My favorite metric to use for business valuation
One of my favorite presentations on valuation was authored by NYU professor and valuation king Aswath Damodaran, a teacher/writer who has authored several books on the subject and maintains a really useful blog which I refer to often.
In the presentation, he describes twelve common myths of valuation ranging from the calculation of unprofitable companies to using debt to estimate your cost of capital. I won’t take you through the entire thing to avoid a long discussion about beta, WACC, T-bills and risk premiums, but I wanted to cite a few myths that I constantly keep in the back of my mind when attempting to value a business:
Myth #1: Good valuations do not change
No valuation is timeless. Each of the inputs to the model are susceptible to change as new information comes out about the firm, its competitors, and the overall economy. This is where that flexibility and open mindedness comes into play. Really important to pay attention to market wide information, industry information and company specific information. I can’t tell you how many times I’ve created a likely scenario model, only to have reality come nowhere near my estimates of cash flows, capex, capital allocation and revenue growth.
Myth #2: Valuation is a science that yields precise answers
All valuations are biased
Equity valuations are always imprecise, but they are most valuable when they are most imprecise
Complex valuations do not yield better estimates of value
The process behind figuring out an intrinsic value for each investment is a lot more art than science. There is also no set way to view the downside in each business. In some cases, value may be the assets on the balance sheet: a building, a collection of patents, a strong brand name, a valuable piece of land; in other cases it may be a business segment with high moat, competitive advantages that produce high returns and cash flows with long-term contracts. I like to think of an analogy by Leon Cooperman, a phenomenal investor, who compares value investing to selecting from different brands of beer in the grocery store: some combination of return-on-equity, high growth, price-to-earnings ratio, free cash flow yield and asset value: “There’s something that makes you reach for one particular brew.”
In my search for the best way to evaluate a company, I have tried to come up with an intrinsic value formula (not invent one myself, but choose one) to help determine a fair price to pay for a business. It should come as no surprise that I found that there was no one metric or formula to accomplish this.
When looking back through history, it’s amazing how far we’ve come in the investment world in terms of a firm or individual’s ability to value a business. Not only has qualitative analysis improve greatly (take a look through VIC, Seeking Alpha or SumZero), but the world has changed so much since say the depression era times in terms of the industries which house the largest companies in the publicly traded universe. Whereas back in the day, value of hard assets such as PP&E was important and measures such as price to book ratios were used to value the cheapness or expensiveness of a certain company, now software companies for example whose chief assets are employees and software (thus highly intangible) and gush cash need to be valued using measures of free cash flow, earnings, and the growth of both of those metrics.
Of all the valuation metrics that have been used in the past few decades, one that I use more than most involves the use of free cash flow, a metric that is difficult to fudge and provides a solid stream of real cash flow that belongs to the owners of the business at the end of each year. Looking at a company’s free cash flow yield, or the inverse, price to free cash flow, gives me a solid sense of how cheap/expensive a business is on the surface, and gives me an idea of whether or not it’s worth a deeper dive. Typically if a company is trading at less than 10-12x free cash flow, or has a free cash flow yield in excess of 8-10%, it’s most likely worth taking a closer look.
I also like to utilize EV/EBITDA ratios as a proxy for cash flow in order to get a measure of a business valuation or how cheap/expensive it is without taking into account each company’s capital structure, capex needs or tax rates. However, I have to admit that I hate using EBITDA to value public companies. It’s an ugly metric that usually doesn’t represent the true economic reality of the company’s growth, profitability, and capital intensity. So I will focus on price to free cash flow.
Accounting scandals and manipulations of financial earnings have given rise to the importance of using free cash flows in company evaluation. Free cash flow numbers are much more difficult to fudge with one-time charges or expenses, accounting gimmicks and restructuring. Free cash flow provides a nice look into the actual cash the company spits off, as well as debt repayment levels and growth/maintenance capital expenditures needed to maintain competitive positioning. You can’t spend earnings.
Free cash flow also provides much greater insight into a company, and through DCFs, it’s key to have a solid understanding of growth in operating earnings, capital efficiency, the capital structure of the business, the cost of equity and debt, and the growth rates of various parts of the business.
Free cash flow represents the actual cash able to be taken out of the business at the end of the year, or used for buybacks, to pay down debt, make acquisitions or pay dividends. Free cash flow is less able to be manipulated by managers because it adds back non-cash expenses and incorporates net income which already adjusts for interest and taxes on some level. In addition, DCFs using free cash flow force the investor to make explicit judgments regarding the company’s future and the critical drivers of the business.
