Reflecting on Company Valuation
Discounted Cash Flow (DCF) models are ubiquitous in funds management. They tend to be time consuming to build, but when it comes to company valuation they are the gold standard, providing a comprehensive and elegant framework by which cash flow forecasts can be translated into estimates of value.
They are also fiddly, fiddly things that demand careful attention to a wide range of critical input assumptions; a bit like a complicated watch movement, whose individual components must be machined to precise tolerances for you to have any chance of being on time for that important meeting.
And here is where we strike a problem, because DCF models are built by people; people who are beset by inconsistency, and a list of cognitive biases, that begins with anchoring, availability, belief bias, and confirmation bias, and works its way through the alphabet from there.
In short, in the context of the theoretical rigour and mathematical precision of a DCF model, we humans are a menace to good order.
A simple example will help illustrate the problem. Let’s say we have a business that generates $100 of revenue for each share on issue and has a profit margin of 10 per cent. For simplicity we’ll assume that the business can grow without reinvestment, such that all dividends can be paid to shareholders.
Now let’s put some growth assumptions together. We’ll start by forecasting 8 per cent per annum revenue growth for a 15 year horizon, with 3.5 per cent per annum terminal growth beyond that.
As the business grows, we expect some operational leverage, so we’ll expand margins by 25bps per annum during the forecast horizon and we’ll discount the resulting cash flows back to present value at a rate of 8 per cent.
This gets us to a value per share of around $46.87.
On reflection though, maybe we should put a little more conservatism into some of our forecasts. We’ll start by shortening the forecast horizon from 15 years to 10 years, because it’s really quite hard to know what the world might look like in 15 years’ time. This brings our valuation back to $38.08 per share.
We may need to revisit the revenue growth assumption as well. High growth rates become harder to sustain as a business gets bigger, so let’s bring our revenue growth rate back to 6 per cent per annum from 8 per cent per annum. That gets us to a valuation of $33.81 per share.
While we’re at it, 3.5 per cent terminal growth rate feels a tad high. Let’s trim that to 2.5 per cent per annum which brings the valuation to $29.42.
Margins probably need a bit more thought as well. This is an attractive business, and over time you might expect increasing competition to put pressure on margins. If we assume a 10bps per annum decline in profit margins that gets us to a valuation of $22.55.
Finally, that discount rate feels a tad low. The business is high quality, but let’s not forget the potential for increasing competition to erode some of its allure, and interest rates won’t stay at this level forever. Let’s nudge the rate up from 8 per cent to 9 per cent, which brings the valuation to $18.91.
You’ll notice that with some plausible modification to assumptions, we generated a very wide range of valuations, the high end of $46.87 being almost 150 per cent higher than the low end of $18.91. With assumptions being so critical to the outcome, how do we settle them so as to have confidence in the results?
The answer, I think, is that an experienced analyst with good commercial judgement, an independent mindset and enough time to devote to the problem can generally be expected to produce sensible results and genuine valuation insight. It’s by no means easy to do, but with diligence and skill it can be done.
However, if the current share price is closer to $50 than to $20, those initial assumptions start to look mighty tempting don’t they?
Is that the time? Think I’m running late for a meeting.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Justin Carroll
:
Trying to predict the trajectory of future earnings is a mug’s game. More effort and greater overall reward would be achieved by endeavouring to ascertain a company’s “earnings power” in the Benjamin Graham sense of that term (which, if I’ve understood Graham correctly, is what today is termed a company’s “earnings yield” ascertained over the course of a full economic cycle).
leon payne
:
Excellent and simple. Thank you. In reality analysts would adjust some assumptions and not others and some changes may cancel each other out – meaning you get a few extremes plus a bunch in the middle – and because we don’t like to be different – analysts would feel more comfortable if they felt part of the group. But that still doesn’t mean it’s the right answer