9. What drives Value

I do want to emphasize, here, the word Value and not Price. Price is decided by the maniac and bipolar Mr. Market (or the speculative public) and thus changes as frequently as everyday. Meanwhile, Value is determined by the fundamentals of the business that reflect more permanent conditions. A broker’s analyst, in making recommendations on Price, focuses on the short-term catalysts that may change a company’s “reported earning”, aiming to get their clients to trade more actively. An investor, in running his or her operations, should focus on the business’ “earning power” in estimating its Value. The former thinks about what the number is, the latter thinks about what the number means.

If you are someone who has received extensive academic education on finance and worked for a long time in industry, I bet you would have, similarly to all other finance professionals, used methods such as public comps and precedent transactions to value businesses. Estimating the business’ LTM or NTM reported earnings, look at the multiples at which other similar companies are trading at, and slap those multiples on the target’s earnings. Well, I don’t have to tell you how many times people have used the same method in valuing properties, until they realize the whole market is in a bubble. Bankers do this since their job is to sell, much like a real estate agent.

The (only) most fundamental way to fairly value a business is to estimate its free cash flows from now until its “judgment day” and discount those cash flows to the present at an appropriate discount rate. Hence, the two things that matter are the business’ expected future cash flows and the discount rate.

Free cash flow (FCF) is calculated as NOPAT (earning from operations after taxes) plus Non-cash Expenses (typically D&A for most businesses) less Working Capital and Capex investments. While this is just basic stuff, I would like to emphasize three things here that most analysts overlook.

First, while some businesses can last for a very long time, none lasts in perpetuity, especially without any deterioration in their competitive advantages. There’s new competition everyday and customers change their preferences all the time. Capitalism is a brutal place. I would be very cautious if a business is valued at 20 to 30 year worth of its annual cash flow.

Second, this analysis places an emphasis on the future long-term, recurring stream of cash flows. Thus, what the reported earning shall be, say next year, does not matter that much in the outcome. What matters is the true recurring earning power (NOPAT) of the business and its future trajectory. To understand the difference between reported earning and earning power, think about a cyclical commodity business such as steel manufacturing. The price of steel can change a lot every year depending on the state of the economic cycle, which obviously would change the “reported earnings” year after year. But if you expand your horizon and look at the average steel price through business cycles, you would be able to derive the true “earning power” (at the same production capacity).

Third, Working Capital and Capex investments matter as much as earnings in this equation. You would agree with me that most analysts (and sadly even company’s management who should know better) mainly look at the earnings or the P&L, and think much less about the Balance Sheet items such as working capital and fixed assets. Determining the business’ earning is not all, one must think about how much capital reinvestment is needed (in the form of working capital and capex) to produce those earnings. In one of my previous posts, I have written about the metric that ties everything together – Return on Invested Capital (ROIC). A high ROIC business would require less capital to maintain (and to grow), meaning less working capital and capex reinvestments needed and thus higher recurring FCF. The higher the ROIC and its growth prospect are, the higher the value (in terms of multiples on earnings) the business shall have. A company’s management can change or even manipulate the reported earning for a particular year. ROIC, however, is more like an identity of a business as it reflects the industry structure and the business’ competitive strength, thus it is a lot harder to flex up or down over time. ROIC helps explain why some sectors such as software would command much higher valuation multiples than something like a steel or cement industry, for the same dollar of earning. If you can understand ROIC, you are already better than 90% of the “investors” out there.

Finally, the discount rate. Here is where people would pull what they learned from school – the CAPM (and beta)- to estimate a company’s cost of capital. I would just say one thing – beta is bullsh*t. Stop looking at the volatility in stock price of the target company (or its comps) to estimate the cost of capital. Think from the owner perspective, how much the returns would have to be for someone to invest and become the owner of the business under review. Also consider other factors such as the long-term level of interest rates of “safer” alternatives such as government bonds or even stock indexes; and apply common sense. For instance, the S&P 500 index has averaged around 10-11% a year throughout history so I would require at least that rate or higher to invest in any business.

So, going back to our question What drives Value – essentially the fundamental profile of the business (as shown by its true earning power, ROIC, and growth prospect), and the discount rate. Price may change everyday, but it takes much longer than several quarters or even years for Value to move. The key takeaway here is that investors and management team (either of a private or public company) should not be overly concerned about short-term catalysts such as what next quarter/year’s reported earnings shall be. They should, instead, focus their attention on what the numbers could mean, in terms of the industry landscape and the business’ competitive strength in the longer term.

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Until next time..