• Lev Mikulitski

Not every nail needs a hammer: The right way to make a company valuation.

There's a belief that DCF and real options based valuations are competing methods and therefore, in a way, mutually exclusive. But this belief is wrong and both methods have their merits side-by-side. Once one accepts that a company's value has both a DCF component and an uncertain growth options component, it will become more clear how various businesses are priced. Hence, there are two things that must be clarified regarding DCF and complex methods, such as real options and games.



First: the methods have different purposes. DCF analysis is a basic capability you need to know for company valuation. On top of that, you can use complex methods, such as option games, which allow you to quantify the firm's flexibility and its long term strategy, and its long-term strategic choices. Learning to use these additional tools and valuation capabilities on top of DCF is a unique aspect of this article. Thus you will need to understand both.


DCF is the best practice for valuing operating assets. That is: an existing business, factory, or product line which already produces revenues. You can use DCF approaches in situations where the cash flows can be specified with reasonable certainty. On top of that, and far from being a replacement of DCF, are real options. They are essential to complement the management team to operationalize and quantify the firm's strategic choices. When companies solely rely on DCF analysis for their long-term strategy, they inevitably fall into the trap of either not investing enough in uncertain but highly promising opportunities or not correctly staging investments under high uncertainty. For instance, consider a takeover example. Traditional DCF analysis typically considers an acquisition as a now or never deal. With real options, instead, you recognize the benefits of acquiring a toehold first, by investing in a minority stake and waiting until uncertainty unravels before making the full acquisition move.


Second: the two methods focus on different components of value. Different stages of business, and different types of investors, focus on different sources of value. In a startup phase, pre-revenue, or perhaps even pre-product, you may find an early stage investor willing to invest. In these cases, you can't show a historical P&L or equipment that has a logical or quantifiable value. A DCF is nearly impossible and the business is largely composed of growth option value. Therefore, using real options as a complementary approach is crucial. Even a real options valuation at this stage of a company's potential value is based heavily on the vision of the investor. But completely ignoring the potential value of these growth options would highly underestimate the startup's value.


Real options also allow you to better value projects with negative cash flows but which are taken for strategic reasons. For instance, research and development, and exploration investments. The DCF works well to value assets in place when we are projecting future cash flows from some historical context, and we are fairly certain of future trends. In other words, for more mature businesses with tangible assets in place, market sizing, sales reports, profitability trending, DCF can be used to estimate value. At this point, an investor is primarily interested in ensuring the business itself and its expected cash flow will represent good value against the price of the business.


Managers may integrate the two approaches if they are to make valuations that reflect the reality and complexity of their business's portfolio and growth prospects and value of assets in place. Equity value is the value of assets in place under a no-growth policy, plus the value of growth options. However, for the purpose of company valuation, it's not always necessary to calculate both components of a project's value.


Let's for now focus on businesses that have assets in place and where DCF is sufficient. for a DCF calculation, you need to identify the various operating value drivers, often estimated based on a historical analysis. These value drivers affect the firm's operating profitability and the firm's assets deployment, and jointly they determine the firm's free cash flows after the firm invested in its business. As these future cash flows are quite uncertain, we need to discount them at a discount factor depending on the risk and capital structure of the company.


So, what is free cash flow?

Free cash flows represent the amount of cash a company is able to generate, after having made all the required expenditures to operate and maintain or expand its asset base. These free cash flows represent the value available to all investors or to grow the business. Basically, there are five main drivers to consider when estimating the free cash flows, and we relate the historical analysis to this. Estimating the free cash flows is based on a simple set of adjustments to the accounting earnings before interest and taxes.

One: for free cash flow, it is profitable growth that matters. We typically base free cash flow by trying to understand the operational profitability, called EBIT, and the growth rate of its revenue.

Two: we adjust EBIT for corporate tax.

Three: we increase the earnings for costs that are not expenses such as depreciation and amortization to arrive at the operational free cash flow.

Fourth: we adjust EBITDA for changes in working capital, which equals to short-term assets minus the short-term liabilities. This is often connected to the revenue growth because the growth of a company may require more working capital.

Five: capital expenditures also affect the free cash flow. They reveal how much the company is investing in the business.

