Discussion Issues and Derivations
- How do you choose between firm and equity valuation?
Done right, firm and equity valuation should yield the same values for the equity with consistent assumptions. Choosing between firm and equity valuation boils down to the pragmatic issue of ease. While both firm and equity valuation are built on leverage as a required input, equity valuation builds in the leverage into the cash flows (in the form on interest payments and net debt issues), whereas firm valuation building the leverage into the discount rate (through leverage in the cost of capital). From the perspective of convenience, it is far easier to estimate the latter than the former, especially when leverage is changing significantly over time.
When leverage is not expected to change significantly over time, I prefer equity valuation. The valuation tends to be much more robust, especially for small changes in the stable growth rate. It measures a real cash flow, rather than an abstraction (free cash flows to the firm exist only on paper), and brings to light potential cash shortfalls (and the likelihood of bankruptcy) much more directly.
- How do you estimate an expected growth rate?
If there is a billion-dollar question in valuation, this is it. While there are many who use historical (past) growth as a measure of expected growth, or choose to trust analysts (with their projections), I put my faith in fundamentals. If nothing else, it forces me to think about the two factors that determine growth - the firm's reinvestment policy and its project quality.
Expected growth in Earnings = Reinvestment Rate * Return on Investment
For expected growth in earnings = Retention Ratio * ROE
For expected growth in EBIT = Reinvestment Rate * ROC
Note that what we really need to estimate are reinvestment rates and marginal returns on equity and capital in the future. While this is difficult to do, it is the essence of valuation. In fact, I do not see how any company can be valued without making assumptions about these variables.
Note that those who use anlayst or historical growth rates are implicitly assuming something about reinvestment rates and returns, but they are either unaware of these assumptions or do not make them explicit.
- How do you estimate how long expected growth will last?
This is the toughest and least analyzed question in valuation. Without claiming to have the answer to the question, I would look at the following characteristics:
1. The greater the current growth rate in earnings of a firm, relative to the stable growth rate, the longer the high growth period, though the growth rate may drop off during the period. Thus, a firm that is growing at 40% currently should have a longer high-growth period than one growing at 14%.
2. The larger the current size of the firm –– both in absolute terms and relative to the market it serves –– the shorter the high growth period. Size remains one of the most potent forces that push firms towards stable growth, size remains one of the most potent; the larger a firm, the less likely it is to maintain an above-normal growth rate.
3. The greater the barriers to entry in a business, either because of legal mechanisms such as patents or marketing mechanisms such as strong brand names, should increase the length of the high growth period for a firm.
In balance, I would look at the combination of the three factors and make a judgment call. In making the call, I would be very reluctant to use an expected growth period longer than 10 years, given how few firms actually are able to sustain growth for that long.
- What is terminal value and how is it estimated?
Terminal value refers to the value of the firm (or equity) at the end of the high growth period. The soundest way of estimating terminal value, in a DCF valuation, is to estimate a stable growth rate after the high growth period that the firm can sustain forever. If we make this assumption, the terminal value becomes:
Terminal Value in year n= Cash Flow in year n+1/(r - g)
This approach requires the assumption that growth is constant forever, and that the cost of capital will not change over time.
- What is a stable growth rate and why cannot it be greater than the discount rate?
A stable growth rate is a growth rate that can be sustained forever. Since no firm, in the long term, can grow faster than the economy which it operates it (which might be the global economy), a stable growth rate cannot be greater than the growth rate of the economy. In making this comparison, it is important that the growth rate be defined in the same currency as the cash flows and that be in the same term (real or nominal) as the cash flows.
This stable growth rate cannot be greater than the discount rate because the riskfree rate that is embedded in the discount rate will also build on these same factors - real growth in the economy and the expected inflation rate.
- What is an "exit multiple" and how is it used in DCF valuation?
In some discounted cash flow valuations, the terminal value is estimated using a multiple, usually of earnings.In an equity valuation model, the exit multiple may be the PE ratio. In firm valuation models, the exit multiple is often of EBIT or EBITDA. Analysts who use these multiples argue that it saves them from the dangers of having to assume a stable growth rate and that it ties in much more closely with their objective of selling the firm or equity to someone else at the end of the estimation period.
As a counter, I would argue that exit multiples introduce relative valuation into discounted cash flow valuation, and that you risk creating an amalgam, which is neither DCF nor relative valuation. Furthermore, the exit multiple used in these multiples is, by far, the biggest single assumption made in these models and is often based upon multiples at which comparable firms are trading at today. On a long term investment, it seems foolhardy to assume that current multiples will remain intact as the industry matures and changes and that investors will continue to pay such multiples, even if the fundamentals do not justify them.
- What are the most common errors in dividend discount model valuation?
