A business buyer's task can be stated simply: to buy a good company at a good price.
Buyers usually have many alternatives, and time is often on their side.
The job of the buyer is to make sure that a company is "as good as it looks" by analyzing financial statements and the competitive landscape of the industry.
The buyer should also question whether a company can successfully navigate a change in ownership, as companies sometimes lose key employees or customers in time of transition.
A business seller's task can be stated simply as well: to position his company to receive the best possible price in the marketplace.
Sellers need to anticipate the sale of their company well before it actually happens so that they have enough time to sell unused assets or make other necessary changes.
Early consideration of important issues will allow sellers to capitalize on favourable conditions in their industry or in the capital markets.
Both buyers and sellers need to think carefully about the extent to which a company has created an economic moat - a sustainable competitive advantage -within its industry. Business with wide moats tend to be more valuable.
Keep INVESTING Simple and Safe (KISS) ****Investment Philosophy, Strategy and various Valuation Methods**** The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
Showing posts with label business valuations. Show all posts
Showing posts with label business valuations. Show all posts
Tuesday, 1 October 2013
Wednesday, 11 April 2012
Tuesday, 13 March 2012
Business Valuation
Day One
Session One:
• The Discounted Cash Flow Model
• Setting up the Model
Session Two :
• The Big Picture of DCF Valuation
• Valuation Examples
• The Discount Rate Question
Session Three :
• Open Q&A
Session Four :
• Risk premiums and Betas
• The Cost of Debt
• Estimating Cash Flows
Session Five :
• Estimating Growth Rates
• Estimating Growth Patterns
• The Terminal Value
• Closing Thoughts on DCF valuation
Session Six :
• Open Q&A
• The Discounted Cash Flow Model
• Setting up the Model
Session Two :
• The Big Picture of DCF Valuation
• Valuation Examples
• The Discount Rate Question
Session Three :
• Open Q&A
Session Four :
• Risk premiums and Betas
• The Cost of Debt
• Estimating Cash Flows
Session Five :
• Estimating Growth Rates
• Estimating Growth Patterns
• The Terminal Value
• Closing Thoughts on DCF valuation
Session Six :
• Open Q&A
Day Two
Session Seven :
• Loose Ends in Valuation
-Cash, Cross holdings and other assets
-The Value of Control, Synergy and Transparency
-The Liquidity Discount
-Employee Stock Options
Session Eight :
• The Allure of Relative Valuation
• Categorizing Multiples
• The Four Steps in Analyzing Multiples
Session Nine :
• Open Q&A
Session Ten :
• Applying Multiples in Valuation
• Finding Comparable firms
• Controlling for differences
• Picking the Right Multiple
Session Elven :
• The Real Options Story
• The Option to Delay (and valuing patents and natural resource companies)
• The Option to Abandon
• The Option to Expand
• Equity in Troubled firms as options
Session Twelve :
• Open Q&A
• Loose Ends in Valuation
-Cash, Cross holdings and other assets
-The Value of Control, Synergy and Transparency
-The Liquidity Discount
-Employee Stock Options
Session Eight :
• The Allure of Relative Valuation
• Categorizing Multiples
• The Four Steps in Analyzing Multiples
Session Nine :
• Open Q&A
Session Ten :
• Applying Multiples in Valuation
• Finding Comparable firms
• Controlling for differences
• Picking the Right Multiple
Session Elven :
• The Real Options Story
• The Option to Delay (and valuing patents and natural resource companies)
• The Option to Abandon
• The Option to Expand
• Equity in Troubled firms as options
Session Twelve :
• Open Q&A
Thursday, 1 March 2012
Buffett: What students should be learning is how to value a business.
John Kenneth Galbraith once slyly observed that economists were most economical with ideas: They made the ones learned in graduate school last a lifetime. University finance departments often behave similarly. Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.” (I always love explanations of that kind: The Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential, anomaly.)
Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option. What students should be learning is how to value a business. That’s what investing is all about.
Saturday, 17 December 2011
Valuation (articles)
PERLS V: Assessing a hybrid security
22 Sep 09Valuing hybrid securities characterised by non-cumulative, variable distributions which are paid solely at the discretion of directors is tricky, but not impossible.
ARTICLES
ARTICLES (CONT.)
Wednesday, 7 December 2011
Characteristics of Growth Companies and their Value Drivers
Characteristics of growth companies
Growth companies are diverse in size, growth prospects and can be spread out over very different businesses but they share some common characteristics that make an impact on how we value them. In this section, we will look at some of these shared features:
- Dynamic financials: Much of the information that we use to value companies comes from their financial statements (income statements, balance sheets and statements of cash flows). One feature shared by growth companies is that the numbers in these statements are in a state of flux. Not only can the numbers for the latest year be very different from numbers in the prior year, but can change dramatically even over shorter time periods. For many smaller, high growth firms, for instance, the revenues and earnings from the most recent four quarters can be dramatically different from the revenues and earnings in the most recent fiscal year (which may have ended only a few months ago).
