The Dark Side of Valuation
I have always believed that valuation is simple and that practitioners choose to make it complex. The intrinsic value of a cash flow-generation asset is a function of how long you expect it to generate cash flows, as well as how large and predictable these cash flows are. This is the principle that we use in valuing businesses, private as well as public, and in valuing securities issued by these businesses.
Although the fundamentals of valuation are straightforward, the challenges we face in valuing companies shift as firms move through the life cycle. We go from idea businesses, often privately owned, to young growth companies, either public or on the verge of going public, to mature companies, with diverse product lines and serving different markets, to companies in decline, marking time until they are liquidated. At each stage, we are called on to estimate the same inputs—cash flows, growth rates, and discount rates—but with varying amounts of information and different degrees of precision. All too often, when confronted with significant uncertainty or limited information, we are tempted by the dark side of valuation, in which first principles are abandoned, new paradigms are created, and common sense is the casualty.
This chapter begins by describing the determinants of value for any company. Then it considers the estimation issues we face at each stage in the life cycle and for different types of companies. We close the chapter by looking at manifestations of the dark side of valuation.
Foundations of Value
We will explore the details of valuation approaches in the next four chapters. But we can establish the determinants of value for any business without delving into the models themselves. In this section, we will first consider a very simple version of an intrinsic value model. Then we will use this version to list the classes of inputs that determine value in any model.
Every asset has an intrinsic value. In spite of our best efforts to observe that value, all we can do, in most cases, is arrive at an estimate of value. In discounted cash flow (DCF) valuation, the intrinsic value of an asset can be written as the present value of expected cash flows over its life, discounted to reflect both the time value of money and the riskiness of the cash flows.
In this equation, E(CFt) is the expected cash flow in period t, r is the risk-adjusted discount rate for the cash flow, and N is the life of the asset.
Now consider the challenges of valuing an ongoing business or company, which, in addition to owning multiple assets, also has the potential to invest in new assets in the future. Consequently, not only do we have to value a portfolio of existing assets, but we also have to consider the value that may be added by new investments in the future. We can encapsulate the challenges by framing a financial balance sheet for an ongoing firm, as shown in Figure 1.1.
Figure 1.1 A Financial Balance Sheet
Thus, to value the company, we have to value both the investments already made (assets in place) and growth assets (investments that are expected in the future) while factoring in the mix of debt and equity used to fund the investments. A final complication must be considered. At least in theory, a business, especially if it is publicly traded, can keep generating cash flows forever, thus requiring us to expand our consideration of cash flows to cover this perpetual life:
Because estimating cash flows forever is not feasible, we simplify the process by estimating cash flows for a finite period (N) and then a "terminal value" that captures the value of all cash flows beyond that period. In effect, the equation for firm value becomes the following:
Although different approaches can be used to estimate terminal value, the one most consistent with intrinsic value for a going concern is to assume that cash flows beyond year N grow at a constant rate forever, yielding the following variation on valuation:
Because no firm can grow at a rate faster than the overall economy forever, this approach to estimating terminal value can be used only when the firm becomes a mature business. We will examine the details of estimating the inputs—cash flows, discount rates, and growth rates—in Chapter 2, "Intrinsic Valuation."
Determinants of Value
Without delving into the details of estimation, we can use the equation for the intrinsic value of the business to list the four broad questions that we need to answer in order to value any business:
- What are the cash flows that will be generated by the existing investments of the company?
- How much value, if any, will be added by future growth?
- How risky are the expected cash flows from both existing and growth investments, and what is the cost of funding them?
- When will the firm become a stable growth firm, allowing us to estimate a terminal value?
What Are the Cash Flows Generated by Existing Assets?
If a firm has already made significant investments, the first inputs into valuation are the cash flows from these existing assets. In practical terms, this requires estimating the following:
- How much the firm generated in earnings and cash flows from these assets in the most recent period
- How much growth (if any) is expected in these earnings/cash flows over time
- How long the assets will continue to generate cash flows
Although data that allows us to answer all these questions may be available in current financial statements, it might be inconclusive. In particular, cash flows can be difficult to obtain if the existing assets are still not fully operational (infrastructure investments that have been made but are not in full production mode) or if they are not being efficiently utilized. There can also be estimation issues when the firm in question is in a volatile business, where earnings on existing assets can rise and fall as a result of macroeconomic forces.
How Much Value Will Be Added by Future Investments (Growth)?
