What Is Valuation? How to See the Real Worth of a Business

Valuation is, at its core, an attempt to answer a deceptively simple question: what is this business truly worth today?

The textbook answer is straightforward: a business is worth the present value of all the cash flows it will generate over its lifetime. In theory, that’s simple, but in practice, estimating those cash flows is anything but easy. Future sales, profit margins, capital needs, taxes, competition, technology changes, and even government rules all affect the amount and timing of cash a business will produce. And once you have an estimate, you still need to discount it back to today’s dollars.

This is where Warren Buffett’s famous line comes in: “Interest rates are like gravity to valuation.” Low rates lift valuations because future dollars are worth more today. High rates pull valuations down, no matter how strong the business appears.

So while the formula is clear, applying it requires judgment, context, and a deep understanding of the business and the world it operates in.

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How Valuation Works in Practice

Investors don’t usually build twenty-year cash flow models with perfect precision. Instead, we rely on proxies—ratios and multiples that condense complex forecasts into numbers we can observe and compare. Common multiples include:

• Price-to-Earnings (P/E): How much investors are willing to pay for each dollar of current earnings, reflecting expectations for growth and risk.
• Price-to-Book (P/B): Often used for asset-heavy businesses, where book value approximates economic worth.
• Price-to-Sales (P/S): Popular for high-growth or early-stage companies, showing what investors pay for each dollar of revenue.

These multiples save time, but they’re not magic. Two companies with the same P/E could look identical on paper yet have wildly different risks, growth prospects, and business realities.

This is where accounting comes in. Multiples rely on the financial statements they’re drawn from. Earnings and book value aren’t facts—they’re outputs of rules, judgments, and assumptions. Understanding accounting is essential to interpret these numbers correctly and see when they might be misleading.

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Accounting Is a Language, Not a Law

Many investors treat accounting like gospel, assuming numbers perfectly reflect reality. But accounting is a framework for telling a story, not reality itself. It gives us structure, but we still need to read between the lines.

For example, two companies could hold identical bond portfolios. One calls them “held-to-maturity” and values them at cost. The other calls them “available-for-sale” and values them at market price. Same assets, same risks—different numbers reported to shareholders. This isn’t fraud, just the flexibility built into accounting.

The key lesson: valuation isn’t just about the numbers. It’s about verifying them and asking whether they align with economic reality.

A recent example is Silicon Valley Bank (SVB). On paper, SVB looked healthy: solid book value, steady earnings, and regulatory filings showing a stable capital base. But behind the scenes, the bank’s bond portfolio was misaligned with reality. Held-to-maturity accounting hid massive interest rate losses. When confidence collapsed, the gap between the accounting story and reality became obvious—and the bank failed.

Accounting is a starting point, not the destination. As investors, we treat numbers as clues. We ask: would an honest management team report these line items this way? Questioning assumptions and understanding the story behind the figures is how we approach the real economic truth.

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Conclusion: Valuation Is an Appraisal, Not a Number

Valuation is ultimately an attempt to answer one deceptively simple question: what is this business really worth today? Accounting gives us the framework and clues, but real understanding comes from verifying numbers, questioning assumptions, and translating them into economic reality.

Next, we’ll dive deeper into the numbers verification process, using SVB as a case study, to see how careful investors could have spotted the mismatch between accounting and reality before disaster struck.