- Private and Public Equity: It is accepted as conventional wisdom that the natural path for a young company that succeeds at the earliest stages is to go public and tap capital markets for new funds. There are three reasons why this transition is neither as orderly nor as predictable in practice. The first is that the private to public transition will vary across different economies, depending upon both institutional considerations and the development of capital markets. Historically, growth companies in the United States have entered public markets earlier in the life cycle than growth companies in Europe, partly because this is the preferred exit path for many venture capitalists in the US. The second is that even within any given market, access to capital markets for new companies can vary across time, as markets ebb and flow. In the United States, for instance, initial public offerings increase in buoyant markets and drop in depressed markets; during the market collapse in the last quarter of 2008, initial public offerings came to a standstill. The third is that the pathway to going public varies across sectors, with companies in some sectors like technology and biotechnology getting access to public markets much earlier in the life cycle than firms in other sectors such as manufacturing or retailing. The net effect is that the growth companies that we cover in chapter will draw on a mix of private equity (venture capital) and public equity for their equity capital. Put another way, some growth companies will be private businesses and some will be publicly traded; many of the latter group will still have venture capitalists and founders as large holders of equity.
- Size disconnect: The contrast we drew in chapter 1 between accounting and financial balance sheets, with the former focused primarily on existing investments and the latter incorporating growth assets into the mix is stark in growth companies. The market values of these companies, if they are publicly traded, are often much higher than the accounting (or book) values, since the former incorporate the value of growth assets and the latter often do not. In addition, the market values can seem discordant with the operating numbers for the firm – revenues and earnings. Many growth firms that have market values in the hundreds of millions or even in the billions can have small revenues and negative earnings. Again, the reason lies in the fact that the operating numbers reflect the existing investments of the firm and these investments may represent a very small portion of the overall value of the firm.
- Use of debt: While the usage of debt can vary across sectors, the growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt. In some sectors, such as technology, even more mature growth firms with large positive earnings and cash flows are reluctant to borrow money. In other sectors, such as telecommunications, where debt is a preferred financing mode, growth companies will generally have lower debt ratios than mature companies.
- Market history is short and shifting: We are dependent upon market price inputs for several key components of valuation and especially so for estimating risk parameters (such as betas). Even if growth companies are publicly traded, they tend to have short and shifting histories. For example, an analyst looking at Google in early 2009 would have been able to draw on about 4 years of market history (a short period) but even those 4 years of data may not be particularly useful or relevant because the company changed dramatically over that period – from revenues in millions to revenues in billions, operating losses to operating profits and from a small market capitalization to a large one.
While the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.
Growth companies- Value Drivers
Scalable growth
The question of how quickly revenue growth rates will decline at a given company can generally be addressed by looking at the company's specifics – the size of the overall market for its products and services, the strength of the competition and quality of both its products and management. Companies in larger markets with less aggressive competition (or protection from competition) and better management can maintain high revenue growth rates for longer periods.
There are a few tools that we can use to assess whether the assumptions we are making about revenue growth rates in the future, for an individual company, are reasonable:
1. Absolute revenue changes: One simple test is to compute the absolute change in revenues each period, rather than to trust the percentage growth rate. Even experienced analysts often under estimate the compounding effect of growth and how much revenues can balloon out over time with high growth rates. Computing the absolute change in revenues, given a growth rate in revenues, can be a sobering antidote to irrational exuberance when it comes to growth.
2. Past history: Looking at past revenue growth rates for the firm in question should give us a sense of how growth rates have changed as the company size changed in the past. To those who are mathematically inclined, there are clues in the relationship that can be used for forecasting future growth.
3. Sector data: The final tool is to look at revenue growth rates of more mature firms in the business, to get a sense of what a reasonable growth rate will be as the firm becomes larger.
In summary, expected revenue growth rates will tend to drop over time for all growth companies but the pace of the drop off will vary across companies.
Sustainable margins
To get from revenues to operating income, we need operating margins over time. The easiest and most convenient scenario is the one where the current margins of the firm being valued are sustainable and can be used as the expected margins over time. In fact, if this is the case, we can dispense with forecasting revenue growth and instead focus on operating income growth, since the two will be the equivalent. In most growth firms, though, it is more likely that the current margin is likely to change over time.
Let us start with the most likely case first, which is that the current margin is either negative or too low, relative to the sustainable long-term margin. There are three reasons why this can happen. One is that the firm has up-front fixed costs that have to be incurred in the initial phases of growth, with the payoff in terms of revenue and growth in later periods. This is often the case with infrastructure companies such as energy, telecommunications and cable firms. The second is the mingling of expenses incurred to generate growth with operating expenses; we noted earlier that selling expenses at growth firms are often directed towards future growth rather than current sales but are included with other operating expenses. As the firm matures, this problem will get smaller, leading to higher margins and profits. The third is that there might be a lag between expenses being incurred and revenues being generated; if the expenses incurred this year are directed towards much higher revenues in 3 years, earnings and margins will be low today.
