The Basics Of Valuing A Company


Fundamentals 02: A framework for analyzing and valuing companies.   Revision date: 19 Aug 2020


Price vs Value
"Price is what you pay, value is what you get" Warren Buffett

Everyone loves a bargain. If you are offered a price for something you want that is at a significant discount to what it is worth, I am sure you will be thrilled. 

This is the heart of investing – to buy an equity stake in a company at a price that is at a discount to its value. The question then boils down to how to determine what the company is worth.

There is no one answer to what a company is worth. You have to triangulate from several angles. Yet you want to keep it simple so that you do not lose the forest from the trees.

Big picture. Simple yet insightful. Come from several perspectives.

To do all of these you need a framework. I have one that came from many trials and tribulations.


Contents
  • How I approach valuation
  • Getting a sense of the company's performance from the valuation results
  • Analyzing Asset Values
  • Analyzing Earnings Value
  • What do I assume in my valuation?
  • Pulling it all together


How I approach valuation

When I first started to invest in equities about 15 years ago, I already had the notion that valuation was going to be an important element in my investment process. 

If you search the web, you will find many articles about how to value companies from rules of thumb, market multiples to complex formulae. I started from using market multiples to more sophisticated techniques as I learned more about valuation. 

I have an engineering background so working with figures and formulae is something I do easily. But even then, with different techniques giving different answers, I reached a stage where I started to think of having a framework to hang all the numbers.

What I have today then is a valuation framework that is a synthesis of several techniques. I determine this intrinsic value (IV) of a company using 2 basic approaches:
  • Asset-based valuation (AV) – this looks at the company as a store of value
  • Earnings based valuation (EV) – this looks at the value generated from the operations

In the AV method, I rely mainly on the Balance Sheet of the company in order to determine the intrinsic value. In many instances, the intrinsic value of the company equals the Total Assets minus Total Liabilities 

In the EV method, the value of the company is determined by both the Residual Earnings method and the Free Cash Flow method with the information extracted from the Profit & Loss as well as the Cash Flow statements.

I then compliment these with several metrics developed by both academics and investment thought leaders. These included the Acquirer's multiple and the Magic Formula. Ya! I am making you read my Definitions' posting.



i4value: How to value companies



Getting a sense of the company's performance from the valuation results

OK, now that you have the AV and EV to tell you how much a company is worth, wouldn't it be nice to have other uses for them since you have spent so much effort to derive the numbers. Think of all the annual reports you have to run through and the Excel model you have to create!

Honestly, it was many years later that I came across someone who showed what else I could do with the AV and EV. 

It was Professor Bruce Greenwald, Columbia Business School who inspired me to analyze the AV and EV together in comparison with the market price to get a sense of the margin of safety. 

He also opined that an analysis of the AV relative to the EV provides some insights into how well the company has deployed its resources. 

There are 3 possible scenarios when comparing the EV with the AV as illustrated below.

AV = EV ; competitive position
Scenario 1: EV = AV. This is the most common situation where the return is equivalent to the cost of capital. In a competitive environment, a business with high returns would attract competition, and eventually, any excess returns would have competed away so that eventually the company just earn its cost of capital.

AV > EV : Under utilized
Scenario 2
: EV < AV. In this case, the assets are under-utilized possible due to some issues with the business e.g. poor management, or business in an industry with secular decline.

EV > AV ; compounder
Scenario 3: EV > AV. In this case, the returns generated by the business far exceeds the cost of capital. I would expect the company to have some form of an economic moat in order for it to continue to enjoy a return that is higher than its cost of capital

In practice, as it is unlikely to have a situation where the AV exactly matches the EV, I have assumed that AV = EV is when the computed difference is within +10% or -10% of each other.

Although I favour looking at both AV and EV, there are certain sectors where due to the accounting treatment and/or nature of the assets, the AV approach should be the main valuation approach. 

Examples of these are companies in the financial services sector when most of the assets are financial in nature and where the accounting rules require such assets to be marked to market value. 

Another example is the property sector. Except for these, because many in the market use PE-based metrics, I favour the EV as the primary valuation approach compared to the AV. 

Is this the end of the story? Of course not as I found that if you build up a picture of the AV and EV, you can get other insights into the company. 

It will get a bit textbook-like here onwards but don't skip as I think it is worth the effort.


Analyzing Asset Values

You can build up a picture of the total asset value based on the four components as illustrated below

Asset value composition

Information to determine the Graham Net-Net, NTA and Book value is generally extracted from the Balance Sheet and if the company has adopted the fair value accounting rules in preparing its accounts, I would consider the values are reflective of the market price. 

However there are instances where the value of properties has been captured at historical costs and in such instances if the value of the properties is significant, I do make an adjustment to reflect the current market price.

Do not be surprised if occasionally you come across negative Graham Net-Net. In such cases, I treat this as zero.

The most challenging to determine is the Reproduction Value as you are trying to estimate what it takes to re-create the company with all its customers' relationship, product branding, and any R&D that have been charged out. 

For some sectors, you may actually have to reduce the value of its Plant, Property, and Equipment as it is now possible to build a new plant cheaper due to technological progress.

For property-based companies with significant landbank, many analysts estimate what is known as the RNAV – the Revised or Re-valued Net Asset Value. The most reliable way to estimate the RNAV is to base the property value on a professional valuer’s assessment. 