For some companies, the bulk of value is derived from investments you expect them to make in the future. To estimate the value added by these investments, you have to make judgments on two variables. The first is the magnitude of these new investments relative to the size of the firm. In other words, the value added can be very different if you assume that a firm reinvests 80% of its earnings into new investments than if you assume that it reinvests 20%. The second variable is the quality of the new investments measured in terms of excess returns. These are the returns the firm makes on the investments over and above the cost of funding those investments. Investing in new assets that generate returns of 15%, when the cost of capital is 10%, will add value, but investing in new assets that generate returns of 10%, with the same cost of capital, will not. In other words, it is growth with excess returns that creates value, not growth per se.
Because growth assets rest entirely on expectations and perception, we can make two statements about them. One is that valuing growth assets generally poses more challenges than valuing existing assets; historical or financial statement information is less likely to provide conclusive results. The other is that there will be far more volatility in the value of growth assets than in the value of existing assets, both over time and across different people valuing the same firm. Not only will analysts be likely to differ more on the inputs into growth asset value—the magnitude and quality of new investments—but they will also change their own estimates more over time as new information about the firm comes out. A poor earnings announcement by a growth company may alter the value of its existing assets just a little, but it can dramatically shift expectations about the value of growth assets.
How Risky Are the Cash Flows, and What Are the Consequences for Discount Rates?
Neither the cash flows from existing assets nor the cash flows from growth investments are guaranteed. When valuing these cash flows, we have to consider risk somewhere, and the discount rate is usually the vehicle that we use to convey the concerns that we may have about uncertainty in the future. In practical terms, we use higher discount rates to discount riskier cash flows and thus give them a lower value than more predictable cash flows. While this is a commonsense notion, we run into issues when putting this into practice when valuing firms:
- Dependence on the past: The risk that we are concerned about is entirely in the future, but our estimates of risk are usually based on data from the past—historical prices, earnings, and cash flows. While this dependence on historical data is understandable, it can give rise to problems when that data is unavailable, unreliable, or shifting.
- Diverse risk investments: When valuing firms, we generally estimate one discount rate for its aggregate cash flows, partly because of how we estimate risk parameters and partly for convenience. Firms generate cash flows from multiple assets, in different locations, with varying amounts of risk, so the discount rates we use should be different for each set of cash flows.
- Changes in risk over time: In most valuations, we estimate one discount rate and leave it unchanged over time, again partly for ease and partly because we feel uncomfortable changing discount rates over time. When valuing a firm, though, it is entirely possible, and indeed likely, that its risk will change over time as its asset mix changes and it matures. In fact, if we accept the earlier proposition that the cash flows from growth assets are more difficult to predict than cash flows from existing assets, we should expect the discount rate used on the cumulative expected cash flows of a growth firm to decrease as its growth rate declines over time.
When Will the Firm Become Mature?
The question of when a firm will become mature is relevant because it determines the length of the high-growth period and the value we attach to the firm at the end of the period (the terminal value). This question may be easy to answer for a few firms. This includes larger and more stable firms that are either already mature businesses or close to maturity, or firms that derive their growth from a single competitive advantage with an expiration date (for instance, a patent). For most firms, however, the conclusion will be murky for two reasons:
- Making a judgment about when a firm will become mature requires us to look at the sector in which the firm operates, the state of its competitors, and what they will do in the future. For firms in sectors that are evolving, with new entrants and existing competitors exiting, this is difficult to do.
- We are sanguine about mapping pathways to the terminal value in discounted cash flow models. We generally assume that every firm makes it to stable growth and goes on. However, the real world delivers surprises along the way that may impede these paths. After all, most firms do not make it to the steady state that we aspire to and instead get acquired, are restructured, or go bankrupt well before the terminal year.
In summary, not only is estimating when a firm will become mature difficult to do, but considering whether a firm will make it as a going concern for a valuation is just as important.
Pulling together all four questions, we get a framework for valuing any business, as shown in Figure 1.2.
Figure 1.2 The Fundamental Questions in Valuation
Although these questions may not change as we value individual firms, the ease with which we can answer them can change. This happens not only as we look across firms at a point in time, but also across time, even for the same firm. Getting from the value of the business to the value of the equity in the business may seem like a simple exercise: subtracting the outstanding debt. But the process can be complicated if the debt is not clearly defined or is contingent on an external event (a claim in a lawsuit). Once we have the value of equity, getting the value of a unit claim in equity (per share value) can be difficult if different equity claims have different voting rights, cash flow claims, or liquidity.