The other possibility, where the current margin is too high and will decrease over time, is less likely but can occur, especially with growth companies that have a niche product in a small market. In fact, the market may be too small to attract the attention of larger, better-capitalized competitors, thus allowing the firms to operate under the radar for the moment, charging high prices to a captive market. As the firm grows, this will change and margins will decrease. In other cases, the high margins may come from owning a patent or other legal protection against competitors, and as this protection lapses, margins will decrease.
In both of the latter two scenarios – low margins converging to a higher value or high margins dropping back to more sustainable levels – we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can be usually be found by looking at both the average operating margin for the industry in which the firm operates and the margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized.
Quality Growth
A constant theme in valuation is the insistence that growth is not free and that firms will have to reinvest to grow. To estimate reinvestment for a growth firm, we will follow one of three paths, depending largely upon the characteristics of the firm in question:
1. For growth firms earlier in the life cycle, we will adopt the same roadmap we used for young growth companies, where we estimated reinvestment based upon the change in revenues and the sales to capital ratio.
Reinvestmentt = Change in revenuest/ (Sales/Capital)
The sales to capital ratio can be estimated using the company's data (and it will be more stable than the net capital expenditure or working capital numbers) and the sector averages. Thus, assuming a sales to capital ratio of 2.5, in conjunction with a revenue increase of $ 250 million will result in reinvestment of $ 100 million. We can build in lags between the reinvestment and revenue change into the computation, by using revenues in a future period to estimate reinvestment in the current one.
2. With a growth firm that has a more established track record of earnings and reinvestment, we can use the relationship between fundamentals and growth rates that we laid out in chapter 2:
Expected growth rate in operating income = Return on Capital * Reinvestment Rate + Efficiency growth (as a result of changing return on capital)
In the unusual case where margins and returns and capital have settled into sustainable levels, the second term will drop out of the equation.
3. Growth firms that have already invested in capacity for future years are in the unusual position of being able to grow with little or no reinvestment for the near term. For these firms, we can forecast capacity usage to determine how long the investment holiday will last and when the firm will have to reinvest again. During the investment holiday, reinvestment can be minimal or even zero, accompanied by healthy growth in revenues and operating income.
With all three classes of firms, though, the leeway that we have in estimating reinvestment needs during the high growth phase should disappear, once the firm has reached its mature phase. The reinvestment in the mature phase should hew strictly to fundamentals:
Reinvestment rate in mature phase =
In fact, even in cases where reinvestment is estimated independently of the operating income during the growth period, and without recourse to the return on capital, we should keep track of the imputed return on capital (based on our forecasts of operating income and capital invested) to ensure that it stays within reasonable bounds.
The Little Book of Valuation
Aswath Damodaran
Sunday, 4 September 2011
Intrinsic Value Basics: Valuing a Business - Seth Klarman's 3 Methods
Valuing a Business - Seth Klarman's 3 Methods
"Price is what you pay. Value is what you get." says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.
The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.
The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.
Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.
1. Discounted Cash Flow / Net Present Value
In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.
DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.
Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.
2. Liquidation
The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.
To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.
However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.
3. Market Value
The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.
Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?
A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.
Conclusion
All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."
"Price is what you pay. Value is what you get." says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.
The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.
The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.
Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.
1. Discounted Cash Flow / Net Present Value
In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.
DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.
Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.
2. Liquidation
The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.
To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.
However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.
3. Market Value
The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.
Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?
A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.
Conclusion
All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."
Thursday, 7 October 2010
12 warning signs of unreliable forecasts from Tarbell and Trugman
Written by David on October 5, 2010
“It’s good to be talking about business forecasts with a lot of CICBV members in the room,” began Gary Trugman at his keynote session on working with financial projections in Miami at the ASA/CICBV Annual Business Valuation Conference. “You’re all already familiar with hockey sticks.”
Trugman and his co-presenter Jeff Tarbell note that USPAP doesn’t address forecasts directly in Sections 9 or 10. SSVS-1 refers to projections in sections on collecting data, and in DCF analyses. But, there’s nothing about the degree to which appraisers need to audit forecasts—which is part of the reason that a standard limiting condition in many valuation reports is something like the language below.
We do not provide assurance on the achievability of the results forecasted by [ABC Company] because events and circumstances frequently do not occur as expected; differences between actual and expected results may be material; and achievement of the forecasted results is dependent on actions, plans, and assumptions of management.
Correctly or incorrectly, some appraisers may try to account for forecasts they don’t trust via the company-specific risk factor. “The courts are catching up with anything that looks like this practice,” Tarbell said.
How good are forecasts? First, “30-40% of the companies we work with don’t have a meaningful forecast,” said Trugman. “But, even when you can obtain one, you often face unreliable assumptions, and they may be unwilling to make changes you suggest.” So, when do you just do your own forecast?
