The value of a business
It is common knowledge in finance (I hope it is) that value of a business is the present value of cash flows over its life discounted at an appropriate rate. But, what is not that common is that despite this knowledge, many analysts do not use it to value firms.
It is common knowledge in finance (I hope it is) that value of a business is the present value of cash flows over its life discounted at an appropriate rate. But, what is not that common is that despite this knowledge, many analysts do not use it to value firms.
The folly
Because the discounted cash flow model requires more difficult estimates to make, easier route is taken by the analysts and investors to come up with a so-called value for the firm. Take for example, the multiples. Price to earnings, price to book or price to sales multiples are used in isolation or in conjunction with cash flows of next few years to value the firm. This method is not only flawed, but also brings with it a lot of subjective bias in valuation. You cannot assume that the market is overall correct (which is what you do when using multiples). Ideally, you need to ignore the market while valuing a business.
I have also seen analysts discounting earnings rather than cash flows. Baffling, it implicitly assumes that depreciation is all that is needed for reinvestment. The flaw becomes more prominent, when these analysts attach a growth rate to these earnings. Aiming for some free lunches, I guess; more on this later.
I have also seen analysts discounting earnings rather than cash flows. Baffling, it implicitly assumes that depreciation is all that is needed for reinvestment. The flaw becomes more prominent, when these analysts attach a growth rate to these earnings. Aiming for some free lunches, I guess; more on this later.
Imprecise but quite useful enough
The dcf valuation is not free from bias either; however, if used properly, can yield better estimates of value than any other methods. Only caution I would add is that the aim should not be to come up with a more precise value, rather a fair estimate of a range of values, just enough to help conclude whether a business is selling at far higher or far lower than its value. If we ever try to make that model precise, we would only be its victim. That is a risky proposition.
The good news is that if we are able to make reasonable estimates of revenue, margins, reinvestment, return on capital and cost of capital, it should be possible for us to make a reasonable estimate of value. What is nice about this process is that if it is not possible to make those estimates reasonably, you can skip that business from analysis. What is the point in guessing its value for the sake of guessing, after all? Time is well spent if you can pick a business where you are more comfortable in making those estimates.
The dcf valuation is not free from bias either; however, if used properly, can yield better estimates of value than any other methods. Only caution I would add is that the aim should not be to come up with a more precise value, rather a fair estimate of a range of values, just enough to help conclude whether a business is selling at far higher or far lower than its value. If we ever try to make that model precise, we would only be its victim. That is a risky proposition.
The good news is that if we are able to make reasonable estimates of revenue, margins, reinvestment, return on capital and cost of capital, it should be possible for us to make a reasonable estimate of value. What is nice about this process is that if it is not possible to make those estimates reasonably, you can skip that business from analysis. What is the point in guessing its value for the sake of guessing, after all? Time is well spent if you can pick a business where you are more comfortable in making those estimates.
The growth rate and value
This brings us to the growth rates. While it is easy to plug in a growth rate that we would like to see for our business, the growth does not come that easy. For growth to come, the firm has to reinvest enough.
Now, let's talk about value. Of course, it is eventually the present value of all cash flows. However, many managers believe that it is possible to create value just by physical growth. Either they don't know finance well, or they don't know what they don't know. The fact remains, however: All growth creates value is just a myth.
Each business has its own set of fundamentals; it cannot grow at any rate without looking at how well it is going to reinvest; and that is measured by the return on capital. A firm that has high return on capital needs lower reinvestment compared to the firm having lower return on capital for the same growth.
The excess returns
For growth to create value, it has to generate positive cash flows. That is possible only when the firm's return on capital exceeds its cost of capital. These excess returns drive value. The higher and longer these excess returns, the higher the value.
This brings us to the growth rates. While it is easy to plug in a growth rate that we would like to see for our business, the growth does not come that easy. For growth to come, the firm has to reinvest enough.
Now, let's talk about value. Of course, it is eventually the present value of all cash flows. However, many managers believe that it is possible to create value just by physical growth. Either they don't know finance well, or they don't know what they don't know. The fact remains, however: All growth creates value is just a myth.
Each business has its own set of fundamentals; it cannot grow at any rate without looking at how well it is going to reinvest; and that is measured by the return on capital. A firm that has high return on capital needs lower reinvestment compared to the firm having lower return on capital for the same growth.
The excess returns
For growth to create value, it has to generate positive cash flows. That is possible only when the firm's return on capital exceeds its cost of capital. These excess returns drive value. The higher and longer these excess returns, the higher the value.
We can argue that the quest for value creation lies in a firm's return on capital and its cost of capital. These depend on the type of business and operating leverage (its competitive advantages), and the financial leverage. Ceteris paribus, higher leverage brings down return on capital and increases cost of capital since the firm is exposed to volatility in margins and default risk.
