Valuations – The Mechanics

Warren Buffett was asked what he would include in the syllabus of an investment degree.  Just two courses made the cut.  Valuations, how to value assets correctly and Market Psychology, how to be greedy when others are fearful and fearful when others are greedy.  This post will focus on the first course recommended by Mr. Buffett.

If you are a student in South Africa, chances are that you already have Financial Management by Carlos Correia.  There is no substitute for reading it, so go along to Chapter 6 and go for it.  This is intended to supplement that experience and not substitute it!

Valuations typically occur at two levels.  There is the “Mechanics” level that simply requires you to apply a methodology consistently and accurately.  These methodologies could include Discounted Cash Flows, Earnings multiples and Net Asset Value (in the case of a liquidation or as a reasonability check).  The “Advanced” level takes things further and analyses trickier concepts that could have a material impact.  Share options, assessed tax losses, terminal value inputs and foreign exchange earnings would all feature in this category.

My experience has been that students get distracted by the “Advanced” level issues and leave a lot of easy marks untouched as a result.  The goal of this post is to help you not make that mistake.  Master these “Mechanics” first and then, if there is time left in the question, move on to the “Advanced” issues.  In life, you always need to cover the “Advanced” issues, or you should lose your job, but when it comes to exams, it’s about being an efficient scorer of marks.

Discounted Cash Flow method

  1. Collect Cash flows. Draw up columns and get cracking.  Separate workings are usually required for Tax, Changes in working capital and Capital Expenditure.  These are little “solve for x” tests.  Some will be hard but don’t get stuck on them – keep moving.  Only collect cash flows related to the operations – investment flows like interest and dividend received will be taken into account in step 4.
  2. Discount rate. This is easy if you are given WACC.  Other times you will need to calculate it.  Cost of equity, cost of debt, weighted and then out pops your discount rate.  Use this to discount your cash flows.  (This is why valuations are such a popular area to include in exams, it integrates so well with other topics, in this case “cost of capital”)
  3. Terminal value. You apply the formula and then don’t forget to apply the discount rate to your answer.
  4. Balance sheet items. Here you collect all the investments and include them at market value.  So instead of including dividend income from an investment in the cash flow projections, you rather include it at market value at this stage.  Cash, in excess of what is required for operations, is also included at this stage.  These are easy marks!  Don’t run out of time and therefore forfeit them.
  5. Less debt. This includes both short-term and long-term interest bearing debt, at market value.
  6. Divide by shares or Multiply by %. Don’t forget this easy step – if you’re only selling 20% of the company, don’t leave the value at 100%.
  7. Perform a reasonability check. Compare your value to the current share price or Net Realisable Value, if these are available.  If it is out by a far way, check your calculation of terminal value especially but don’t stress – if you have run out of time, you need to move on to the next question.

The Learn Accounting website has a free video of Carlos Correia explaining a DCF – click here to watch it.

Earnings multiple method

  1. Calculate the adjusted earnings. There are a variety of possible starting points but basically you need to get a “sustainable” earnings number.  Typical adjustments include removing unusual or abnormal once-off numbers.  Sometimes management is getting paid too much or little.  If the multiples you have been given are after-tax, this number must also be after-tax, so the above adjustments would require tax consequences as well.
  2. Calculate the multiple. You might be required to choose a comparable company.  Once you have done so, you use their multiple as the starting point.  Now you need to make adjustments for any differences that exist between the company and the comparable company.  Typical these could be downwards adjustments for lack of marketability (if your company is unlisted), lack of size, reliance on key staff.  Adjustments upwards would include a premium for control (if they are getting >50%) or if you have a future source of revenue that hasn’t been included already in earnings (assuming that the comparable company doesn’t have this either).  Don’t stress too much about the size of the adjustments but make sure the direction is correct.
  3. Multiply the earnings by the multiple, take off the market value of any debt, and then by the % being sold.

Net Asset Value method

  1. Market value for assets. Collect all the market values for the assets and don’t forget to include the tax consequences of any changes (these could be recoupments, CGT and scrapping allowances).  Typically, your starting point will be the Equity value and all you need to do are the adjustments required to get assets to market value, and the tax consequences.
  2. Less market value for liabilities. Same as step 1 but with liabilities.
  3. Use as a reasonability check. This method is not appropriate for a going concern but it serves as a check to make sure your valuation makes sense.

In practice you will often get a range of answers from the above methods and will need to use judgement to arrive at the final value.  That is why you will often be asked in tests to comment on the correct value.  Don’t stress about choosing the “right value” but be clear in the process you are following to arrive at your answer.

“Advanced” issues are important for your future careers, so in the next post I will focus on them, but for now please master these “Mechanics”.

Paul Maughan

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