Particularly with public companies “you’re going to have a hard time justifying numbers you made up as opposed to numbers management made up,” says Tarbell. “You could be asking management to revise numbers that may have already been presented to analysts or others. You’re opening a lot of doors no one wants to open.” But, if you do your own, the best hope is “to get management to sign off on what you’ve done. Maybe they don’t have a balance sheet forecast so we fill in the blanks, send it to management, and ask them to agree to it with all the disclaimers that you can’t predict the future.”
Trugman and Tarbell feel that if you can’t obtain a forecast, or adjust a weak forecast, or create your own, your option is to reject the income approach. And, they warn all appraisers to recognize two rules about nearly all forecasts:
– The distribution of future cash flows is not likely symmetric.
– Downside often exceeds upside due to capacity constraints, market size, competition, etc.
– This is not the particular outcome with the highest probability of occurrence.
Pratt and Grabowski’s Cost of Capital 4th Edition is due out very soon. Tarbell reports that these two points are freshly emphasized in the update. And, Tarbell and Trugman recognize that there are a dozen Indications of possible unreliability:
1. Forecast results are notably different than past results.—“It’s OK to be wrong in a forecast; all the public companies are. But by looking at past forecasts you can see patterns of unreliability,” says Trugman.
2. Forecast was prepared by a party with an interest in the valuation outcome.
3. Resulting value is not consistent with the values from other methods used.
4. Forecast was prepared by CEO/CFO without input from business unit heads. “If the CEO hasn’t spoken to sales and marketing, you may see very different results,” says Tarbell.
5. Forecast is inconsistent with analyst expectations for public comps. “Are growth rates and margins consistent with what analysts are projecting for public companies in your industry,” asks Tarbell. “There better be a good explanation if a forecast is different that other companies who are all competing for the same market share.”
6. Forecast income statement without balance sheet and statement of cash flows. “It may not be very safe when you’re missing such critical inputs to the DCF method such as working capital, CAPEX/depreciation, or financing needs,” warns Trugman. He sees many clients who project faster than historical growth, but in fact when balance sheet forecasts are prepared, it turns out that you outstrip cash resources very quickly and there’s no way to support this growth. “The company may have exceeded its borrowing capacity early in the projection cycle,” Trugman explains in the most typical case.
7. Forecast assumes capital spending at levels that are not financeable. “We often see a forecast that assumes a doubling of some factor in the middle of the cycle,” says Tarbell. This is a clear warning sign. “A leveraged analysis may be more appropriate where the subject company has significant capital needs over the course of the forecast,” Trugman agrees.
8. Forecast ends on the peak or trough of a business cycle. “What do we do with forecasts now, for instance,” asks Trugman. “The answer is we’re looking at longer business cycles, even beyond the standard five year projections. How did the business do during the last downturn?”
9. Forecast not accompanied by a detailed schedule of assumptions. Tarbell says “even if there aren’t detailed notes, can management explain the significant assumptions and particularly any of those that are inconsistent with the past. I don’t like those.”
Determining Forecast Reliability
– Forecast should be based on normalized operations
http://www.bvwirenews.com/2010/10/05/12-warning-signs-of-unreliable-forecasts-from-tarbell-and-trugman/
“It’s good to be talking about business forecasts with a lot of CICBV members in the room,” began Gary Trugman at his keynote session on working with financial projections in Miami at the ASA/CICBV Annual Business Valuation Conference. “You’re all already familiar with hockey sticks.”
Trugman and his co-presenter Jeff Tarbell note that USPAP doesn’t address forecasts directly in Sections 9 or 10. SSVS-1 refers to projections in sections on collecting data, and in DCF analyses. But, there’s nothing about the degree to which appraisers need to audit forecasts—which is part of the reason that a standard limiting condition in many valuation reports is something like the language below.
We do not provide assurance on the achievability of the results forecasted by [ABC Company] because events and circumstances frequently do not occur as expected; differences between actual and expected results may be material; and achievement of the forecasted results is dependent on actions, plans, and assumptions of management.
Correctly or incorrectly, some appraisers may try to account for forecasts they don’t trust via the company-specific risk factor. “The courts are catching up with anything that looks like this practice,” Tarbell said.
How good are forecasts? First, “30-40% of the companies we work with don’t have a meaningful forecast,” said Trugman. “But, even when you can obtain one, you often face unreliable assumptions, and they may be unwilling to make changes you suggest.” So, when do you just do your own forecast?
Particularly with public companies “you’re going to have a hard time justifying numbers you made up as opposed to numbers management made up,” says Tarbell. “You could be asking management to revise numbers that may have already been presented to analysts or others. You’re opening a lot of doors no one wants to open.” But, if you do your own, the best hope is “to get management to sign off on what you’ve done. Maybe they don’t have a balance sheet forecast so we fill in the blanks, send it to management, and ask them to agree to it with all the disclaimers that you can’t predict the future.”
Trugman and Tarbell feel that if you can’t obtain a forecast, or adjust a weak forecast, or create your own, your option is to reject the income approach. And, they warn all appraisers to recognize two rules about nearly all forecasts:
1. Management tends to over-estimate projected cash flows:
– The distribution of future cash flows is not likely symmetric.
