On the 16th of October 2008 Warren Buffet wrote an Op-Ed piece in the New York Times. It includes this section:

I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

On the 16th October 2008 the Dow Jones Industrial Average was at 8,451.19.

On the 6th March 2009 – 13 months ago – the Dow Jones Industrial Average was at 6,626.94.

Today the Dow Jones Industrial Average is at 10,997.35 (having been over 11,000 at the end of last week).

The Dow Jones Industrial Average is up 30.13% since the 16th October 2008 and 65.95% since the 6th March 2009.

UPDATE: The Dow Jones Industrial Average hit an all-time high of 14,164 on the 9th October 2007.

Just amazing.

He is Warren Buffett – and he can prove it.

We are a little bit late with this piece – but we wanted to highlight it anyway.  James Berman has a fantastic piece of analysis in The Huffington Post called Reports of the Death of Equities: Greatly Exaggerated.  In the article Berman makes a very clear case for the fundamental valuation of equities and the understanding of concepts like intrinsic value.  We strongly recommend the article as outlining a framework similar to how we here at Valuecruncher look at valuing companies.

On understanding why intrinsic value matters

“To understand why intrinsic value matters, we need to step away from the panic and the bleak macro picture to understand that stocks are valued on earnings or cash flows. The latter is preferable because it strips out the accounting fictions of depreciation, amortization, goodwill write-downs and other non-cash charges. I teach my NYU students to follow the cash flows, not the earnings, because cash is what a business actually runs on.

Let’s take the example of Automatic Data Processing, or ADP (which is a core holding in both the Torray Fund, which we own for clients in separate accounts, and in the JBGlobal Fund L.P.). ADP is the largest payroll processor, the leader in a tremendously stable and unglamorous business. Due to rising unemployment, its stock has been hit hard, despite the fact that ADP has virtually no debt, an enormous cash position, healthy cash flows (even in this severe recession), and virtually no chance of going bust. I chose ADP but I could have chosen so many of the stocks now trading on the Dow, given how undervalued stocks are on a global basis.

ADP is currently trading at $32 per share, or 9 times its operating cash flows of $3.50 per share. In 1999 it was around four times as expensive, trading at 37 times cash flows. In effect, it is selling at a 76% discount to its 1999 price. People get excited when a pair of shoes, a car or a house sell at a 76% discount — but not stocks. As Benjamin Graham (the father of value investing and Warren Buffett’s mentor) liked to say, you should buy your stocks like you do your groceries, not as you do your jewelry: you should be happy to buy a stock when it’s on sale, even if a bleak environment is responsible for the sales price. As value investors often preach, you pay a dear price for a cheery consensus.”

The Valuecruncher interactive analyst report for ADP agrees that the stock is undervalued.

And on Warren Buffett

“Warren Buffett readily admits that his secret in acquiring enormous wealth was not vastly superior intelligence, prescience, or any trading strategy — but in always looking at stocks for what they really were: claims on the underlying cash flows of a business. Instead of trying to time the market, trade in and out, predict macroeconomic trends or divine the next stimulus package, he simply tried to buy businesses selling at reasonable prices relative to their cash flow and hold them for long periods of time — as they increased in value — often “forever.”

His secret was in understanding that when the price of a valuable business goes down, it’s time to buy, not sell. This understanding allowed him to hold stocks during the paralyzing market of the Seventies. At that time, the world seemed like it was coming to an end with Watergate, war in the Middle East, Vietnam, horrible inflation, recession, price controls, gas shortages, double digit unemployment and riots in the streets. But he held and bought more stocks (as he is now) because he understood the value at such prices.”

Well worth the read.

If you have not seen this – it is a must read.

Warren Buffett in an Op-Ed in the New York Times – valuation of US stocks today

Amazing.

It has been a week of financial market turmoil. The Dow is closed at 8,451 on Friday – over 40% below the 52-week high of 14,279 and down 18% for last week alone. There are a lot of very smart people concerned that the markets and broader global economy are headed for a long-term slump. Within this turmoil there is a lot of discussion about valuation. Here at Valuecruncher we wanted to explain our take on valuation and the analysis we provide.

Here at Valuecruncher we believe that in the long-run markets are broadly efficient – market prices properly reflect the intrinsic value of assets. By intrinsic value we mean a ‘true’ underlying value. However, in the short-term there can be and are inefficiencies. At Valuecruncher, valuation is an attempt to estimate what this intrinsic value is and how it relates to current market prices. At Valuecruncher we do that by calculating a discounted cash flow (DCF) valuation. As we noted, in the longer-term we believe that markets will price assets at this intrinsic value. In the shorter term market prices may differ (either up or down). Our approach is a longer term approach. If someone is looking for a valuation of where a stock will be this week – a DCF isn’t the way to go. However, if you want to understand the underlying value of a stock relative the market price and have a longer-term view – that is where a DCF adds value.

