Valuation – The Art of Connecting Narrative with Numbers

Would you consider yourself an investor or speculator when thinking about stock markets? Most people would like to be seen as investors, since they feel well informed by following financial news related to firms, politics, central banks, or perhaps by going through financial statements. While reading plentiful but not applying the collected information to a valuation model in order to determine its potential impact on companies’ value, people end up guessing about the future price development of their stock holdings. For a majority of people, the answer to my initial question is therefore: speculator.

Setting up and plugging in values into a standard valuation model such as the discounted cash flow (DCF) model or market multiples requires only basic math. More an art than a science, however, is the collection of qualitative data about changes in firms’ strategy or market environment from financial press or company publications and translation into accounting terms for valuation purposes. First and foremost, this requires a fundamental understanding both for the financial determinants of an intrinsic share price and whether a change in their values moves that price up or down within the respective model framework. In the DCF model, using free cash flows to the firm1) (FCFF), the total amount of value a company can create over time depends on:

  • return on invested capital2) (ROIC)
  • reinvestment rate3) (RIR) of net operating profits after tax (NOPAT)
  • growth rate4) (g) of FCFF
  • cost of capital5) (WACC) of debt and equity

A company’s intrinsic value and thus share price can be raised by increasing ROIC to generate returns in excess of cost of capital. The higher the earnings remaining after financing costs the higher the free cash flows. Likewise, increasing growth through reinvesting earnings into assets which can generate excess returns (ROIC > WACC) creates value for shareholders through share price appreciation. A longer growth period with excess returns on existing and new assets can not only be achieved by selecting businesses to newly invest in or reinvest with high positive net present value6) (NPV), while avoiding new investment projects or scaling down on assets in place with low or even negative NPVs. But also, maintaining the firm’s competitive advantage(s) over others in the industry helps high earnings to sustain longer. Cost of capital is relatively stable among companies in the same sector, as it is often more difficult to change drastically for a firm. Consequently, one should focus more on the impact of public releases of information on other fundamental drivers of firm value, namely ROIC and growth. An important note regarding reinvestments: Free cash flows are growing at a faster rate into the future, but only at the expense of current free cash flows financing the reinvestment into projects with expected excess returns. In other words, managers must sacrifice current for future growth to some degree.

Now, let me come back to connecting qualitative with quantitative information and provide your imagination some tangible and easy to grasp scenarios:

One question remains: Why are only very few managers able to increase their firm’s share price consistently? There are many reasons for it. Share price improvements are firm-specific, requiring diagnosing the specific problems of a firm and tailoring the response to these problems. There is usually no blueprint to follow. Further, managers are reluctant to cost cuts, which demands hard decisions on layoffs or critically analyzing new investment opportunities from an excess return point of view. Besides, any change also needs interdepartmental cooperation to be executed successfully. Taking all the right value-enhancing actions may not necessarily be rewarded immediately by financial markets through an increase in share price. Managers who made those decisions may not be around to share in the rewards and are thus more reluctant to initiate bigger changes.

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1) FCFF = NOPAT – Reinvestments

2) ROIC = NOPAT/Invested Capital

3) RIR = Reinvestments/NOPAT

4) g = RIR * ROIC

5) weighted average cost of capital, WACC = return on equity * equity ratio + (1 – tax rate) * cost of debt * debt ratio

6) NPV = discounted payoffs from investment – initial investment, pos. NPV if ROIC > WACC

Sources:

Damadoran, A. (2012). Investment Valuation, 3rd ed.

Koller, T., et al. (2015). Valuation, 6th ed.

Stockholm Business School (2018). Analyst Guide.

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