Some companies are easier to value than others. When we have to leave the comfort zone of companies with solid earnings and predictable futures, we invariably stray into the dark side of valuation. Here we invent new principles, violate established ones, and come up with unsustainable values for businesses.
This chapter described the four inputs that we have to estimate to value any company:
- The expected cash from investments that the business has already made (existing assets)
- The value that will be added by new investments (growth assets)
- The risk in these cash flows
- The point in time where we expect the firm to become a mature firm
The estimation challenges we face will vary widely across companies, so we must consider how estimation issues vary across a firm's life cycle. For young and start-up firms, the absence of historical data and the dependence on growth assets make estimating future cash flows and risk particularly difficult. With growth firms, the question shifts to whether growth rates can be maintained and, if so, for how long, as firms scale up. With mature firms, the big issue in valuation shifts to whether existing assets are being efficiently utilized and whether the financial mix used by the firm makes sense. Restructuring the firm to make it run better may dramatically alter value. For declining firms, estimating revenues and margins as assets get divested is messy, and considering the possibility of default can be tricky. The estimation challenges we face can also be different for different subsets of companies. Cyclical and commodity companies have volatile operating results. Companies with intangible assets have earnings that are skewed by how accountants treat investments in these assets. The risk in emerging-market and global companies can be difficult to assess. Finally, valuing any company can become more difficult in economies where the fundamentals—risk-free rates, risk premiums, and economic growth—are volatile.
In the last part of the chapter, we turned our attention to how analysts respond to uncertainty, with an emphasis on some of the more unhealthy responses. The dark side of valuation manifests itself at each phase of a valuation; our task for the rest of the book is clear. Accepting the fact that uncertainty will always be with us and that we have to sometimes value "difficult" businesses, we will look at healthy ways of responding to uncertainty.