My one issue with DCFs and other valuation metrics such as price/free cash flow is not changes in inputs resulting in big changes in the valuation (garbage in, garbage out) but rather that the method implies there is a correct and often precise value. It feels arrogant to have a specific price target given all the unknowns, and never have I considered a company investable when I thought the DCF value produced something higher than the current share price. I don’t do one discounted cash flow and come to the conclusion that “Company A is worth $67.55.” I believe most companies have a relatively wide range for intrinsic value. I like to use DCFs using free cash flow mostly to tell me what the result says about a company’s prospects – i.e. my per share value means this company is only going to grow at 8% for the next 3-5 years or that debt won’t be paid down etc. If the output is way off from what I am seeing both historically and quantitatively than maybe I’m getting somewhere.
It should be noted, however that familiarity with DCFs grows as does the frequency of use. The key drivers of a discounted cash flow are revenue, operating margin, and capital intensity. While I sometimes estimate each line on the income statement individually, my focus is on those three key drivers. If can estimate the direction of those numbers in a reasonable way, my valuation should work out alright.
When it’s all said and done, how do I determine an entry price? Ideally, I’d like to identify a buy-in price target that I feel will result in 10-20% chance of permanent capital loss if I’m wrong and a reward upside that is at least a four-to-five times the potential loss. Calculations of a company’s downside is usually done on bull, base and bear case scenario growth and profitability estimates using conservative historical valuations and/or combination of the conservative estimate of the value of the assets on the balance sheet.
While models, and analysis of metrics such as free cash flow and price/free cash flow are important, the outputs of competitive advantages and capital allocation also require careful qualitative evaluation. The key consideration becomes whether the business will throw off enough cash to allow us to earn a satisfactory return on investment. Many considerations enter the picture here, including the relationship between net income and free cash flow, the ability of the business to reinvest capital at high rates of return, and the nature of management’s capital allocation policies. If I was stuck on a deserted island and could only bring with me one valuation metric, I’d choose price/free cash flow.
A few final thoughts on valuation:
The process for making a new investment can take days, or months. Usually I’ll know if a given company will be a suitable investment (before further due diligence) within a few days of research. If not, I toss it aside (often times in a manner of minutes), and my ‘toss aside’ pile is much larger than the investable pile.
Valuation is often the last thing I look at, and the most difficult given that the future is unpredictable. Price is incredibly important here, and there is a reason that ‘margin of safety’ are the three most important words in investing. Given the difficulty of a specific company’s execution risk, I aim to try and pay the lowest price possible for value.
To that point, value can be found in many places. Often assets are undervalued, GAAP accounting numbers are misleading, or the company is small and therefore under-followed, all of which can distort the valuation picture. Within my own portfolio, I try to aim for 50% – 100% returns within a few years. As one of my favorite investors, Mohnish Pabrai would say ‘be unreasonable’. Given my concentrated portfolio and limited number of companies, I try look for compelling situations where the risk/reward profile is skewed toward the upside.
This would get me ridiculed in most investment circles, but I almost never have a specific per share number or target price where I’d like to end up. Buffett has a quote about ‘it’s better to be roughly right than precisely wrong’, which I think about a lot. In fact, I believe it to be somewhat arrogant to have a specific price target for a company given an unknowable future. It always amazes me when an analyst or investor will say that ‘the fair value of company X is $56.78 per share’. That may be the right path for some, and I understand discounted cash flow models (something I utilize) can generate exact numbers, but I don’t operate in that way in terms of needing to be married to a specific number. I’ve never come up with an exact price target before investing, and fair or intrinsic value is an elusive concept that tends to be more of a range as opposed to specific figure. Instead, for my final valuation, I try to find a range where there are multiple ways to win, with low execution risk, as long as the business continues the status quo. I utilize discounted cash flows to determine a good starting point, and often to let me know how the key drivers will impact the cash flows (i.e. – a business is worth a PV of ‘X’ if it’s growing at 8% per year etc., even though revenues just grew 15%).
To sum it all up, I strive to get an initial favorable free cash flow yield (or clear path to one) with limited downside risk, and several sources of potential upside.
Using financial metrics and formulas to value a business can be powerful, but also flawed. Above everything, it’s important to remember that valuation is more art than science, and although numbers are precise, they can also be inaccurate.