applied for the purpose of investing in public securities such as stocks, bonds, warrants, etc, but the ultimate essence of value investing is to help you analyze any investment opportunity and understand it in such a way that you have realized its value and you are not making a pure bet or speculation which most often than not ends in tears.
There are many simple methods of determining the intrinsic or present value of an investment, I usually apply two, first the reproduction of the balance sheet of the investment or valuating the assets of the company and second determining the earnings power of the company using historical data. Both methods are very straight forward, first you look at a balance sheet of the company, you analyze the value of their assets and subtract their liabilities, usual company assets are cash, receivables, real estate, etc. For earnings power you look at the company’s net income or cash flow and apply different formulas that include a multiple of those earnings, etc.
It seems that these methods of value investing can only be applied to analyze established companies with tangible assets that you can easily see and touch, and that have been in business for many years so that you can determine their earnings power. But I have added some flavors and customized the process to analyzing internet start-ups, the area of my professional experience.
When analyzing internet start-ups, these are the component of an intangible balance sheet I look for, I apply value to the entrepreneur, his/hers experience, the drive, clear proof of execution, the ability to develop teams and software, their deep understanding or the business and what the business is solving, I apply value to the intellectual property owned by the business, the number of registered users, the visits, the growth of in traffic. Those are the parts of the intangible balance sheet, then for earnings power I apply value to how the service will monetize given user growth, etc. Once I have done this analysis of the assets and earnings power I add all the figures and if the value is more than what I am paying for it I feel easier about making the investment, and helps me wait patiently to realize a gain from the investment.
Still, nothing is guaranteed in any investment, but having a good methodology to analyze any investment will at least help your chances to succeed. Happy investing!
Jose Vargas is co-funder and President of BrokersWeb.com