– Downside often exceeds upside due to capacity constraints, market size, competition, etc.
2. The appropriate projected cash flow for discounting is the statistically expected value, meaning a probability-weighted expectation of future results.
– This is not the particular outcome with the highest probability of occurrence.
Pratt and Grabowski’s Cost of Capital 4th Edition is due out very soon. Tarbell reports that these two points are freshly emphasized in the update. And, Tarbell and Trugman recognize that there are a dozen Indications of possible unreliability:
1. Forecast results are notably different than past results.—“It’s OK to be wrong in a forecast; all the public companies are. But by looking at past forecasts you can see patterns of unreliability,” says Trugman.
2. Forecast was prepared by a party with an interest in the valuation outcome.
3. Resulting value is not consistent with the values from other methods used.
4. Forecast was prepared by CEO/CFO without input from business unit heads. “If the CEO hasn’t spoken to sales and marketing, you may see very different results,” says Tarbell.
5. Forecast is inconsistent with analyst expectations for public comps. “Are growth rates and margins consistent with what analysts are projecting for public companies in your industry,” asks Tarbell. “There better be a good explanation if a forecast is different that other companies who are all competing for the same market share.”
6. Forecast income statement without balance sheet and statement of cash flows. “It may not be very safe when you’re missing such critical inputs to the DCF method such as working capital, CAPEX/depreciation, or financing needs,” warns Trugman. He sees many clients who project faster than historical growth, but in fact when balance sheet forecasts are prepared, it turns out that you outstrip cash resources very quickly and there’s no way to support this growth. “The company may have exceeded its borrowing capacity early in the projection cycle,” Trugman explains in the most typical case.
7. Forecast assumes capital spending at levels that are not financeable. “We often see a forecast that assumes a doubling of some factor in the middle of the cycle,” says Tarbell. This is a clear warning sign. “A leveraged analysis may be more appropriate where the subject company has significant capital needs over the course of the forecast,” Trugman agrees.
8. Forecast ends on the peak or trough of a business cycle. “What do we do with forecasts now, for instance,” asks Trugman. “The answer is we’re looking at longer business cycles, even beyond the standard five year projections. How did the business do during the last downturn?”
9. Forecast not accompanied by a detailed schedule of assumptions. Tarbell says “even if there aren’t detailed notes, can management explain the significant assumptions and particularly any of those that are inconsistent with the past. I don’t like those.”
10. Forecast not achievable without additional financing or acquisition.
11. Forecast hinges on one or two extraordinary assumptions. “If good results are tied to the outcome of one key assumption, you’ll need to examine that assumption very carefully, and be very suspicious of the projections,” Trugman warned.12. Too much of the indicated value is coming from the terminal value.
Trugman and Tarbell’s indicators of forecast reliability appear in the table below
Determining Forecast Reliability
• Revenues
– Are growth rates consistent with history?
– What are new revenue streams based on?
– What is the timing of new revenue streams?
– Are changes in revenues consistent with industry information?
• Expenses
– Forecast should be based on normalized operations
– Fixed vs. variable cost analysis
– What do variable costs vary against? Revenues? Payroll? Square footage?
– Is this consistent with history?
– What is basis for research and development costs?
http://www.bvwirenews.com/2010/10/05/12-warning-signs-of-unreliable-forecasts-from-tarbell-and-trugman/
Saturday, 31 July 2010
Thursday, 17 June 2010
How is the Price of a Stock Determined?
How is the Price of a Stock Determined?
By Joseph Nicholson,
eHow Contributing Writer
There are many ways to value a stock, and the method to use might vary based on the type of company and the general investment climate. A stock market is the sum total of investors' valuation of stocks at any given time, and fluctuations in prices represent changing moods and reactions to ongoing developments.
Instructions
Things You'll Need:
* Financial statements Access to financial websites
1. Step 1
Obtain the data. The place to start when valuing a company is gathering press releases, financial statements, analysts opinions and other relevant information. The company's financial statements, probably the most important data, are available through the quarterly report, and usually are online.
2. Step 2
Choose a method. While knowing all the key metrics is important when considering a stock's value, every company cannot be compared in the same way. P/E, for example, is probably not the best way to value a start-up that is yet to generate any profits. Revenue or sales growth might be more appropriate. In contrast, the price-to-earnings ratio may be an excellent way to evaluate a profitable and quickly growing company.
3. Step 3
Calculate key metrics. Valuation methods which rely on the fundamentals of a company--those that are not purely technically oriented--use financial ratios calculated from information provided in financial statements. These ratios include return on equity (ROE), price-to-earnings (P/E), price-to-sales (PSR) and others. Some metrics are already figured and available on financial websites.
4. Step 4
Compare with similar businesses. One of the best ways to value a stock is to see how other similar businesses are valued, whatever metrics are used. Most of the time, the better business will be more highly valued as reflected by the stock price. Comparisons within a specific sector are among the most common.
