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Must Read: Not Your Father’s Way of Viewing Valuation

publication date: Sep 30, 2015
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author/source: Brian Nelson, CFA

A version of this article appeared on our website September 10, 2015.

There are not “right” ways and “wrong” ways to value companies. There are not even different ways to value companies. There is one way. Let’s explain what we mean in this illustrative example.

Mrs. Nelson owns a candy store (100 shares in all), and she plans to sell $100,000 worth of tootsie rolls, peppermint hard candies, and caramels this year. The average gross margin on each piece of candy sold is 50%, and she expects revenue to grow 3% each year after the first year.

She has overhead of about $10,000 per year comprising of a) interest on the loan for the building she owns ($3,000 per year), b) depreciation associated with the building ($3,000 per year) and c) utilities ($4,000 per year). Interest expense and utilities expense are expected to grow 3% per annum along with sales.

Mrs. Nelson plans to invest $10,000 in capital spending this year, with 20% of such an investment to maintain her business ($2,000) and the balance of the capex to grow it ($8,000). She expects both measures of capex as well as depreciation expense to grow at 3% per year.

She had ~$970.50 in inventory last year, which she expects to increase at a pace of 1% of total revenue going forward. That means she expects to end the first year with $1,000 in candy inventory. She always pays her bills on time.

Her tax rate is 50%, and she has $100,000 in cash and $50,000 in mortgage and business-related debt.

Working through these assumptions, for the first year, Mrs. Nelson’s gross profit is $50,000 ($100,000 x 50% gross margin) and her earnings before interest and taxes (EBIT) is $43,000—the $50,000 less the $7,000, which comprises the sum of both depreciation expense ($3,000) and utilities ($4,000).

The candy store’s EBT, or earnings before taxes, is $40,000, made up of $43,000 in EBIT less the $3,000 in interest expense, and her earnings after taxes, or net income, is $20,000—which is $40,000 less the $20,000 she pays in taxes ($40,000 x 50% tax rate).

In this case, her funds from operations (FFO), effectively defined as net income + depreciation, is $23,000. Earnings before interest after taxes (EBI) or tax-effected EBIT is $21,500—comprising of $43,000 in EBIT multiplied by the tax rate (50%).

Since Mrs. Nelson expects to increase the inventory of candy this year , a use of cash, cash flow from operations in the first year, traditionally defined as net income + depreciation and amortization +/- working capital changes, is ~$22,970.50.

The candy store’s distributable cash flow (DCF), traditionally defined as cash flow from operations less maintenance capital spending of $2,000 in this case, is $20,970.50.

Mrs. Nelson’s candy store generates free cash flow of $12,970.50 in the first year, comprising of cash flow from operations of $22,970.50 less total capital expenditure spending, which was $10,000.

With such tremendous success, Mrs. Nelson is considering taking her candy store public.

What multiples of price-to-earnings (P/E), price-to-funds from operations (P/FFO), and price-to-distributable-cash-flow (P/DCF) would you place on this candy store business? Now, we’re asking the right questions in the right order.

The answer is quite straightforward, and we have all of the information we need.

First, we assume that Mrs. Nelson pays down her mortgage and business-related debt, whether she does so or not is irrelevant within the valuation context. That gives us $50,000 in net worth so far into the exercise.

Second, because we have “analytically” assumed her business is now debt-free in the immediate step above, we must also assume that her “new” income profile is earnings before interest after taxes (EBI), excluding payments related to interest, which analytically no longer exists.

Earnings before interest after taxes (EBI) or tax-effected EBIT is $21,500 in this case, and assuming no changes in the tax code, the measure should grow at the same pace of revenue going forward, or at 3% per annum.

To get to Mrs. Nelson’s enterprise free cash flow, or the value that her business generates in free cash flow to the firm (FCFF), as if it were an all-equity firm (which in this case, we’ve made it so by analytically paying down the debt), we must subtract net new investment (or total capital spending less depreciation) while also subtracting her working capital investment (increase in inventory).

Her enterprise free cash flow or free cash flow to the firm is therefore: $21,500 in earnings before interest after taxes (EBI or tax-effected EBIT) less $7,000, the difference between total capital spending (both growth and maintenance) and depreciation, less the ~$30, or the annual incremental investment in inventory. That comes to ~$14,470.50 for the first year.

Because revenue will grow at 3% per annum and therefore EBI will grow at 3% per annum going forward, and because both capex will grow at 3% per annum and increases in inventory will grow at 3% per annum going forward (given that the latter is tied to revenue), enterprise free cash flow or free cash flow to the firm (FCFF) will also grow at 3% per annum.

We’ve made it simple for illustrative purposes.

Mrs. Nelson plans to work another 20 years and has locked in a take-or-pay candy agreement that guarantees her future growing revenue stream. She plans to give the business to her son once she retires in two decades, and the business is expected to continue to grow at 3% per year into perpetuity.

Assuming a 10% hurdle rate (or cost of capital), let’s assume a growing perpetuity to arrive at the value of her candy store today, or {[$14,470.50*(1+.03)]/[0.1-0.03)} = $212,923.10. To get to the value of her total business, let’s now add back the net cash position: ~$263,000 (~$213,000 + $50,000 in net cash).

Let’s now figure out what multiples of price-to-earnings (P/E), price-to-funds from operations (P/FFO), and price-to-distributable-cash-flow (P/DCF) should be placed on her business. This should be your “aha moment” that may very well change your life.

Here they are:

P/E = 13.2x, or ~$263,000 divided by net income of $20,000. On a per share basis (100 shares), that’s $2,630/$200.

P/FFO = 11.4x, or ~$263,000 divided by funds from operations of $23,000. On a per share basis (100 shares), that’s $2,630/$230.

P/DCF = 12.5x, or ~$263,000 divided by $20,970.50. On a per share basis (100 shares), that’s $2,630/~$209.7.

You see, companies of varying business models cannot possibly be “valued” in different ways, or at least in the sense that we believe analysts and investors are thinking they are. For example, if Mrs. Nelson’s candy store was a REIT, its value may be referenced on a P/FFO basis or not (it wouldn’t matter), or if the candy store was an MLP, its valuation prospects may be outlined on P/DCF metric or not (it wouldn’t matter). The enterprise free cash flow model has already solved for the “correct” P/FFO and P/DCF multiple for each company; the multiples are outputs of the process, as in the example above.

It is our view that where some analysts and investors get it wrong is when they make the case that P/FFO should be used to value REITs and P/DCF should be used to value MLPs, as if the enterprise valuation process does not already imply P/FFO and P/DCF outputs and the latter two outputs do not implicitly account for all of the drivers of an enterprise valuation process. It is our view that a company’s value is its value, and applying a different approach to its valuation should not (cannot) change that value that’s already derived within the enterprise free cash flow process.

The reason for different fair values or price targets should only rest in differences in the underlying assumptions behind a company’s operations (i.e. differing opinions among analysts, not in the application of valuation principles but in the actual future expectations of a company). Picking and choosing a desired valuation process for different industries should not (and cannot) alter the realities of the entity’s enterprise free cash flow stream and net balance sheet. It is our view that once analysts and investors start straying from actual enterprise free cash flows and the balance sheet, they are trying to “sell” you something.

If you have any questions about this article, please reach out to me personally at brian@valuentum.com. There are very few breakthroughs in valuation that are more profound than understanding how enterprise free cash flow valuation and multiples are forever inseparable and inherently linked.


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