Showing posts with label NPV. Show all posts
Showing posts with label NPV. Show all posts

Thursday 29 December 2022

Three useful yardsticks of business value

 Business Valuation 

To be a value investor, you must buy at a discount from underlying value. 

Analyzing each potential value investment opportunity therefore begins with an assessment of business value. 

While a great many methods of business valuation exist, there are only three that I find useful. 

1.  NPV

The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. 

[Using multiples.  A frequently used but flawed shortcut method of valuing a going concern is known as private-market value. This is an investor’s assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety. ]


2.  Liquidation value

The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not. 


3.  Stock market value

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value. 


Conclusions:

Each of these methods of valuation has strengths and weaknesses. 

None of them provides accurate values all the time. 

Unfortunately no better methods of valuation exist. 

Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.

Sunday 12 January 2020

Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow

When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation.

Unfortunately future cash flows are usually uncertain, often highly so.

Moreover, the choice of a discount rate can be somewhat arbitrary. 

These factors together typically make present value analysis an imprecise and difficult task.



The Perfect Business to Value - Annuity

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. 



Real businesses, even the best ones, are unfortunately not annuities. 

Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. 

Small changes in either revenues or expenses cause far greater percentage changes in profits. 

The number of things that can go wrong greatly exceeds the number that can go right.

Responding to business uncertainty is the job of corporate management.

However, controlling or preventing uncertainty is generally beyond management's ability and should not be expected by investors.'

Sunday 19 August 2018

Project Evaluation

The decisions of where to invest the company's resources have a major impact on the future competitiveness of the company.

Trying to get involved in the right projects is worth an effort, both to

  • avoid wasting the company's time and resources in meaningless activities, and 
  • to improve the chances of success.


Project evaluation is a process used to determine whether a firm's investments are worth pursuing.

Producing new products, buying a new machine and investing in a new plant are examples of firm's investment.

Investing in those activities involves a major capital expenditure, and management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.



Capital Budgeting Factors

Factors involved in capital budgeting are:

1.  Initial Cost
The initial investment or cash capital required to start a project.

2.  Cash In Flow
The estimated cash amount that flows into a business due to operations of the project or business.

3.  Investment Period
The duration of the project and when it is estimated to be completed.

4.  Discount Factor
The value of interest that will be received or charged during the period of the project's execution and it will affect the present value of cash in flows for different years.

5.  Time Value of Money
The idea that a ringgit now is worth more than a ringgit in the future, even after adjusting for inflation, because a ringgit now can earn interest or other appreciation until the time the ringgit  in the future would be received.This theory has its base in the calculation for present value.



Factors influencing investment decision

A firm must make an investment decision to improve or increase the incomes of the company in order to compete in the market.

Investment environments include:

1.  Product development/enhancement
2.  Replacing equipment/machinery
3.  Exploration of new fields or business.



Project Evaluation Methods

Common methods used in evaluating projects, investments or alternatives are:

1.  Payback Period (PBP)
2.  Accounting Rate of Return/Average Rate of Return (ARR)
3.  Net Present Value (NPV)
4.  Profitability Index (PI)
5.  Internal Rate of Return (IRR)


In choosing an investment or project, select the project which generates HIGHER ARR, NPV, PI and IRR; and SHORTER PBP.



APPENDIX:

Saturday 3 June 2017

Flexibility: The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

Net present values (NPVs) calculated from single cash flow projections may be inadequate because they do not take into account the ability to expand or scale back.



Here is a simple example.  

A firm can scale back by eliminating a negative cash flow project after the first period.

There is a 60% probability of $20 per year forever or 40% probability of -$6 per year forever.

The discount rate is 10%.


Without an option to cancel

If the initial cost today is $100, then without an option to cancel, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/0.10) = -$4


With an option to cancel after the first year

With the option to abandon after the first year, the NPV would be:

-$100 + 0.6 x ($20/0.10) + 0.4 x (-$6/1.10) = $17.82


The value of the option to cancel the project is the difference, or $21.82



Conclusion:

The inclusion of flexibility into the analysis is generally more relevant in the valuation of individual businesses and projects.

The real-option valuation (ROV) and decision tree analysis (DTA) are the two primary methods of valuation.

  • Both depend on forecasting based on contingent states of the world.
  • Although ROV is often a better methodology to use than DTA, it is not the right approach in every case.



Monday 9 July 2012

How to Value a Company in 3 Easy Steps




Valuing a Business:
How much is a business worth?
Don't care about the 'asset value' or 'owner's equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its "horizon value".

Saturday 18 February 2012

How should investors choose among these several valuation methods?