The most common errors in dividend discount model valuation lie in the assumptions about the evolution of the payout ratio as the growth rate changes. Many high growth firms either pay low dividends or no dividends. As the growth rate changes, the dividend payout ratio should rise. If it does not, these firms will not be worth much using these models.
- What are the most common errors in FCFE/FCFF model valuation?
In cash flow valuation models, the assumptions about net capital expenditures and growth are linked strongly. When one changes, so should the other. In general, there are two types of errors that show up in these valuations. In the first, high growth firms with high net capital expenditures are assumed to keep reinvesting at current rates, even as growth drops off. Not surprisingly, these firms are not valued very highly in these models. In the second, the net capital expenditures are reduced to zero in stable growth, even as the firm is assumed to grow at some rate forever. Here, the valuations tend to be too high.
To avoid both errors, make the assumptions about reinvestment a function of the growth and the return on capital. As growth changes, the reinvestment rate will also change.
- How do you value a firm that is losing money?
There are a number of reasons why a firm might have negative earnings, and the response will vary depending upon the reason:
- If the earnings of a cyclical firm are depressed due to a recession, the best response is to normalize earnings by taking the average earnings over a entire business cycle. (A good example would be Ford or Chrysler in 1991, when both companies had negative earnings as a consequence of the recession.)
- Normalized Net Income = Average ROE * Current Book Value of Equity
- Normalized after-tax Operating Income = Average ROC * Current Book Value of Assets
- Once earnings are normalized, the growth rate used should be consistent with the normalized earnings, and should reflect the real growth potential of the firm rather than the cyclical effects.
- If the earnings of a firm are depressed due to a one-time charge, the best response is to estimate the earnings without the one-time charge and value the firm based upon these earnings. (This would apply to firms such as ITT and Eastman Kodak, that had significant restructuring charges in the mid-nineties.)
- If the earnings of a firm are depressed due to poor management, i.e. the firm is a poor performer in a sector with healthy earnings, the average return on equity or capital for the industry can be used to estimate normalized earnings for the firm. The implicit assumption is that the firm will recover back to industry averages, once management has been removed.
- Normalized Net Income = Industry-average ROE * Current Book Value of Equity
- Normalized after-tax Operating Income = Industry-average ROC * Current Book Value of Assets
- If the negative earnings over time have caused the book value to decline significantly over time, use the average operating or profit margins for the industry in conjunction with revenues to arrive at normalized earnings. Note that in the context of a discounted cash flow valuation, this normalization will occur over time, rather than instantaneously. Thus, a firm with negative operating income today could be assumed to converge on the normalized earnings five years from now. (This would be the approach to use for a firm like Digital Equipment, which had low earnings in 1996, while other firms in the sector were reporting record profits)
- If the earnings of a firm are depressed or negative because it operates in a sector which is in its early stages of its life cycle, the discounted cash flow valuation will be driven by the perception of what the operating margins and returns on equity (capital) will be when the sector matures. (This would apply for firms in the cellular technology business in the mid-nineties.)
- If the equity earnings are depressed due to high leverage, the best solution is to value the firm rather than just the equity, factoring in the reduction in leverage over time. (This would be the choice when valuing a firm right after a leveraged buyout.)
- How do you value a financial service firm?
We would like to value financial service firms, just as we value other firms, using expected cash flows to equity (since leverage at banks is usually high and fairly stable). The problem we run into is that cash flows at a bank are not easily estimated. Neither net capital expenditures not working capital are well defined, and banks expense many items (such as training expenses) that can be viewed as the equivalent of capital expenditures.
Given these difficulties in estimating cash flows, we are often stuck with the dividend discount model as a model of last resort. For banks that choose not to pay dividends or pay less than they can afford to, the potential dividends can be estimated using the expected growth rate and the return on equity.
Potential Dividend Payout ratio = 1 - g / ROE
- How do you value a private firm?
Unlike the valuation of stock in a publicly traded firm, the valuation of a private firm presents significant challenges. In particular,
1. The information available on private firms will be sketchier than the information available on publicly traded firms.
2. Past financial statements, even when available, might not reflect the true earnings potential of the firm. Many private businesses understate earnings to reduce their tax liabilities, and the expenses at many private businesses often reflect the blurring of lines between private and business expenses.
3. The owners of many private businesses, who are taxed on both the salary that they make and the dividends they take out of the business at the same rate, often do not try to distinguish between the two.
None of these limitations, by themselves, creates an insurmountable problem. The limited availability of information does make the estimation of cash flows much more noisy, past financial statements might need to be restated to make them reflect the true earnings of the firm and a reasonable opportunity cost might have to be charged for the owners contribution to the business. Once the cash flows are estimated, however, the choice of a discount rate might be affected by the identity of the potential buyer of the business. If the potential buyer of the business is a publicly traded firm, the valuation should be done using the discount rates based upon market risk