Tips & Warnings
* The price of a stock reflects the value of future performance. In other words, information that reflects the past is less relevant than what may affect earnings in the months and years to come.
* Valuation is not an exact science and tends to fluctuate with perceptions about the economy. In boom times, valuations will probably expand beyond what may seem reasonable, just as they may be crushed in the bust cycle.
Resources
Read more: How is the Price of a Stock Determined? | eHow.com http://www.ehow.com/print/how_4596873_how-price-stock-determined.html#ixzz0r77eEWFq
By Joseph Nicholson,
eHow Contributing Writer
There are many ways to value a stock, and the method to use might vary based on the type of company and the general investment climate. A stock market is the sum total of investors' valuation of stocks at any given time, and fluctuations in prices represent changing moods and reactions to ongoing developments.
Instructions
Things You'll Need:
* Financial statements Access to financial websites
1. Step 1
Obtain the data. The place to start when valuing a company is gathering press releases, financial statements, analysts opinions and other relevant information. The company's financial statements, probably the most important data, are available through the quarterly report, and usually are online.
2. Step 2
Choose a method. While knowing all the key metrics is important when considering a stock's value, every company cannot be compared in the same way. P/E, for example, is probably not the best way to value a start-up that is yet to generate any profits. Revenue or sales growth might be more appropriate. In contrast, the price-to-earnings ratio may be an excellent way to evaluate a profitable and quickly growing company.
3. Step 3
Calculate key metrics. Valuation methods which rely on the fundamentals of a company--those that are not purely technically oriented--use financial ratios calculated from information provided in financial statements. These ratios include return on equity (ROE), price-to-earnings (P/E), price-to-sales (PSR) and others. Some metrics are already figured and available on financial websites.
4. Step 4
Compare with similar businesses. One of the best ways to value a stock is to see how other similar businesses are valued, whatever metrics are used. Most of the time, the better business will be more highly valued as reflected by the stock price. Comparisons within a specific sector are among the most common.
Tips & Warnings
* The price of a stock reflects the value of future performance. In other words, information that reflects the past is less relevant than what may affect earnings in the months and years to come.
* Valuation is not an exact science and tends to fluctuate with perceptions about the economy. In boom times, valuations will probably expand beyond what may seem reasonable, just as they may be crushed in the bust cycle.
Resources
Read more: How is the Price of a Stock Determined? | eHow.com http://www.ehow.com/print/how_4596873_how-price-stock-determined.html#ixzz0r77eEWFq
Tuesday, 13 April 2010
Introduction to Valuation - Videos
Valuation is the process of determining what something is worth. It is arguably the most important, and most difficult thing we do in finance.
This gives an introductory look at valuation from Discounted CashFlow Analysis (DCF) to market multiples (comparables).
Saturday, 13 March 2010
Some Valuation Models are conservative, some are aggressive.
Friday, March 12, 2010
Valuation Models
A private equity player of my acquaintance once confessed that he had a basic rule of thumb about investments: double estimated expenses and halve projected future profits!There are more systematic methods of valuation. Some valuation methods are themselves optimistic, others conservative. The multiples assigned to the valuation may also be conservative or optimistic. For example, the price to book value (PBV) ratio is a conservative valuation method. The underlying assumption: in bankruptcy, the investor will receive some portion of the original investment back. A cut-off PBV of 1 or less would be a conservative multiple.
But in an emerging market such as India with its high growth rates, a more optimistic PBV multiple can be assigned. In fact, if one examines average index PBV since 1991, the PBV has never dropped below 1.5.
A dividend yield-based valuation method is also conservative. It assumes no capital appreciation and treats the original investment like debt. Again, a high or low cut-off yield could be set depending on the risk-appetite.
Earnings growth-based valuations such as the PEG (Price-earnings to projected Earnings Growth) ratio are optimistic. A PEG valuation implies that a reliable projection of forward earnings and forward earnings growth is possible. A PEG multiple of less than 1 is conservative but the valuation method itself is optimistic.
Another, more conservative valuation method using earnings, is comparing earnings yield with the yield from a risk-free instrument. If the earnings yield is higher than the risk-free yield, the stock is worth investment. Again, conservative investors will keep greater margins of safety.
In a bull market, people give maximum weight to PEG ratios. In bear markets, more conservative methods come to the fore. At the peak of a business cycle, businesses will tend to be optimistically valued at high multiples. At the bottom, the same businesses will be available at low multiples.
In fact, historically, peaks and troughs in the same economy tend to be associated with similar levels of valuation. In India, bear market bottoms tend to be associated with conservative average multiples.
- Usually the Nifty will be available at an earnings yield that is higher than the 364-day T-Bill yield.
- The PEG will be well below 1.
- The Price-book-value ratio will be down to less than 2.5 and
- the Nifty's dividend yield will be over 2 per cent.
At the top of a bull market on the other hand, these multiples are all optimistic.
- The PEG will be 1 or higher.
- The earnings yield will be below the T-Bill yield.