How should investors choose among these several valuation methods?  When is one clearly preferable to the others?  When one method yields very different values from the others, which should be trusted?

At times a particular method may stand out as the most appropriate.  

  • Net present value would be most applicable, for example, in valuing a high-return business with stable cash flows such as a consumer-products company; its liquidation value would be far too low.
  • Similarly, a business with regulated rates of return on assets such as a utility might best be valued using NPV analysis.  
  • Liquidation analysis is probably the most appropriate method for valuing an unprofitable business whose stock trades well below book value.  
  • A closed-ended fund or other company that owns only marketable securities should be valued by the stock market method, no other makes sense.


Often several valuation methods should be employed simultaneously.  

  • To value a complex entity such as a conglomerate operating several distinct businesses, for example, some portion of the assets might be best valued using one method and the rest with another.  
Frequently investors will want to use several methods to value a single business in order to obtain a range of values.  

  • In this case investors should err on the side of conservatism, adopting lower values over higher ones unless there is strong reasons to do otherwise.  
  • True, conservatism may cause investors to refrain from making some investments that in hindsight would have been successful, but it will also prevent some sizable losses that would ensue from adopting less conservative business valuations.

Analyzing Investment Opportunity Begins with an assessment of Business Value


To be a value investor, you must buy at a discount from underlying value.

Analyzing each potential value investment opportunity therefore begins with an assessment of business value.

While a great many methods of business valuation exist, there are only three that I find useful.

1.  Net Present Value
The first is an analysis of going-concern value, known as net present value (NPV) analysis.  NPV is the discounted value of all future cash flows that a business is expected to generate.  A frequently used but flawed short cut method of valuing a going concern is known as private-market value.  This is an investor's assessment of the price that a sophisticated business person would be willing to pay for a business.  Investors using this shortcut, in effect, value business using the multiples paid when comparable businesses were previously bought and sold in their entirety.

2.  Liquidation value.
The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off.  Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.

3.  Stock market value.
The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries consider separately, would trade in the stock market.  Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses.

  • None of them provide accurate values all the time.
  • Unfortunately no better methods of valuation exist.  
Investors have no choice but to consider the values generated by each of them, when they appreciably diverge, investors should generally err on the side of conservatism.


Ref:  Margin of Safety by Seth Klarman

NPV and IRR - place more importance to the Assumptions than to the Output. "Garbage in, garbage out"


Any attempt to value businesses with precision will yield values that are precisely inaccurate.  The problem is that it is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.

Anyone wi th a simple, hand-held calculator can perform net present va lue (NPV) and internal rate of return (IRR) calculations.  The NPV calculation provides a single-point value of an investment by discounting estimates of future cash flow back to the present.  IRR, using assumptions of future cash flow and price paid, is a calculation of the rate of return on an investment to as many decimal places as desired.

The seeming precision provided by NPV and IRR calculations can give investors a false sense of certainty for they are really as accurate as the cash flow assumptions that were used to derive them.

The advent of the computerized spreadsheet has exacerbated this problem, creating the illusion of extensive and thoughtful analysis, even for the most haphazard of efforts.  Typically, investors place a great deal of importance on the output, even though they pay little attention to the assumptions.  "Garbage in, garbage out" is an apt description of the process.


Net Present Value and Internal Rate of Return Summarize the Returns for a Given Series of Cash Flows


NPV and IRR are wonderful at summarizing, in absolute and percentage terms, respectively, the returns for a given series of cash flows.

When cash flows are contractually determined, as in the case of a bond, and when all payments are received when due, IRR provides the precise rate of return to the investor while NPV describes the value of the investment at a given discount rate.

In the case of a bond, these calculations allow investors to quantify their returns under one set of assumptions, that is, that contractual payments are received when due.

These tools, however, are of no use in determining the likelihood that investors will actually receive all contractual payments and, in fact, achieve the projected returns.

Friday 23 April 2010

How much should you pay for a business? Valuing a company (6)

Cash flows

When considering purchasing a company, another way to value the business is to examine what cash it will generate over a period of time.
  • This can be in straight cash terms not taking into account inflation, price erosion etc. 
  • You may also wish to apply discounted cash flow principles to arrive at a net present value (NPV) for the company, or 
  • even an internal rate of return (IRR) on the purchase.

Perhaps the most useful way to value it is to estimate the economic benefits that the business will generate in the next few years and then apply the NPV process to them. All valuations based on forecast figures are essentially educated guesses, but this analysis is likely to pinpoint the best opportunity for creating value, if the forecasts turn into reality.



Also read:

Valuing a company (1)