Tag: valuation

Topic: There is only one correct way to value shares. Unfortunately it’s nigh impossible to use. In the best of times. In a world of negative rates it’s even worse.

Theme: I’m talking about DCF valuations: Discounted Cash Flow Valuation, adding all future cashflows together and assessing their worth depending on their risk and timing

Conclusion: The most important thing in investing is the price you you pay today, since for a given future it determines your return

Signal: Either human nature has changed, or we stand before impending doom

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“To discount” means to sell at a reduced price, or to disregard or doubt something (e.g., a rumour). It can also mean to anticipate and take into account.

The word “discount” is made up of the two parts “count” and “dis”, where “dis” is a negating or reversing prefix. You’ll recognize it from words like “dislike” and “disability”, not to mention “to diss” which means “to disrespect”.

Count means tally, matter (have value), record or include.

“dis_count” thus means reversing or negating the counting, i.e. making the count less somehow. It’s a little weird that “to discount” both means “to make less” and “to add and take into account”, but there actually is a logic to it.

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In finance you’ll often hear the word used in association with attempts to calculate the value of a company’s or a project’s future cash flows: “discounted cash flow valuation” or, for short, “DCF valuation”.

A DCF computation assumes that a dollar received a year from now is less worth than a dollar in the hand today. How much less is constantly debated and depends on personal preferences and situation, as well as the level of return available from risky and risk free alternatives, such as money in the bank, government bonds, stocks and gold.

Personally I think a dollar a year from now is worth about the same as 90 cents today, i.e., I expect a return of some 10-11% a year to want to part with my money. If the risk is deemed higher than “almost risk free” I might demand 20% or more. Putting it another way, my default “time preference and risk factor” (or “discount factor”) for an investment that is “almost risk free” and about a year long is (1+10%)=1.1. Thus 110 dollars 12 months from now is worth about 110/1.1=100 dollars today. If I think every year is about the same I can use the formula 1.1^n as my discount factor for periods of n years in length.

To make a DCF analysis you have to list (and take into account, add together) all the relevant future cash flows and their timing. Then you reduce every single cash flow item by dividing each one with your personal time preference and risk factor for the specific time period for respective cash flow.

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Imagine a company or project throwing off the following cash flow stream to you over a period of 5 years, starting one year from now:

+110, +125, +55, -40, +120 (the straight arithmetic sum is 370)

How much is that worth to you today; what would you pay today to get that stream over the coming five years? Well, to me it would be worth something like:

110/1.1 + 125/1.1^2 +55/1.1^3 -40/1.1^4 +120/1.1^5 = 292 (which is considerably less than the straight sum of 370; to be precise, 21% less)

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To discount a future stream of cash flows mean to calculate the sum of those cash flows, but instead of a straight sum of the actual cash flows, each item is divided by your discount rate for every period of time. That rate is dependent on what you could have done with that money instead during that time, i.e., what your personal alternative cost is.

The reason “to discount” means both “reduce” and “add” (as in “take into account”) is that you take into account, or “allow for”, future events while at the same time reducing their impact based on how far away into the future those events are and based on what your alternative use for your money meanwhile could have been.

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According to financial theory, there is only one correct way to value a company or project — to calculate the DCF value. Unfortunately all the factors in the calculation are unknown: the size and timing of cash flows (based on unknown growth rates, competition, margins, business cycles, corporate borrowing costs and so on), as well as the risk level and your alternative cost.

Nevertheless the DCF methodology allows for clarifying and testing assumptions (often referred to as “playing around with the DCF model”), answering What If-questions.

• What if the company introduces new product hits, leaving competition in the dust?
• What if sales grow 5% per annum over the coming decade?
• What if product gross margins increase slightly year after year?
• What if automation allows for reducing overhead costs in terms of personnel, offices and stores?
• What if profits on average increase by 8 per cent per year the coming ten years?
• What if the effective tax rate falls?
• What if profits increase by 10 per cent per year for ten years before tapering off
• What if the company’s capital management improves; paying suppliers later and getting paid by customers faster, perhaps owing to more competitive products and generally being more important to both suppliers and clients.
• What if annual cash flow appreciates by 12 per cent per year over the coming 10 years before growth normalizes due to competitive forces?
• What if there is a recession sometime during the coming ten years, temporarily causing a slowdown, or outright reduction, in sales as well as falling (negative?!) margins?
• What if interest rates (and my discount rate) rise or fall in the meantime?

Well, Just put it all into your Excel spread sheet; and watch the quarterly cash flows change, and the sum of all discounted cash flows (the DCF value, i.e. what the company is worth today) change accordingly.

Alternatively try changing, e.g., the growth rate up or down until you get the DCF value you’re looking for (maybe today’s market value). The latter method can be used to calculate what a certain share price implicitly says about the growth forecasts for the company, i.e., what growth rate the market is predicting (or “discounting”, allowing for, anticipating).