The return
That is why it is prudent to estimate a firm's return on capital based on its fundamentals during its growth period, and based on both fundamentals and industry average when it becomes a mature business.
That is why it is prudent to estimate a firm's return on capital based on its fundamentals during its growth period, and based on both fundamentals and industry average when it becomes a mature business.
The cost
The cost of capital is more complicated, yet possible to estimate. For this we have some choices; one is to use the corporate finance models to get a precise-but-almost-incorrect estimate; the other is to use a more intuitive model which estimates cost of capital based on what investors seek to earn on their investments, yet, is not-so-precise-but-a-useful estimate. This cost has to be in excess of the long-term inflation rate plus some additional points. The business has to provide this return at a minimum.
The cost of capital is more complicated, yet possible to estimate. For this we have some choices; one is to use the corporate finance models to get a precise-but-almost-incorrect estimate; the other is to use a more intuitive model which estimates cost of capital based on what investors seek to earn on their investments, yet, is not-so-precise-but-a-useful estimate. This cost has to be in excess of the long-term inflation rate plus some additional points. The business has to provide this return at a minimum.
The implications for an investor
There are several implications of this analysis:
A business will lose its value if it continues earnings negative returns (cost of capital higher than return on capital) for long. Investors should shun these declining firms. Many big firms make this list too. So one should not be carried away with the size of the firm. Sooner or later the value destruction will be apparent even for those firms with access to large capital. Watch out for return on capital declining at a steady rate over the period; it is a sign of caution.
It is not possible to sustain high return on capital (and consequent excess returns) for long. As the firm grows over the period, the excess returns have to come down (and may eventually have to move towards zero); perpetual high excess returns remain valid only on the spreadsheet. What it means is that while valuing a firm with high return on capital, one has to be alert enough to bring it to more prudent levels. Investors should look out for firms that have demonstrated high return on capital over long-term; it is a sign that managers of these firms are good at capital allocation, a key measure of survival.
When excess returns are nil, i.e. return on capital equals cost of capital, the value of the firm becomes a function of its book value of capital and growth rate. However, while setting the growth rate it is advisable to consider the reinvestment that is required in conjunction with the return on capital. Otherwise, the analyst can easily set a very high growth rate and say, lo behold, value is created even without having any excess returns! That works in fantasy island. As a corollary, when the growth rate is zero and there are no excess returns, the value of the business is its current book value of capital. Although, this thought appears academic, while valuing a firm on a stable-growth basis, these assumptions are useful.
Long-term returns for investors
Go look for those bright stars who have demonstrated ability to generate excess returns for a long period, and not shown any signs of its deterioration. This is hard to come by for two reasons, though: One, these firms are rare to find. The consolation, however, is that if one doesn't try, someone else will and reap rewards; investors are well advised to work hard at that if they are any serious about making money. Two, these firms sell at premium prices. The consolation again, however, is the market inefficiency. If investors don't believe in market inefficiency, they are well advised to at least buy the index.
Let's get on with work.
A business will lose its value if it continues earnings negative returns (cost of capital higher than return on capital) for long. Investors should shun these declining firms. Many big firms make this list too. So one should not be carried away with the size of the firm. Sooner or later the value destruction will be apparent even for those firms with access to large capital. Watch out for return on capital declining at a steady rate over the period; it is a sign of caution.
It is not possible to sustain high return on capital (and consequent excess returns) for long. As the firm grows over the period, the excess returns have to come down (and may eventually have to move towards zero); perpetual high excess returns remain valid only on the spreadsheet. What it means is that while valuing a firm with high return on capital, one has to be alert enough to bring it to more prudent levels. Investors should look out for firms that have demonstrated high return on capital over long-term; it is a sign that managers of these firms are good at capital allocation, a key measure of survival.
When excess returns are nil, i.e. return on capital equals cost of capital, the value of the firm becomes a function of its book value of capital and growth rate. However, while setting the growth rate it is advisable to consider the reinvestment that is required in conjunction with the return on capital. Otherwise, the analyst can easily set a very high growth rate and say, lo behold, value is created even without having any excess returns! That works in fantasy island. As a corollary, when the growth rate is zero and there are no excess returns, the value of the business is its current book value of capital. Although, this thought appears academic, while valuing a firm on a stable-growth basis, these assumptions are useful.
Long-term returns for investors
Go look for those bright stars who have demonstrated ability to generate excess returns for a long period, and not shown any signs of its deterioration. This is hard to come by for two reasons, though: One, these firms are rare to find. The consolation, however, is that if one doesn't try, someone else will and reap rewards; investors are well advised to work hard at that if they are any serious about making money. Two, these firms sell at premium prices. The consolation again, however, is the market inefficiency. If investors don't believe in market inefficiency, they are well advised to at least buy the index.
Let's get on with work.
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