We try to develop valuations that at least address assets that we believe may be carried on the balance sheet at some discount to their true value. To the degree that we believe some of these assets understated, we may modify our price target analysis slightly to reflect these hidden values. However, when it comes to the bulk of our valuation analysis, we essentially employ typical discounted cash flow and earnings techniques. In the words of Warren Buffett, we "work out how much it will pay out from now until Judgment Day, then discount it back and buy it cheaper,"
The trick here is to create financial models that we believe reflect what companies are capable of generating both in terms of earnings and cash flow. Once we have created our model projections, we discount the future values of the cash flows back at rates that we think account for the risk that our estimates are overstated. Typically, that means we use discounts rates in the 20% range. The heavy discounts mean that we can overestimate future cash flows and earnings, but still end up at ultimate valuations that are reasonable relative to our price targets. In the event that our models prove relatively accurate over time, then even our price targets will prove theoretically cheap. That being said, while we recognize that being accurate with respect to small companies on a quarter over quarter basis is considerably difficult, we look for actual results that at least validate an earnings trend that can justify the targets we have established. Again, we believe that using substantial discount rates will provide us with enough slack to overestimate to some degree, yet still justify our price targets.
