By: Leonardo Etro – Professor of Corporate Finance
Some focus very little on valuation while others think valuation is “The Thing,” the only one that matters in putting capital at risk in an investment. Honestly speaking, valuation is essential in Finance. Why? Because eventually any business is worth the amount of free cash flow it can generate over its life, that is it.
Imagine you owned a grocery store, and your time machine ball told you it will generate EUR 100,000 of cash flow per year for the next 20 years, before shutting doors. This means that over its entire life, that store would allow you to cash EUR 2 million into your pocket. If you just skip for a moment the time value of money, the store’s intrinsic value is EUR 2 million. A potential buyer of that business – on condition he’s equipped with that same time machine – would never agree to pay more than $2 million for your grocery store, as he would obviously end up with a loss. The buyer probably wouldn’t pay $2 million for that business, either. So, a potential buyer would only buy the store for less than $2 million.
There are no time machines around, indeed. By definition, estimating the cash flow of a company over its entire life is an inaccurate exercise at best. It can be an easier task to do for mature and stable companies, while almost impossible for start-up, high-growth businesses. Regardless the company, though, we must at least make some educated guesses in estimating cash flows and value. More often than not, picturing out different scenarios – such as optimistic, moderate, and pessimistic – is a mind-clearing process. We all know that no analyst is going to be exactly right in valuing a company. Still, it’s much better to be vaguely right than… exactly wrong! This is precisely the reason we need a framework to help us make decisions, even if that framework is not 100% accurate as we’d love it to be. The alternative is having no framework at all: and this is the difference between gambling and investing.
Don’t forget that for valuation purposes, there is no difference between a pop-and-mom grocery store and a mega-cap, publicly traded company. Regardless whether a business is private or listed, a value is value. Obviously so, no rational individual would be willing to pay more for business than what it’s worth. On the contrary: he would be actively looking for companies then come for less than what they are truly worth. Sometimes, investors in public companies just stick to prices’ and volumes’ movements. Don’t fool yourself around: always secure yourself back to cash flow and valuation.
It’s time to add an extra trouble in our framework: time value of money. This is an extremely relevant point. We must acknowledge that the EUR 2 million that the grocery store will produce over its life is not worth EUR 2 million today. There is a time value of money – a.k.a. “present value”. When we perform a discounted cash flow analysis, we are estimating a business’s cash flow for its entire life, and then we apply a discount rate to that cash flow, to establish what it’s worth in today’s money. Why? Because if we decide to go for it now, then we have to pay for it now. So, the discount rate is relevant. Rather than an inflation rate or anything the like, investors often use a number that represents their required annual rate of return. What does this mean? It means that as long as we buy the business – or its listed shares – around the output value of the discounted cash flow calculation, we’ll manage to earn our required rate of return. Obviously so, it’s far better if the business – or its listed shares – overcome by large our valuation estimate. This provides us with a cushion, which is widely known as “margin of safety.” This represents the room we give yourselves to be wrong (likely) or not completely precise (certain) in our estimates. Even if our valuation estimates prove out right over time, we’ll have the following lovely “problem” to handle: the margin of safety will allow us to earn a rate of return that’s higher than the discount rate.
So far, we’ve been talking about buying. Some words on the opposite play (selling, or even not buying; in short, folding) are deemed. Selling or not buying a business – or again, its shares – is a good move, when the business’s appreciation potential already locates behind its shoulders; or, if the downside potential has become significantly larger that the upside potential, or, if we can identify other investments that offer greater return potential as compared with risk. This does not necessarily mean that the business or the shares we sell – or not buy – will never get higher. It means that our analysis highlights limited appreciation potential and too much risk. Selling, or not buying, is just as inaccurate as buying, given that it is grounded on valuation as well.