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Using the DCF method is incredibly simple, really:

1. Start with the current P&L and Balance Sheets of the company you’re researching. Only use the items you really need and understand, such as: Sales, Costs, Profits, Taxes and Cash flow
2. Forecast the future for those items by predicting their respective positive or negative growth rates, based on your guesses of how successful the company will be — given business cycles, currency fluctuations, competition etc.
3. Decide on your time and risk preferences of money and establish your discount rate
4. Discount the future cash flows that you will get, and calculate their sum
5. Divide the sum by the number of shares in the company (could be more or less than today) et voilà

There is one little snag though; the things you need to predict usually can’t be predicted. However, using a DCF model you can at least state what needs to happen for you to get the desired return in terms of, e.g., growth rates and margins.

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Competing methods take their starting points in dividends, equity book value or Price/Earnings, Price/Sales, PEG-ratio, Earnings Before Certain Costs, Total Assets Value and so on. However, they are all just shortcuts to answer how much cash you’ll get back in your hands tomorrow, in exchange for forking out cash today.

A valuation multiple

is nothing but shorthand

for a proper analysis of

long term discounted cash flows

-Dr. John P. Hussman

You might buy an insurance company at 0.8x Book Value, where the company is expected to produce an annual Return On Book Equity of 8%, which is all expected to be distributed as dividends. You hope to sell the company at 1.2x Book Value in three years time. If you invest 80k dollars (buying 100k’s worth of Book Equity), your cash flows will be:

+8, +8, +8+120, which at a discount rate of 10% is worth 110 today (or 37.5% more than your investment of 80). As you can see no matter what you start with, everything boils down to the value of discounted cash flows in the end.

If your assumptions regarding annual returns and the final price point were correct, you’d make a handsome profit if you paid 80k for the shares, but a loss if you paid more than 110k. The price you pay is the most important factor in deciding what your return will be.

Sure, the annual cash flows, not to mention the residual value are immensely important. However, you don’t know what they’ll be, you can only make educated guesses. No matter how the future turns out (ruling out bankruptcy), there is a price at which your investment will have a negative return and a price at which you’ll make a profit.

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The most important thing in investing is the price paid, since it determines your return. You don’t know the future but whatever the future entails it will come to pass no matter what price you pay. In that respect you can consider it fixed. Unknown but fixed.

If you pay a high enough a price — a higher price than the discounted sum of future cash flows entitled to you from the investment — you will make a loss.

Please remember that the cash flows coming back to you include both dividends and the selling price for your shares. In practice that means you are exposed to what a future buyer thinks about valuation. Will he be prepared to pay a higher or lower multiple of book or profits than you are? That depends on his discount rate, as well as his view of the company’s future and how he sees the charts above (including the future buyer of his shares).

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The point of this post is two-fold:

1. The price paid for an asset, such as a share, is incredibly important, since whatever the future turns out to be, form your point of view that future will materialize no matter what you do. Thus, for all practical purposes, if you pay more than that future entitles you, you’ll make a loss.
2. The DCF model is based on the intuitive (self-evident?) premise that humans prefer their rewards today rather than tomorrow, whether it be a mammoth kill or money. However, the insane level of monetary stimulus, popular these days with academics at the world’s most important central banks, aims to reverse the discounting mechanism by setting negative interest rates
   1. Presumably, in Yellen’s, Kuroda’s and Draghi’s minds, at a stroke of a pen, human nature has changed altogether; we no longer value something today more than something tomorrow. Does that sound ridiculous to you? That’s because it is. In Dr Philippa Malmgren’s words, ridiculous policy and market rates (I think) are a signal, a signal of something wrong and unsustainable, something needing to change.

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Abandon hope all ye who enter here

Conclusion: If nothing else you learned something about the word “to discount”, including the method it describes. In addition, I hope you gained some insight into the use and limitations of the DCF model. Finally, I wanted to recommend Pippa’s book Signals (check it out at Amazon here) and maybe convey the ominous signal I think negative rates are sending.

In my view, they tell tales of the fall of the Roman Empire, of future turmoil, fiat money re-sets, of recessions, depressions and uncontrolled inflation. When the natural order of time and risk preferences is upset, economies and markets stop working properly. Malinvestments and rampant speculation are likely to follow, while productive efforts are discouraged. Right when profits and valuations are at their highest, the risk of failure is at it’s worst, and the potential for growth the lowest.

Unfortunately that’s where we are right now, in my opinion. I’m hiding in gold and private ventures, honing my own capabilities and networks, preparing for a few years of extreme financial calamities before a new dawn of technological promise takes its beginning.

What future are you discounting?

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