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Valuation Q&A


WneverLOSE
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Hi, I'm gonna start this valuation Q&A topic so I can ask everything I want in the same place, maybe someone will find this helpful.

 

The first thing I wanna ask is about growth and ROIC.

Let's say company XYZ can earn a 30% ROIC if they don't invest for future growth. Let's assume they see huge opportunity to grow and dominate the market so they reinvest all of their "earnings" into more inventory/systems and so on. Let's assume that they grow this way at 30%.

Now this company earnings are 0 since all of it is invested for growth, why isn't it that such a company is worth 0 ? (0 money is availably for distribution to the owners and 0 dollars growing at 30% is still 0)

 

How does somebody value a company that grows by investing all the money that otherwise would have been considered as distributable earnings ?

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The key thing to understand is that the value of a company is the present value of all of it's FUTURE cash flows.   

 

All else equal, if a company earns $100 in 2016 and can reinvest those earnings at a 30% incremental return on invested capital, earnings in year 2 will be $130 (previous earnings power of $100 + increased earnings power from reinvestment of $30).  In the future, the company which reinvests its earnings at a 30% return will have higher cash flows than the company which distributes all cash flows in the current year (in this simplistic example where the company MUST reinvest its earnings to achieve incremental returns on capital).   

 

The value of the business is the sum of all cash flows the company can earn and distribute going forward. 

 

 

 

 

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Valuing high growth companies is the same as any other company (estimate future cash flows and discount them back to today), but there's generally a much wider range of possible outcomes so it's a more difficult task. If a company (like Amazon) invests almost all of it's "earnings" back into the business, you have to think about how the business will look when it matures in 5 or 10 or 20 years and what it may be able to earn at that point. It requires asking yourself a lot of questions such as:

 

[*]How might this industry evolve over the next 10+ years?

[*]How big might the eventual addressable market be?

[*]How might this company's competitive position change over that time?

[*]How durable is their competitive advantage (assuming they have one)?

[*]Is the company or industry at risk for technological disruption?

[*]How much operating leverage can this company benefit from as it scales?

 

and on and on. The investors who can predict how industries and companies will evolve over time more accurately than others will make the most money. It's not easy though, that's what makes it fun  :)

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Hi WneverLOSE

 

The traditional method is to use a 2-step (or multi-step) model where you assume different growth rates at different times in the future.

 

STEP 1: assume future growth periods

So you might fx assume that your 30% grower can keep up that rate for 4 years, then dropping to 15% for 10 years and then dropping to 3% from that time onwards.

 

STEP 2: assume future margins and ROE/ROIC

You then think about the future ROIC: will it increase, decrease or remain stable? If you have some operational leverage the ROIC might increase over time as your margins expand. If you assume competitors come gunning for your business then it might fall. Etc. Map this out along a timeline as well for each of your growth periods.

 

STEP 3: assume future capital structure and cost

Estimate/think about what future capital structure the company might use. Look at sector examples and estimate the cost of debt as it is (there is a lot of techniques involved in optimising WACC. Google is your friend).

 

STEP 4: Calculate required reinvestment rate

Given earnings and perhaps a leveraged capital structure you can now calculate the needed reinvestment rate. 30% growth assuming a stable 30% ROIC and no debt is = 100% reinvestment rate. A 15% growth rate at a 30% ROIC is a 50% reinvestment rate and so on. New debt naturally detracts from required reinvestment but lowers net margins due to interest expense. Given your Growth Timeline, your ROIC Timeline and your Capital Structure Timeline then the Reinvestment Timeline becomes calculable.

 

Step 5: calculate net earnings for each year and discount back to today

Pretty straight forward I hope, but given profit, debt and reinvestment you have excess earnings available, the present value of which is the value of your company. There will be more earnings available in the future but it will be discounted more.

 

Step 6: apply a margin of safety.

As you can see there are LOTS of assumptions in all the above steps. No way around this: better make them explicitly than hidden back in the dark recesses of your mind. Be critical of course. Generally the triad of Growth-Risk-Reinvestment has to add up: if growth and reinvestment is assumed high but risk low you really have to know why this is so (and vice versa around the triad).

 

The margin of safety then is applied ON TOP of your conservative estimates.

 

Then compare to price and buy if appropriate :-)

 

Voila!

 

/Ulrik

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Damodaran does something very similar to what Lehrskov described: varied growth periods, varied reinvestment percentage periods, etc., then discounted back.

