NOT AN ANALYST

It’s in the best interest of every investor to know the exact value of their investments. However, more often than not, business value cannot be precisely determined. Any attempt to precisely value an enterprise, will yield values that are precisely inaccurate because business value changes over time, fluctuating along numerous variables such as macroeconomic and microeconomic factors. This is the beauty of valuation. It’s more an art than a science. How can you precisely value a business that, unlike debt instruments, may not have a constant stream of cash flows? Thus, the value of a business is never a single number, but a range of values where the highest estimate is sometimes twice as much as the lowest one. For example, we all experienced the difficulties or impossibility to value an enterprise such as General Growth Properties. I remember that at the beginning of the bankruptcy process, valuation ranged from $5 per shares to more than $20. That’s where opportunities arise. If securities could be valued precisely, there would be few differences in opinion, market prices would fluctuate less frequently, and trading would diminish significantly, making our job useless. Discrepancies over the value of a business result from differences among the assumptions used, especially discount rates, projected cash flows, differences among the valuation methods used. I consider three different valuation methods that can be used to value en enterprise.

Absolute value

When futures cash flows are reasonably predictable and an appropriate discount rate can be chosen, the absolute value represents the most reliable source of information. However, cash flows are usually uncertain and the choice of the appropriate discount rate is usually an area of debate, hence we have to be careful when we use this valuation method. In the context of absolute valuation, cash flow, which comprises of dividends, free cash flow or residual income, is discounted at the required rate of return to find the PV of such cash flows.

Dividends

Generally, using dividends as cash flows is most suitable when the company is dividend paying, the board of directors has established a dividend policy that bears an understandable and consistent relationship with profitability and the investor takes a non-controlling ownership, because shareholders do not have control over the dividend policy.

Free cash flow

Valuation using free cash flow to the firm (FCFF) or to equity (FCFE) is most suitable when a company is dividend-paying but dividends significantly fall short or exceed FCFE, the company doesn’t pay dividends at all and the investor takes the ownership prospective. However, applying the free cash flow approach posts problems in some cases.  Some companies have intense capital demands and, as a result, have negative expected free cash flows far into the future. A profitable enterprise that is expanding may have a negative free cash flow indefinitely because of the level of capital expenditures. The present value of a series of negative cash flows is a negative number, therefore the use of a free cash flow model entails a long forecast horizon to capture the point at which expected free cash flow turns positive. The uncertainty associated with such forecasts may be considerable.

Residual value

Conceptually, residual income is the book value per share plus the present value of expected future earnings reduced by the equity charge.  Because the record of residual income can always be calculated, a residual income model can be used for both dividend-paying and non-dividend-paying companies, and for companies with negative expected free cash flow with reasonable forecast horizon. However, the application of the residual income model requires a detailed knowledge of accrual accounting. In some cases, the degree of distortion and the quality of accounting disclosure can be such that the application of the residual income model is error-prone.

Relative value

A valuation method relies on price multiples that sophisticated and prudent investors have recently paid to purchase similar businesses. For example, multiplying a benchmark value of the price-to-earnings (P/E) by an estimate of a company’s EPS provides a quick estimate of the value of a company’s stock. The concept behind price multiples is that a stock’s price cannot be valued in isolation (absolute value). Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net assets, or some other measure of value. The economic rationale behind the method of comparables is the “Law of one price”, which is the economic principle that two identical assets should sell at the same price. But what can constitute the benchmark? Generally, it’s the mean/median multiple of the company’s peer group within a certain industry, or the mean/median multiple of the company’s whole industry sector or the company’s own past multiples. However, this valuation method is not without shortcomings. The method of comparables argues that a firm with multiples below the benchmark is undervalued, and with multiples above the benchmark is overvalued. In this case, the fundamental of the stock have to be similar to the fundamental of the benchmark before we make any direct comparison and draw conclusions whether the stock is overvalued or undervalued. Let’s suppose that, after hours of research, you determine that the P/E of the stock you are trying to value is less than the benchmark. There are at least three possible explanations for this:

• The stock is undervalued
• The stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower P/E
• The stock is properly valued, but it has a higher expected return (higher risk or required rate of return) than then benchmark, which leads to a lower P/E.

In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to the benchmark, it should have similar expected growth and similar risk/return.

Liquidation value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment opportunity. The assets of a company are generally worth more as a part of a going concern than in liquidation, hence liquidation value is generally a worst-case scenario assessment. When no crisis is at hand, liquidation proceeds are maximized through an orderly winding up of a business. Cash is worth one hundred cents on the dollar. Investment securities are valued at market prices, less any transaction cost. Accounts receivable are appraised at close to their face amount. The value of inventories is not easily determined and it depends on whether or not the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is the risk of technological obsolescence. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flow and their next best use. Emulating Benjamin Graham, the approximation of the liquidation value of a company can be calculated as “net-net working capital”, which is net working capital minus all long term liabilities. As long as working capital is not overstated and operations are not rapidly consuming cash, if a company could liquidate its assets, extinguish all liabilities and still distribute proceeds in excess of the market price to investors, it represents an attractive opportunity.