Value of a business is the present value of its future cash flows. For an investor it becomes difficult to predict cash flows and estimate the right discount rate. He struggles in that attempt all the time. What to expect of an investment, say, in a stock, is a pertinent question.
While many analysts stick to the standard DCF model (of course, they do complicate it in the process is another matter), some loathe it citing reasons that it is difficult to predict cash flows. The latter take solace in applying multiples. And a few others use the combo - a mix of DCF and multiples. Really, there is no dearth of imagination when it comes to an analyst's emotions and his excel worksheet.
I can argue that it is possible to use DCF model in estimating an approximate (rather than precise) value of a business. I would rather keep that for another post.
The topic of this post is how venture capital and private equity firms earn their returns. They use different models to supply finance and acquire stake in the (often a private) business. The simplest form is usually the most sought after: Invest in equity of the business. Estimate the price (it isn't value) of the business 3-5 years hence. The pricing model usually is earnings-multiple, revenue multiple, or any other multiple. Have a minimum hurdle rate for the investment. Work back to calculate the price to be paid for the equity today.
If that means squeezing the present owners, so be it. In capitalism, it is fair. What is fancy in this investment model is that it is not fancy.
I want to argue that it is not difficult to use this pricing (not valuation) model for a small individual investor. It is actually a superior model to use for returns in excess of the market returns provided he is aware that pricing game is what is played here. The key to success with this model is of course the behavior of the investor.
Here's how it works:
The buy price depends upon the expected return:
As we can see for an investor who wants 30% return, the buy price has to be 47.40 which has an implied PE ratio of 13.54. This is about 52.60% down from the current price.
Is it possible to play this game in a publicly listed company? Of course it is possible because the market can be squeezed on occasion. For a patient investor there would be occasions to buy at his price. After all, the markets are inefficient, and a more-sensible investor can make money at the cost of the less-sensible one.
Two things hold out: Estimating future growth rate and PE ratio can be anybody's guess, and in addition, the emotions of the analyst can flow through to spoil the pricing game.
Nevertheless, thinking like a private equity investor is often useful. At least, it lets you to play the game on your terms.
If that means squeezing the present owners, so be it. In capitalism, it is fair. What is fancy in this investment model is that it is not fancy.
I want to argue that it is not difficult to use this pricing (not valuation) model for a small individual investor. It is actually a superior model to use for returns in excess of the market returns provided he is aware that pricing game is what is played here. The key to success with this model is of course the behavior of the investor.
Here's how it works:
The buy price depends upon the expected return:
As we can see for an investor who wants 30% return, the buy price has to be 47.40 which has an implied PE ratio of 13.54. This is about 52.60% down from the current price.
Is it possible to play this game in a publicly listed company? Of course it is possible because the market can be squeezed on occasion. For a patient investor there would be occasions to buy at his price. After all, the markets are inefficient, and a more-sensible investor can make money at the cost of the less-sensible one.
Two things hold out: Estimating future growth rate and PE ratio can be anybody's guess, and in addition, the emotions of the analyst can flow through to spoil the pricing game.
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