Why should we even value a company?
Price is what you pay, and value is what you get – Warren Buffet
- It allows us to obtain a clearer picture to determine intrinsic values (we are value investors!)
- To identify mispriced opportunities so we can profit from undervaluation, and steer clear of overvalued companies
Can you think of any more?
Introduction to Valuation by Aswath Damodaran
How can we value a business?
- Dividends: actual cash flow distributions to equity holders (i.e. shareholders)
- Free cash flow to equity (FCFE): available cash flows to shareholders only
- Free cash flow to the firm (FCFF): available cash flows to both debt and equity holders
Cash flows = operating cash flows – cash reinvestment
Discount rate: is the required rate of return for the investors and is a function of the riskiness of the cash flows.
Dividend Discount Model: focuses on stable dividends (we will explore this further in module 4)
You own a cafe which is expected to generate $10,500 in 2015, and cash flows are expected to grow 5% each year. Assuming a discount rate (r) of 10% and that all cash flows are generated at the end of the period, what is the PV of cash flows generated in the first 5 years (t)?Now, let’s assume that this cafe continues to operate indefinitely. How do we value this business if the cash flows continue? We use a perpetuity formula in mathematics
DCF: Two Stage Approach
- Stage 1: Explicit forecast period discounted to present value
- Stage 2: All cash flows beyond the forecast period in a perpetual growth stage
Take a look at the four key columns below. These are the essential aspects of fundamental valuation.
Hint: OPEX = operating expenses; IBL = interest bearing liabilities; Net debt = cash – total debt
Cost of Equity: The CAPM Equation
Time value of money and risks are factored into consideration.
3. Financial performance
For this module, we will start by building up the historical profit and loss statements first, derived from the key drivers, with as much detail as possible. Segmental revenues, costs and EBIT figures should add up to the total group numbers reported in the annual reports. Sometimes we will choose to emphasise EBITDA over EBIT as it may be a better representation of underlying profit as as different companies have different depreciation and amortisation costs. Remember that numbers in a model don’t mean anything unless you have a story, context or meaning behind it.
For SWM, all the individual segments should total to the final group figures below. This is an approach which derives the total amounts from first principles, allowing future forecasts to be auto-populated easily. In 2017, Seven West Media reported:
- Revenue of $1673.6m
- EBITDA of $306.7m
- EBIT of $261.4
Your turn: Once you have identified the historical performance, take note and discuss the historical trends and views around each division to determine how the company is tracking at a group level, in line with the strategic pillars.
4. Future outlook and forecasts
Analysts often prefer a bottom up approach when conducting fundamental forecasts, drilling into each division / segment, line by line. A top down approach is then used as a sense-checking mechanism. Of course, depending on the sector, this may not always be possible
For our purposes with SWM, we will take a number of angles:
1. Company Guidance
For most company results and announcements, management releases outlook comments and guidance around key metrics. These form the frameworks of an analyst’s forecasts. Note that, some companies scatter outlook comments across their announcements / releases so you may have to dig around for your selected company!
For SWM, management released a series of outlook commentary as seen below. These are incorporated into forecasting models:
Guidance comments are only released at major announcements and results so analysts must also have their own way of tracking ongoing changes and trends. Also, we can’t just rely on management commentary because we need to have our own independent opinion. That is why a series of independent research and third party consultations are required.
For TV, we triangulate the data with official industry bodies such as:
- CEASA data (Commercial Economic Advisory Service of Australia) for total ad revenues
- OzTAM data for ratings shares data by segments
- KPMG FreeTV data for revenues shares data by segments
- SMI Data for agency ad expenditure
Your turn: For your own individual stock, come up with a list of industry sources which can help you value the business and understand the market. A good place to start is to dig into the annual reports and company releases of the selected company and their peer comparables. Then read existing broker reports and understand their source of information and research.
3. Broker Forecasts
To ensure that you can justify your forecasts, it is crucial to determine where you sit relative to the rest of the market. The most common metrics to check against are:
One way to set out the updates is an excel layout below which can be updated when a catalyst occurs in the market which changes analyst views, e.g. the company makes an acquisition, or delivers a set of results.
- Log into the terminal and computer
- Launch the Bloomberg software and log in using the provided username and password details at the desk
- Search the company ticker name (“SWM AU EQUITY”) in the top bar
- Add “EEB” to the end of the search function to find the best analyst estimates in the market
- Take a screenshot and update your excel template according to each bank
We collate all of the above data first and then proceed to forecast line by line performances. See if you can use the information / approach for your own selected stocks and come up with your own independent forecasts as you work through the task items below.
At our next F2F workshop and in the next few modules, we will go through more detail about forecasting and valuation. Stay tuned!