However, I have seen many analysts estimate the RNAV based on the projected earnings from developing the land. This is different from what property valuers would do when they use the earnings method. 

So I have doubts about some analysts' RNAV approach as they include the profit element as well. How I will value property developers is a story for another day.


Analyzing Earnings Value

You can also build up a picture of the total earnings value as illustrated below.
Earnings value composition

What are some of the challenges I have found in using the Earnings-based valuation method?

  • Growth does not add value unless the company's return is greater than its cost of capital. If you work out the numbers for such a case, you will find that the value with growth would be less than the value without growth. In such cases, I ignore the value with growth.
  • Some companies retain a significant amount of cash. I have occasionally come across cases where the market price is around the value of cash and other non-operating assets. Yes, these are prized findings.
  • If there are significant differences between the value from the Residual Income method compared to that from the Free Cash Flow method, I choose the Residual Income. You will meet such situations if the company has an expansion programme. It will then require significant capital expenditure that will affect the value of the Free Cash Flow method.
  • If you are valuing a conglomerate operating in several different sectors, the risks and hence the cost of capital will be different for the various sectors. In such cases, you have to do more work to first value the various sectors independently. Then add them all up to get the value of the conglomerate – the sum of the parts valuation.

What do I assume in my valuation?

If you adopt Professor Bruce Greenwald’ valuation framework involving the Asset Value (AV), Earnings Power Value and Value with Growth (collectively EV) you will progress from

  • the most reliable method with minimal assumptions when determining the AV
  • to the Earnings Power Value (EPV) with assumptions about the sustainable earnings but without any assumption about growth
  • to the least reliable Value with Growth where you have to make assumptions about the growth prospects.
Most of the information required to determine the AV will be available from the Balance Sheet and there are not many assumptions to be made about the future of the company. 

On the other hand, all earnings-based valuations are based on some assumptions about the future performance of the company. When I talk of the future, it covers the life of the company. 

If you are still with me, there is a bit more to the valuation framework. 

To get a handle on the assumptions to make, I categorized companies into 2:
  • Companies operating “steadily” – these are situations where I can confidently assume that the historical performance provides a good indication of the future performance
  • “Companies in transition” – these can be companies facing some secular decline in the demand for its products, or/and those undergoing structural changes and/or those at the start-up stage. Looking at the historical performance here is not very helpful.
The AV and EV methodologies are more suited to those operating “steadily” and hence I shy away from valuing “companies in transition.” If there is a need to value “companies in transition”, either I rely on the AV or I have a way to project the future performance that is independent of the transition and/or historical performance. 

In order to ensure that our estimates are not skewed by an unusually good or bad year, I take the average performance over a business cycle to represent the typical performance. In the context of Malaysia, I have assumed that a business cycle is equivalent to 12 years. 

In practice, this meant that I only value companies with at least a 10 years track record as a listed company. I thus ignore start-ups, IPOs, and companies with less than 10 years of the listed company financials and place them into the “too difficult to value” box. 

OK, this is as far as the valuation framework is concerned. I am very sure that there are other angles that I have not thought of. If you have any or see holes in my framework, feel free to let me know.

What is next is mainly for those who want to get a bit more into the technicalities of the valuation. If you are not trying to reverse-engineer my valuation method, you can skip and go straight to the end. 

Key assumptions for my valuation models are: 

1) Typical performance = past 12 years’ time-weighted average performance where the values from the current period are given more weight c/w with those further back in time.

2) The data is first “cleaned up” for any one-off transactions e.g. profits from a one-off sale of assets, one-off restructuring charges

3) If growth is involved, I use the weighted average historical growth to represent future growth but this is then capped at 5% per year. This 5 % represents the long-term economic growth of the country

4) The computed value under the Free Cash Flow and Residual income models is the average value obtained from the perpetual model and the 10 years single-stage growth model

5) Occasionally I use a 2-stage growth model but this is only used if it meets both of the following
  • Revenue growth AND EBIT growth AND TCE growth > 8 %. The 8 % is the average 
  • Correlation for Revenue growth, EBIT growth and TCE growth > 0.7 i.e. they explain 49 % of the variation
6) In the Free Cash Flow valuation method, there are assumptions for the capital expenditure, working capital requirements, and depreciation as follows:
  • Capital expenditure – I first estimate the capital expenditure as a % of revenue for each year. I then use this together with changes in the fixed assets to estimate the capital expenditure
  • Working capital – I first estimate the net change in working capital as a % of revenue for each year. I then use this together with changes in working capital extracted from the Cashflow statement to estimate the net working capital requirement
  • Depreciation – this comprises all depreciation and amortization
7) In the Residual income valuation method, I compute the annual Residual Income based on the capital charge for the capital employed at the beginning of the year. The capital employed is after deducting the investment in associates/joint ventures whose earnings are not captured as part of the earnings from operations.

8) For the discount rate, I use the WACC that is derived based on Professor Aswath Damodaran's model. (Refer to Definitions for the assumptions used in computing the WACC)


Pulling it all together

There are many ways to value a company, from rules of thumb to more elaborate methods as presented above. The key thing is that they are all based on your outlook on the businesses and their economic environment. You must understand not just its usefulness but also its shortcomings. 


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Disclaimer
I am not an investment adviser, security analyst or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned in this website may not be suitable to you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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