- The PBV will be higher than 4 and
- the dividend yield will be below 1 per cent.
Since January 2006, most of the valuation multiples have been high. However until late 2007, the PEG was below 1. It was only in early 2008 that the PEG rose beyond 1 and gave the final sell signal. By then, the market had already peaked.
The crash in October has pulled all the valuation multiples back close to the levels that would be expected at a bear market bottom. Right now, at a Nifty level of 2900, the PBV is at 2.42, while the dividend yield is 1.96 per cent and the PE ratio is 12.57, with an earnings yield of 7.9 per cent in comparison to the T-Bill yield of 7.4 per cent.
At the 2550 levels that prevailed for a while in late October, these multiples were even more attractive. The PEG ratio incidentally is close to 1. While the current PE ratios have dropped, so have the forward earnings growth estimates for 2008-09. But given the turmoil, there could be further EPS downgrades.
Is it worth buying into this market? Yes, it looks that way. Certainly systematic accumulation at these prices should work over the long-term.
This column appeared in the November 2008 Issue of Wealth Insight.
http://stockmakers.blogspot.com/2010/03/valuation-models.html
Sunday, 3 January 2010
Stick to a valuation discipline: For every Wal-Mart, there's a Woolworth's
"If you don't buy today, you might miss the boat forever on the stock."
Sticking to a valuation discipline is tough for many people because they're worried that if they don't buy today, they might miss the boat forever on the stock.
That's certainly a possibility - but it is also a possibility that the company will hit a financial speed bump and send the shares tumbling. The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another.
As for the few that jsut keep going straight up year after year - well, let's just say that NOT MAKING money is a lot less painful than LOSING money you already have. For every Wal-Mart, there's a Woolworth's,
Friday, 13 November 2009
Combining P/E and P/Sales to determine a stock's valuation
Stock Valuation - The Price to Earnings Ratio
In my previous article, I wrote about the Price to Sales Ratio, a very valuable tool in a value investor's toolbox. I now continue the Stock Valuation series with another valuable tool - The Price to Earnings Ratio. All of the tools in this series are valuable by themselves, but when combined together, they make the task of stock picking methodical and very profitable.
The Price to Earnings Ratio is also known as the Earnings Multiple or Price Multiple. Most people refer to the ratio simply as the "P/E".
The formula for calculating the P/E is simple: P/E Ratio = Share Price / Earnings per Share
For example, if a stock is trading at $22.00 per share, and trailing earnings is $1.15 per share, the P/E ratio is 19.13 (22.00/1.15).
Typically, the lower the P/E, the more attractive the stock is to a value investor. Just like the Price to Sales Ratio, the P/E is very useful for comparing multiple companies within the same industry.
Let's compare the P/E's for two companies:
Pear Computer:
Share Price: 54.27
Earnings per share: 5.72
P/E Ratio: 54.27 / 5.72 = 9.49
Fastway Computers:
Share Price: 38.12
Earnings per share: 1.96
P/E Ratio: 38.12 / 1.96 = 19.45
As you can see, Pear Computer has a much lower P/E than Fastway Computers.
The P/E is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings. If a stock is trading at a multiple (P/E) of 15, that means that an investor is willing to pay $15.00 for every $1.00 of earnings. A high P/E is a warning sign that a stock may be over bought, which means it may be "hyped up" and valued too high.
Even though the P/E is a valuable tool, it is very important that you don't base the value of a stock on its P/E alone. The reason for this is, the earnings figure is based on the honesty of the company's accounting practices and is susceptible to manipulation. You should always use the Price to Sales Ratio, that I wrote about previously, in addition to the P/E to determine a stock's valuation.
Let's add in the Price to Sales Ratio to our two stocks and see how they compare (see my previous article for the Price to Sales calculation:
Pear Computer:
P/E = 9.49
Price to Sales = 1.46
Fastway Computers:
P/E = 19.45
Price to Sales = 3.15
By comparing the ratios of these two stocks, it is clear which one has the better value. Both the P/E and the Price to Sales are more than double for Fastway compared to Pear. When it comes to picking stocks for a portfolio of value stocks, Pear Computer is the clear winner.
http://www.xomba.com/stock_valuation_price_earnings_ratio
http://www.xomba.com/stock_valuation_price_sales_ratio
In my previous article, I wrote about the Price to Sales Ratio, a very valuable tool in a value investor's toolbox. I now continue the Stock Valuation series with another valuable tool - The Price to Earnings Ratio. All of the tools in this series are valuable by themselves, but when combined together, they make the task of stock picking methodical and very profitable.
The Price to Earnings Ratio is also known as the Earnings Multiple or Price Multiple. Most people refer to the ratio simply as the "P/E".
The formula for calculating the P/E is simple: P/E Ratio = Share Price / Earnings per Share
For example, if a stock is trading at $22.00 per share, and trailing earnings is $1.15 per share, the P/E ratio is 19.13 (22.00/1.15).
Typically, the lower the P/E, the more attractive the stock is to a value investor. Just like the Price to Sales Ratio, the P/E is very useful for comparing multiple companies within the same industry.
