Monday, 29 March 2010

Valuation Models that better capture the meaning of “fundamental” financial analysis: the cash flow forecast and the discounted cash flow (DCF)

The unbearable lightness of value

As global markets have risen in the past year, some observers are at a loss to reconcile the trend with what they see as still soft fundamentals. At the macroeconomic level, such fundamentals would include unemployment, debt on a variety of levels, deficits of a variety of kinds. At the microeconomic level, fundamentals have to do with free cash flows and the relation between these and the value of a business. Watching global markets rise while fundamentals remain questionable, one wonders if the way we look at fundamentals, at least in the microeconomic sense, is outdated. Without becoming overly dramatic, I wonder if corporate finance theory is losing some of its meaning in an environment in which option value, rather than operating profit, becomes the dominant strain.

There are no models that better capture the meaning of “fundamental” financial analysis than the cash flow forecast and the discounted cash flow (DCF) valuation method that is its close affiliate. And in the DCF method, there is a permanence implied, that nowadays seems increasingly flawed. When a multi-year financial model is created, and when an enterprise valuation is estimated at the end of such a timeframe and discounted back to the present, we have an understanding that the business underlying this exercise will be more or less the same business in the future. For a widget producer, say, while there will be new widget competition, new widget markets, fluctuations in profit margins and economic cycles, it is nevertheless a given – inherent in the financial forecast – that there will always be widgets. The fluctuations are addressed with risk-adjusted discount rates, and with fine-tuned details and line-items, but widget production does not go away.

Yet what business, what industry segment, can we really point to nowadays, and with any confidence determine that its widget manufacture will continue? Ten years ago, we felt pretty good about newspapers, radio, and television. The telephone system. With hindsight, what did those AT&T financial forecasts mean? What do financial forecasts for newspapers and television mean now? I am unfair, I know, choosing my examples from among the vulnerable. We have had a technology revolution, after all… but is this era showing any signs of pause? With rumors going around about cloud computing, might Windows not become a niche product just like landline telephones are quickly becoming?

Media and technology are isolated and extreme cases, I suppose. I guess we could confidently assemble a long term perspective of the energy segment then? Or biotechnology? For that matter, healthcare? Basic manufacturing? There is some degree of permanence in real estate, as roofs over our heads will probably not be rendered obsolete within a 5-year forecast model, but that is sort of a sore subject nowadays, isn’t it… using real estate and financial forecasting in the same phrase together. I mean, considering what happened.

Before anyone jumps to the wrong conclusion in these musings, assuming incorrectly that such thinking is bound to lead to inaction if not downright paralysis, my point is not that value does not exist or is impossible to measure. Pagers had value, newspapers still do. Even Netscape (where is it now?) is discussed today as a success story, and the media sector is not going away. But the financial value in these and other assets, or asset classes, may be seen less through the filter of fundamentals, perhaps, and more on the basis of steps along the way of progress. What emerges, and what has greater value all the time in this affair, is optionality.

Option value: the unknown but real future opportunity that a current business makes possible. According to option theory, option value increase as volatility increases. Perhaps the rise in global financial markets that we have witnessed in the past twelve months, which seems to have occurred even as certain risks have mounted, serves as introduction to a new investor perspective, by which value rises not despite, but because of, uncertainty, fluctuation, and constant change.

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