 

One issue with this approach - and almost any DCF actually - is that usually terminal value dominates the overall value or is a large chunk of the overall value. And if your terminal value comes from 10+ years in the future I would say that it is likely to be a wild ass guess.

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I pulled this from the 1991 Chairman's Letter.  He makes it seem so easy...

 

http://www.berkshirehathaway.com/letters/1991.html

 

A few years ago the conventional wisdom held that a newspaper,

television or magazine property would forever increase its earnings

at 6% or so annually and would do so without the employment of

additional capital, for the reason that depreciation charges would

roughly match capital expenditures and working capital requirements

would be minor. Therefore, reported earnings (before amortization

of intangibles) were also freely-distributable earnings, which

meant that ownership of a media property could be construed as akin

to owning a perpetual annuity set to grow at 6% a year. Say, next,

that a discount rate of 10% was used to determine the present value

of that earnings stream. One could then calculate that it was

appropriate to pay a whopping $25 million for a property with

current after-tax earnings of $1 million. (This after-tax multiplier

of 25 translates to a multiplier on pre-tax earnings of about 16.)

 

    Now change the assumption and posit that the $1 million

represents "normal earning power" and that earnings will bob around

this figure cyclically. A "bob-around" pattern is indeed the lot of

most businesses, whose income stream grows only if their owners are

willing to commit more capital (usually in the form of retained

earnings). Under our revised assumption, $1 million of earnings,

discounted by the same 10%, translates to a $10 million valuation.

Thus a seemingly modest shift in assumptions reduces the property's

valuation to 10 times after-tax earnings (or about 6 1/2 times

pre-tax earnings).

 

    Dollars are dollars whether they are derived from the

operation of media properties or of steel mills. What in the past

caused buyers to value a dollar of earnings from media far higher

than a dollar from steel was that the earnings of a media property

were expected to constantly grow (without the business requiring

much additional capital), whereas steel earnings clearly fell in

the bob-around category. Now, however, expectations for media have

moved toward the bob-around model. And, as our simplified example

illustrates, valuations must change dramatically when expectations

are revised.

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Damodaran does something very similar to what Lehrskov described: varied growth periods, varied reinvestment percentage periods, etc., then discounted back.

 

One issue with this approach - and almost any DCF actually - is that usually terminal value dominates the overall value or is a large chunk of the overall value. And if your terminal value comes from 10+ years in the future I would say that it is likely to be a wild ass guess.

 

The terminal value is a huge flaw of equity DCF valuation and is why it's so important to use a multitude of valuation metrics.  There is so much room for error.

 

Graham on investing vs. speculating in regard to future predictions:

 

"Needless to say, the analyst must take possible future changes into account, but his primary aim is not so much to profit from them as to guard against them. Broadly speaking, he views the business future as a hazard which his conclusions must encounter rather than as the source of his vindication.”

 

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Just a note on what some of the other commenters said here regarding the DCF: I absolutely agree that one of the weaknesses of the DCF is that the precision it seems to offer is mistaken for accuracy. Just because you go through X steps of assumptions and calculations and then get a result in the end doesn't mean that that result is true (if only it were so!).

 

The strength, above combining quantitative layers, is simply that it provides a structured method of assumptions. But they are still assumptions.

 

Damodaran actually mentions that he at one point historically noticed that he didn't trust his own DCFs and that he then changed approach to combining his DCFs with storytelling or, as I would call it, scenario forecasting for the development of the business.

(check the GoogleTalk here:

)

 

Okay WneverLose: next question! :-)

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I think it's easy to forget that all valuation methods involve the same assumptions that DCFs make. Most other methods just make those assumptions implicitly vs a DCF that forces explicit assumptions. Ultimately no valuation method is perfect so it's best to look at companies from multiple angles. Below is a quote about DCFs from a blog post I wrote on this topic last year:

 

The number of assumptions one has to make to build a DCF model is very large. It’s impossible for me to accurately make fifty different assumptions that determine a company’s future. Doesn’t this mean the final output of the model will be inaccurate and useless? The thing that took me awhile to realize is that slapping a multiple on earnings or cash flow involves the exact same assumptions. The only difference is valuing companies based on multiples makes those assumptions implicit versus a DCF model that forces explicit assumptions. You may not realize it, but slapping a 15x multiple on a stock is absolutely making assumptions about the company’s future growth rate, margin compression or expansion, return on invested capital, debt-to-equity ratios and all the other explicit assumptions in a DCF.

 

https://traviswiedower.com/2016/05/17/my-love-hate-relationship-with-dcfs/

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