Part II
Corporate Valuation Methodologies Utilized
There are variety of approaches are used to value future earnings power. Three of the more common approaches are capitalized earnings, discounted future earnings, and discounted cash flow.
Capitalized earnings can be quickly computed and are best used to make preliminary estimates of value. They are calculated based on annual after-tax income. In using this method for valuing a company, you first determine your desired rate of return. The initial investment or value is then computed by dividing the average after-tax earnings by the desired rate of return. The problem with this method is that it does not take into account the time value of money. In addition, it assumes that the most recent earnings are a valid indicator of future performance, which is not necessarily true.
The discounted future earnings method initially requires an estimate of after-tax income for future years (generally three to ten years), an estimate of value at the end of this future period ( terminal value ), and the investor's desired rate of return. Each year's income and the residual value are then discounted (the process of dividing sums to be received in the future by an assumed earnings rate) by the desired rate of return. The sum of these discounted values is the estimated value (present value) of the company.
The primary advantage of the discounted future earnings approach is that future earnings potential becomes the investment parameter, taking into account the time value of money. Disadvantages include the fact that, like any estimate, future earnings cannot be projected with certainty. Terminal value (which may be affected by industry and economic uncertainties, the buyer's intent, and other factors) is also difficult to project. Reinvestment risk - the possibility of the inability to reinvest all earnings at a contiguous rate because of practical limitations imposed by factors such as the market, the business environment and because earnings do not necessarily take the form of cash assets - also limit the accuracy of the future earnings approach.
The first two disadvantages can be overcome to some extent by using computing models based on optimistic, pessimistic, and most-likely outcomes for future earnings and residual value. The last disadvantage can be overcome by using the discounted cash flow method . The RCM Discounted Cash Flow valuation models are anchored by three different growth rates which constitute optimistic, pessimistic and most-likely outcomes for future growth, which are then subcategorized by three different discounting rate scenarios. This method is essentially the same as the discounted future earnings method, except that cash flow rather than income is projected for each future year. Many consider this method the best for determining value. In many cases cash flow is a more important consideration than profits, as in the case of a heavily leveraged transaction such as a leveraged buy out (LBO) or in the case of a hypergrowth company such as Netscape Communications.
Discounted Cash Flow Analysis
Discounted cash flow analysis allows the investor to consider the timing of cash outlays and returns over the life of an investment. Based on the theory of compound interest discounted cash flow analysis uses relatively simple mathematical procedures to convert future net income to a present value. Once a net income has been projected for each period of the projected holding period the individual cash flows are discounted and summed. The formula is:
Present Value = CF#1 divided by (1+Y) + CF#2 divided by (1+Y)^2 ....
+CF#n divided by (1+Y)^n
Where: CF = anticipated cash flow; Y = the discount rate used to reflect the time value of money; ^ represents exponential operation; n = cash flow and period numbers.
This analysis is applicable to a wide variety of investments . The discounted cash flow analysis takes into account the timing and of size of anticipated income and expenditures and can be easily adjusted for inflation and deflation however, the technique does not adequately adjust for risk. The discount rate which reflects the time value of money has been adjusted by some investors or analysts to consider risk by increasing or decreasing the discount rate. Any significant adjustment in the discount rate to adjust for risk will impact the discount process and distort the value estimate. Adjustments for risk have been made by considering the potential changes in income or expenses (in our examples, this is reflected by the perpetual growth rate) or potential changes in the time value of money over the holding period (reflected by the multiple discounting factors in our model and the horizon analysis). A sensitivity analysis will indicate the impact of changes in income, gross expenses, operating expenses, and discount rates over the holding period by changing one or more of the variables and estimating value based on these potential changes. Our valuation model uses a six by six sensitivity matrix to offer the widest possible analysis over a broad range of scenarios). Use of a scenario or sensitivity analysis is most appropriate for considering risk while adjusting the discount rate is less so due to a distortion of results.
Market Relative Valuation
This portion of the RCM Valuation model relies on financial ratios, a value-to-price comparison ratio for a quick comparison of a valuation relative to the current stock price, two valuation models that relate company multiples to market multiples, historical multiples of price to sales, price to cash flow, price to earnings, price to book value, and dividend to price coupled with next year's estimates to arrive at a range of valuations for a stock.
The Historical Market Sector (RCM Software Comp.) Data: (as was described earlier in technical outlook section) and the S&P 500 is used with the price-earnings (P/E) relative and dividend yield relative models.
Financial ratios included are asset turnover, return on assets, total liabilities to total assets, total liabilities to equity, and sustainable growth. Of particular relevance is ROE (which the author considers the ultimate acid test of overall investment performance) and sustainable growth.
Average Multiple Models
The valuation estimates are the result of the Market Relative section of the RCM model. The value-to-price ratio provides an overview of how the valuation compares to the current stock price. A ratio of 100% means that the valuation is equal to the current price, ratios above 100% indicate valuations above the current price, and ratios below 100% indicate valuations below the current price. A ratio of 150% indicates that the valuation is 50% above the current price. In the case of Microsoft, the Average Close P/SPS X Estimated SPS is 125% (where Sales = S and Sales per share = SPS).
Relative Market Multiple Models
Comparing the relationship of a stock to the market displays a company position with more clarity than the plain vanilla examination of the company's historical market multiples. As a function of growth expectations, companies trade at multiples greater or smaller than that of the market. For example, one would expect companies with prospects better than the market as a whole to trade with higher multiples than that of the market. By dividing a company's multiple by that of the market's, a multiple relative is determined.
In order for an accurate determination of valuation based on adjusted P/E is to be considered valid, one must consider whether the Data's P/E ratio of 21.0 is fair. If the market's earnings are expected to go up as a consequence of a preliminary phase of a paradigm shift, then a higher market P/E may be appropriate. Conversely, if a slump is expected due to a downward turn in the growth rate of the economy as earnings increase during the economic recovery, then a lower market P/E may be appropriate.
Using the RCM Valuation Alpha provides a consistent technique for examining a company and its relationship to the market. This is advantageous in that it eliminates emotional bias, which has proven to be the primary weakness of even the best investors. A consistent and well thought out model also helps to identify the factors driving the current market price and test many of the various assumptions to assist the investor in arriving at a fair price. Accurate stock valuation is not an easy process, as can be seen from the model I will present (over 1,175 lines of code and formulae), however it is far from impossible for the average investor. When performed effectively, it can be quite rewarding as it prevents the novice and the professional alike form getting caught up in the euphoria while allowing them to participate in opportunities not apparent to the masses.
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Available for download is an alpha version of a quasi-public domain portfolio valuation model that values equities using five of the traditional accrual methods, theoretically values puts, calls, and warrants, graphs values and will soon use Economic Value Added, Discounted Cash flows and free cash flow valuation methodologies. It also maintains a database of your portfolio and updates the new interest rate and stock prices automatically through the web. Please fill out the form at rcmfinancial.com in order to join the software distribution list (this allows me to email you updated models and reports), then proceed to the download link from the top of that page. Enjoy!! |
