VALUATION THEORY
Chepakovich Valuation Model Valuation Basics Valuation of Banks Intrinsic Value
Intrinsic Value
Introduction Cash Flows Risk-Free Rate Assesment of Risk
Estimation of future cash flows
The key to any investment decision is the knowledge of how much the investor is going to receive from it in the future (as it was already mentioned above, we will concentrate only on the monetary side of things in this treatise). For some investments (such as bonds) this is known in advance. For the vast majority of others – where there is no contractual obligation on the part of the seller of the asset to pay to the buyer pre-defined sums of money in the future (take common shares of a company, for example) – it needs to be estimated.
Estimation of future cash flows is investor-centric: we need to estimate amounts of money a particular investor – not all investors – is expected to get. This distinction is a very important one. It you take a company, for example, it can have equity investors (or shareholders), preferred shares and bond investors, and different categories of lenders. For each category of investors/lenders there is a different cash flow stream or different priority of claim on the cash flow generated by the company.
In finance there is a very useful notion of the cash flow cascade, which helps to visualize this process. Senior lenders and bondholders have a priority over other capital providers to the company – they are paid first out of the total cash flow generated by the company. Whatever is left can be distributed to other investors according to their order of priority. Common shareholders are entitled to whatever is left after all other categories of investors are paid in full. It does not necessarily mean, however, that common shareholders are always at a disadvantage. Their income from the investment (or the cash flow of the company they are entitled to) is not limited by a certain fixed amount (as is the case for lenders and bond holders). True, they bear the highest risk, but also have an opportunity to benefit the most from the company's success. As everywhere else, there is the risk-benefit trade-off.
In the text below we will use terminology and describe the valuation algorithm applicable to valuation of a common stock, but this is just for easiness of the narration only: the valuation model presented here is universal and is not confined to any particular asset class.
A common shareholder is interested in how much cash he will receive directly (in the form of dividends) and indirectly (in the form of common share repurchases by the company) and how much will accrue to him in the company (in the form of undistributed – or reinvested – cash). The cash flow forecast consists of forecasting company's future cash revenues, expenses, investments and financings. It is all pure arithmetic: add cash in and subtract cash out.
Forecasting revenues
Forecasting of future cash flows begins with forecasting of the top line – the revenues or sales. This is the most difficult and most important part of the intrinsic value calculation. Even a slight change in estimates of future revenues will lead to a very different result. Therefore, it is vital to be diligent in assumptions. And to be conservative: if you are planning to take a long position in the company's common stock, then it is better to err on underestimating future revenue, and vice versa.
Companies have different revenue growth/decline patterns depending on where they are in their products' life cycles. Whatever is the case, however, the combined revenue growth rate of all companies is practically the same as the growth rate of the gross domestic product (GDP) of the resident country. Thus, it would be safe to assume for intrinsic value calculation purposes that the revenue growth rate of a company eventually will converge to the GDP growth rate.
Historical revenue growth data is the best place to start in forecasting the company's future revenues. There is one caveat, though: the historical data has to be adjusted for effects of acquisitions and disposals, which distort the whole picture. In our intrinsic value calculation we use organic revenue growth rates.
Forecasting cash expenses
To generate revenues, the company must first spend on research and development (R&D), materials/supplies, labor, marketing and general administrative purposes. This is assuming that it already has the necessary production facilities (the cost of acquiring of which falls into the category 'investments' discussed below).
Next – and this is the most important element distinguishing the Chepakovich valuation model from other valuation methods out there – based on the information we have on the past financial performance of the company, we split expenses into fixed or quasy-fixed (the ones that change only with the rate of inflation) and variable (they are a fixed portion of revenues). How this can be done in a simplified and elegant way is shown in the article describing the Chepakovich Valuation Model.
Then, we need to forecast interest payments and taxes, which is quite straightforward. The amount of interest payments will depend on the amount of debt and the level of interest rates. Taxes usually is a fixed percentage of pre-tax income (to calculate which we would also need to estimate first the amount of the accounting item 'depreciation and depletion' and, maybe, some smaller items that are very company-specific).
Forecasting investments
In order to be able to produce products or to provide services, the company usually needs to have fixed assets – buildings, machinery, etc. They are called 'property, plant and equipment' (PPE) on the balance sheet. Some companies (pharmaceutical firms, for example) where the process of product development is long and expensive capitalize a bulk of their R&D expenses and put them into a related category – 'intangible assets'. We call these two categories collectively means of production or production assets.
There are two types of cash outlays – called investments in this case – associated with production assets: 1) maintenance capital expenditures (CAPEX) – needed to maintain current level of production capacity and 2) new CAPEX – needed to support revenue growth and product modifications. Once again, we rely heavily on historic financial statements (adjusted for acquisitions and disposals) for their estimations.
Forecasting financings
Depending on the company's financial performance and plans for the future, it can choose to do one of the three things: a) increase its debt, b) decrease it, or c) maintain it at the same level. In Case "a" there will be cash inflow, in Case "b" cash outflow, and no change in cash in Case "c".
While it is difficult to foresee actions of a particular company's management, we think that it is safe to assume that the company would want to minimize its cost of capital by either reducing its debt when it is too high (and the increased risk of default because of this leads to disproportional increase in the cost of equity and debt) or by increasing it when it is too low (for attaining full benefits of financial leverage, which we define here as the ratio of debt to equity).
If the debt level is in-between, then is it reasonable to assume that the company will tend to maintain the same level of financial leverage, provided, of course, that all of its capital expenditure needs are satisfied. For fast-growing companies with insufficient cash flow generation and limited ability to raise equity capital, the maximum amount of debt it can safely support is a very important growth-limiting factor.