Let's compare the P/E's for two companies:
Pear Computer:
Share Price: 54.27
Earnings per share: 5.72
P/E Ratio: 54.27 / 5.72 = 9.49
Fastway Computers:
Share Price: 38.12
Earnings per share: 1.96
P/E Ratio: 38.12 / 1.96 = 19.45
As you can see, Pear Computer has a much lower P/E than Fastway Computers.
The P/E is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings. If a stock is trading at a multiple (P/E) of 15, that means that an investor is willing to pay $15.00 for every $1.00 of earnings. A high P/E is a warning sign that a stock may be over bought, which means it may be "hyped up" and valued too high.
Even though the P/E is a valuable tool, it is very important that you don't base the value of a stock on its P/E alone. The reason for this is, the earnings figure is based on the honesty of the company's accounting practices and is susceptible to manipulation. You should always use the Price to Sales Ratio, that I wrote about previously, in addition to the P/E to determine a stock's valuation.
Let's add in the Price to Sales Ratio to our two stocks and see how they compare (see my previous article for the Price to Sales calculation:
Pear Computer:
P/E = 9.49
Price to Sales = 1.46
Fastway Computers:
P/E = 19.45
Price to Sales = 3.15
By comparing the ratios of these two stocks, it is clear which one has the better value. Both the P/E and the Price to Sales are more than double for Fastway compared to Pear. When it comes to picking stocks for a portfolio of value stocks, Pear Computer is the clear winner.
http://www.xomba.com/stock_valuation_price_earnings_ratio
http://www.xomba.com/stock_valuation_price_sales_ratio
Difference in Expert Opinion on Valuation of a closely held firm
Valuation of Closely Held Firm: Difference in Expert Opinion
http://www.nafe.net/JFE/j02_1_03.pdf
The paper reviews four basic approaches to the valuation of the equity of a closely-helf firm: net asset value, discounted cash flow, earnings multiples, and captialized earnings. Financial and narrative information on an anonymous closely-held firm were evaluated by 18 valutaion experts.
Findings:
1. All respondents reported valuation methods; 15 recommended values ranging from $6.0 million to $17.5 million.
2. The dispersion of values was not consistent with our expectation of convergence of value estimates.
3. The professional training and background of the experts proved significant in the valuation methodology and estimate. The 8 experts who are investors fvoured, by 7 to 1, a non-DCF approach, such as an earnings multiple or capitalized earnings. The 10 consultants/appraisers expressed a slight preference, 6 to 4, for the DCF approach.
4. The greatest disparity between investor experts and consultants was in the recommended value of the firm. The average value recommende by the consultants was $14.7 million, almost 50 percent higher than the investors' average estimate of $9.87 million.
Conclusions:
Three implications of the study.
1. The substantial variation in valuation opinions suggests that courts cannot expect convergence of expert valuation of a firm even from a large number of experts.
2. The variation in opinion may be related to the professional training and background of the experts. Consultants, those who are not investors or risk bearers, offered significantly higher valutaion opinions than investor experts.
3. The valuation expert who are interested in economically sound valuation opinons would be well-advised to use more than one valuation approach, if circumstances permit, cross verify valuation estimates. The dispersion of values provided by the sample of experts suggests that the expert who can demonstrate the soundness of an opinion by the independent application of two or more methods is likely to have more credibility.
http://www.nafe.net/JFE/j02_1_03.pdf
The paper reviews four basic approaches to the valuation of the equity of a closely-helf firm: net asset value, discounted cash flow, earnings multiples, and captialized earnings. Financial and narrative information on an anonymous closely-held firm were evaluated by 18 valutaion experts.
Findings:
1. All respondents reported valuation methods; 15 recommended values ranging from $6.0 million to $17.5 million.
2. The dispersion of values was not consistent with our expectation of convergence of value estimates.
3. The professional training and background of the experts proved significant in the valuation methodology and estimate. The 8 experts who are investors fvoured, by 7 to 1, a non-DCF approach, such as an earnings multiple or capitalized earnings. The 10 consultants/appraisers expressed a slight preference, 6 to 4, for the DCF approach.
4. The greatest disparity between investor experts and consultants was in the recommended value of the firm. The average value recommende by the consultants was $14.7 million, almost 50 percent higher than the investors' average estimate of $9.87 million.
Conclusions:
Three implications of the study.
1. The substantial variation in valuation opinions suggests that courts cannot expect convergence of expert valuation of a firm even from a large number of experts.
2. The variation in opinion may be related to the professional training and background of the experts. Consultants, those who are not investors or risk bearers, offered significantly higher valutaion opinions than investor experts.
3. The valuation expert who are interested in economically sound valuation opinons would be well-advised to use more than one valuation approach, if circumstances permit, cross verify valuation estimates. The dispersion of values provided by the sample of experts suggests that the expert who can demonstrate the soundness of an opinion by the independent application of two or more methods is likely to have more credibility.
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