reliable valuation is a farce

Predicting the future is a waste of time

Someone said he was not good at prediction, especially the future. Well it applies to everyone, but not many accept it. That is why soothsayers and fortunetellers flourish. If there is demand, supply is automatic and natural. Nevertheless, investing in stocks requires knowing the future. We are talking about investors, not speculators and traders. Since a stock represents its underlying business, knowing the value of that business before making investments is imperative. 

Intrinsic value of a business

The value of a business is essentially the present value of all of its future cash flows using an appropriate discount rate. That may sound profound because it is. If it were straightforward, a worksheet would make people rich. All you require as input data are the cash flows until liquidation of the business and a discount rate to bring them to the present value. 

To make life a little simpler, we break down the lifespan of the business in two parts: One, a selected period comprising the number of years we expect the business to grow and to be able to estimate its cash flows, and Two, the stable period representing the rest of the lifespan. The common periods being used are: 10 years of business growth, and then a stable-growth period. Now we need inputs relating to the growth rates over 10 years and then a stable growth rate. The whole exercise involves estimating revenues, operating margins, and reinvestment. It requires estimating debt, including off-balance sheet. We may even have to estimate possible equity dilutions, and this can get complicated by the grant of stock options. Any claims against the business from the non-equity holders will have to be considered as well. There are more. 

Even when we want to keep things simple, we require at least a few estimates to arrive at the free cash flows: 1) The expected growth rate in revenues for the next 10 years; 2) The expected operating margins, and therefore operating profits over the next 10 years; 3) The expected reinvestment required to sustain the expected growth; 4) A stable growth rate assuming that the business will grow at a constant rate perpetually; 5) The stable period operating margins, profits, and reinvestment. 

The past growth rates and near-future prospects usually are a guide for estimating the future growth rates and operating margins. A cap on the business growth considering the whole economy is helpful in estimating the stable period growth. The internal consistency in our calculations helps us estimate the reinvestment required. Yet, these are estimates, and all estimates miss actual numbers reported by the business. Analysts then blame the managers for not meeting their estimates; and that calls for an ugh. Investors are left either amused or let down by their own estimates turning turkeys. 

It's a farce

I have been valuing businesses for a long time, and I know what it means to use a discounted cash flow approach to value a stock. But then I also know its demerits. When every single estimate used is going to miss the actual, is there a point in doing the whole calculation? And what's this stable-period business business? For a high-growth business, like Amazon, most of the value comes from the stable period, which may not be a true reflection of its forthcoming proceedings. We falter when we use a constant growth period after say, 10 years and the business moves on to grow at different rates over say, the subsequent 10-year period. For a mature business, the other way around is true, where most of the value will be front loaded, and the perpetual-growth value will be a small portion of it. But who knows when businesses such as Maruti Suzuki, Bharti Airtel, and Kotak bank, for instance, will become mature? We cannot use say, 4% perpetual growth rate after 10 years, if they can grow significantly higher in the 11-to-20 year period. Die-hard fans of DCF claim that the present value of the second decade cash flow will not be much to impact the total intrinsic value of the business. They are wrong because it will, if the growth rates are significantly different. They also advice using a second growth period, say the second decade, if required. Again as someone said, is there a perverse human behavior that likes to make simple things complicated?

Analysts and investors dealing with the multiples such as earnings, book, and revenues are cheating themselves if they thought they are valuing the business. They are not because the multiples are a pricing mechanism. They might come in handy to them, but these multiples if used intrinsically should yield the response similar to a DCF valuation, because after all, each multiple is reflective of the cash flows, growth rate, and the risks of the business. 

The hack

What's it then, can we not value a business at all? Where's the alternative? The first thing I have found is that dealing with perpetuity is both a pain and foolish. So I chuck the assumption of the stable growth period. Now we have only a selected future period for which estimates will have to be made. We still need cash flows and growth rates for that period. Because these cash flows aren't the entire stash of the business, we cannot use DCF to value the business. We will have to pick a pricing tool to estimate the price of the business. But central to this theme is I don't want to use my own estimate of the price. How do I know for sure that the business is worth 25 times earnings or 3 times book, for instance? 

Instead I want the market to tell me what the business is worth as per its own estimates and pricing. My life then becomes much easier. All I have to do is deal with the market in terms of buy, sell, or no action. Here's the vital piece of the model: The market gives me the clue as to whether the business is priced significantly higher, significantly lower, or reasonably priced. I will know it estimating the market implied growth rates in earnings, book value, or cash flows. Earnings are more important than revenues; but earnings can be manipulated. Cash flows are much better than earnings. Accounting rules can trick earnings, but not cash flows. Here's another point: I will never know the actual intrinsic value of the business. But thank heavens, I don't need to know it. All I need is the market's estimates during my investment period, and my own knowledge about the business. The key is to assess whether the absurdity in pricing is apparent. It is not important to know by how much because that is not possible without having an accurate value for the business. As long as the price appears to be absurd and out of sync with the business fundamentals, there's a case for either a buy or a sell decision.

I believe that wherever humans are involved we will find some sort of inefficiencies, which often take to some absurd levels. The financial markets aren't an exception; they happen all the time there, but at different points. The overall market may be reasonably priced, but a specific stock may be significantly underpriced, for instance. For a careful investor, observing this game from a distance gives opportunities for profit. All the investor has to do is to play the game by own terms, not giving in to the market's stunts. The game is more behavioral than mathematical. 

Apple reached $1 t market value yesterday. Since this is a fact, the potential investor has to find out what's in store for him in future. Apple's annual numbers are a couple of months away. But we know that it generated average free cash flows to firm of $45 b during the past (2013-2017) five years. It also had net cash of $153 b as of September 2017, not very different from what it reported for June 2018. The free cash flows peaked in 2015 to $66 b; for 2017, they were $41 b. We don't have to estimate the cash flows during each of the next say, 5 years. Let markets do that work. We know that the growth rates have been erratic in the past. However based on the current pricing, the markets are telling us that if these cash flows grow 5% annually, and if they are priced 18 times at the 5th year, we can make 10% annually over the 5-year period. The markets have brought their estimates of the 5-year cash flows to the present value using a discount rate of 10%. Now we have some clue regarding our decision as to whether to buy, sell, or ignore the market offering. This, I have understood, gives me the comfort in making decisions rather than simply input the numbers on the worksheet and bring out the present value. We will have to assess whether the growth rates are significantly higher or lower than that are sustainable for Apple as a business. It is still heavily dependent upon iPhones; none of its new products have been that encouraging. There is a fair amount of judgment involved in making the decision, but at least here we are challenging the market's estimates rather than making our own. We also have to check if 10% returns sound interesting to us. We can also juggle around with the growth rates and pricing multiple to arrive at the current market value of the business. It's not difficult to catch insanity in the market's assumptions. 

By the way, I still love doing that DCF stuff, why I valued Apple, Facebook, and Alphabet only yesterday. It is fun, and just that; I love it. I don't make any investment decisions based on DCF anymore, although if done accurately, DCF is the only model to calculate the intrinsic value of a cash-flow-throwing asset. But then the catch is we cannot do it accurately. Why lie to ourselves then?

That does not stop business managers and their investment advisors in pulling out complex worksheets and fancy presentations to compensate for the hollow math. That is how the mergers and acquisitions take place anyway. As I said when there is demand, supply will find its place. Managers look grand, and advisors make money on most acquisitions. The joke is, if you keep lying to yourself about something, you will eventually start believing it. Repetition works like magic in here too. My advice though is that don't try it.