The recommended way for approaching the discounted cash flow procedure is to forecast the complete income statement and balance sheet first, based on the trends in the key value drivers and use those as inputs for trends in the free cash flow forecast. It is always important to make relative comparisons and benchmark against rivals in the industry. We consider these key drivers in particular, because they are the fundamental components and they are relatively straightforward to estimate.


A historical analysis assesses which company fundamentals influence these drivers of free cash flow and makes forward projections based on that information. We start by looking at the income statement.


Revenue analysis: the first important item to evaluate for estimating the evolution of free cash flow is company revenue. The timing and structure of a company's revenue is important to forecast the future income statement and the free cash flow. Is there a structural historical growth pattern in the revenue? Is the historical revenue stream cyclical? And are revenues one-off or are they recurring? Managers may use company-specific ratios to assess the health of a revenue stream. For examples, for retailers this could be revenue per square meter. Other frequently used ratios to help estimate free cash flows are cumulative average growth rates or year-on-year growth. These ratios can especially be informative when comparing years with each other, and to understand trends over time.


COGS Analysis: next there is the analysis of cost of goods sold. These represent all the costs directly related to the company's production. Typical ratios to analyze cost of goods sold are gross margin as a percentage of revenue or gross margin per unit of volume.


Other Operating Costs: another item on the cost side that impacts the future free cash flows are other operating costs, which usually consists of personnel costs, marketing and sales costs, distribution, housing and IT costs. The future costs are often estimated as a percentage of revenue or per unit of volume. For those costs that are not clearly linked with sales year-on-year growth is a more appropriate metric for analysis, or alternatively, one can look at how it relates to fundamentals. Based on these items we can make an estimate of EBITDA. A profitability analysis using the income statement can help you assess normalized proforma profitability of the business using ratios such as EBITDA to revenue or net profit to revenue.


Tax Analysis: lastly, a key influence on cash flows are taxes, and therefore you should examine in what countries profits are being reported and at what rates the business is being taxed, and does the company have tax deductible items or tax credits? Does it have deferred tax assets or liabilities on its balance sheet? Next, we move to the future proforma balance sheet.


Working Capital Analysis: changes in the required working capital affects the free cash flows. Particularly trade working capital, which focuses on accounts receivable, accounts payable, and inventories, provides an insight into a company's operating efficiency. Rather than simply looking at the absolute levels of working capital, you should express the working capital items in terms of trade days. These trade days provide an insight into how many days it takes the company to turn working capital into revenue. Understanding how they develop over time and how they compare to competitors in the same industry can provide meaningful information about the company's operating efficiency.


Capex: year-on-year changes in property plant and equipment and intangibles reflect the company's capital expenditures, also known as capex. You can distinguish between maintenance and expansion capex. Of course, with high growth in the long run, you cannot be funded with maintenance capex only. It's also important to understand the patterns of the company's capex. Capex can be lumpy, e.g. for purchasing a new factory plant. Alternatively, it may be incremental when small investments are made continuously.


In estimating trends, capex is often analyzed as a percentage of revenue or as a fixed asset turnover, which is calculated by dividing net sales by property plant and equipment. Besides scrutinizing the income statement and balance sheet, there are many other relevant aspects to look at and question when analyzing company performance. For instance, what is the company's capital structure? What is its solvency? This represents the company's ability to meet its long-term obligations. And can it meet its required debt servicing? This includes, required interest payments and amortization of outstanding loans. You should also be careful to distinguish between operating cash, which is necessary to cover day-to-day expenses and excess cash, the amount of cash left that can be used for expanding production, pursuing acquisitions, paying out dividends or reducing debt.


Lastly, in takeovers, practitioners often look at profitability-to-price metrics such as earnings per share. Now, having analyzed the historical ratios of these values drivers and having forecasted them, you can plug the values into the following formula to calculate free cash flows: So EBIT, or earnings before interest and taxes, after the tax rate, so compensated for taxes, plus the depreciation, plus the amortization, minus the change in net working capital and minus the capital expenditures. That equals the free cash flows.


In summary, the recommended way for approaching a DCF is to forecast the complete income statement and balance sheet first, then forecast the future free cash flows, which in turn are used to derive an estimate of the company's value. The key drivers of free cash flows are revenue growth, EBITDA margin, taxes, working capital, and capital expenditures. Looking at how these drivers have developed in the past, breaking them up and understanding their components is vital for making realistic and accurate forecasts.





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