For example: Apple ($AAPL). On 4 June 2008 with the $AAPL share price at US$186.10 our estimate of the $AAPL intrinsic value was US$146.70. By 23 September 2008 with the $AAPL share price at US$131.05 our estimate of the $AAPL intrinsic value was US$163.98. $AAPL closed on Friday at US$96.80. In just over four months the market price of $AAPL has dropped 48% – dramatic times indeed. Our estimate of intrinsic value has changed based on changing assumptions of the underlying business. But what we are trying to estimate is the intrinsic value – and we have argued it is both below and above the prevailing share price of $AAPL over the last four months.

At Valuecruncher we will continue to put out our take on the intrinsic value of companies like $AAPL and how this relates to the current share price. Our on-line interactive valuation models allow anyone to change our assumptions and calculate their own intrinsic value. In our own analysis we are going to try and avoid rhetoric like “buy”, “sell”, “cheap” and “expensive”. Ours is a longer-term analysis. We still believe that in the long-run that market prices and intrinsic value will eventually converge.

Understanding intrinsic value helps us to understand corporate transactions like share buy-backs. It can illuminate mergers and acquisitions activity. It can even expose opportunities to invest (and dispose) of stocks.

After a wild week we expect there are still some brave souls out there trying at assess value.

Continuing on from our look at the terminal growth rate we now turn our attention to the discount rate assumption. The discount rate is one of the key assumptions in the Valuecruncher valuation.

Deciphering the discount rate

Before addressing the technical definition of the Valuecruncher discount rate it is important to understand what the discount rate is designed to capture. The discount rate reflects the required rate of return on the investment. The discount rate consists of two key components, the time value of money and risk.

Time Value of Money

The time value of money assumes that all other things being equal you would prefer have a $1 today as opposed to waiting until tomorrow, next year or retirement. To sacrifice the opportunity to use that $1 today an incentive is required. The time value of money is reflected in the risk free rate component of the discount rate.

Risk

When considering risk in a financial context NYU Professor Aswath Damodaran cites the Chinese symbol for risk which is a combination of the characters for danger (crisis) and opportunity.

This approach recognises that risk represents more than just downside outcomes. Drawing on Damodaran again:

“…risk in finance is defined in terms of variability of actual returns on an
investment around an expected return, even when those returns represent positive outcomes.”

Valuecruncher’s valuation considers the risk associated with the company’s forecast free cash flow.

Games of chance such as roulette have a discrete number of potential outcomes with explicitly defined returns and probabilities. The expected return, variability and therefore risk can be established relatively easily.

The risk associated with a company is the function of countless potential outcomes that reflect a multitude of company specific and macro factors.

Examples of risks associated with Apple’s future cash flows:

• How much will the new 3G iPhone and price point increase sales?
• Will the economic downturn impact on the company’s sales?
• How big will the mobile web be and what will be the iPhone’s role?
• Can Apple continue their successful development of new and improved products?

The impact and likelihood of these factors are not directly observable like the outcomes of the roulette wheel but all contribute to Apple Inc’s discount rate. This makes the process of identifying and quantifying risk one of the major challenges of the valuation process.

A technical definition of the Valuecruncher discount rate

The discount rate used in the Valuecruncher valuation is the nominal post-tax weighted average cost of capital (WACC). The weighted average cost of capital is a combination of the required rate of return of the company’s equity holders (shares/stocks) and debt holders (bonds/loans).

Valuecruncher applies the discount rate to the company’s forecast nominal post-tax free cash flow (FCF). The free cash flow is calculated as a function of Valuecruncher inputs revenue, profitability, capital expenditure, depreciation and tax.

Wake up!! That was meant to be the boring part

Calculating, estimating or guessing the discount rate for companies

As stated the discount rate reflects the required rate of return on both debt and equity. The debt component of the discount rate is relatively easy to estimate based on the lending terms the company enjoys i.e. what interest rate (coupon rate) does the company pay. The required rate of return of the equity component is a more difficult proposition.

Practitioners often draw on mathematical approaches such as the capital asset prising model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return on equity. These like all approaches have their pro’s and con’s. Despite the mathematical fire power inherent in these models a subjective assessment must be made before they are incorporated into the discount rate. This subjective component relates to the relationship between the discount rate and the company’s forecast free cash flows. A discount rate calculated based on historic returns, alternative forecasts or expectations may not be consistent with the forecast free cash flow. Examples of this issue include when companies are shifting their focus (e.g. IBM’s restructuring) or the industry is in the process of dramatic change (e.g. newspapers).

There are extensive resources available online on calculating the discount rate:

• Investopedia
• Damodaran on Valuation (2nd Edition)
  
• Estimated discount rate for New Zealand listed companies – PwC Cost of Capital Report
• Estimated discount rate by industry for the United States – Aswath Damodaran’s discount rate table

The terminal value is a key component of any valuation. A significant portion of a company’s future cash flows will be generated beyond the Valuecruncher 3-year forecast period. The value of these cash flows is recognised in the terminal value calculation.

Valuecruncher uses a perpetuity (the company continues to generate cash flows forever) approach to calculate the terminal value that incorporates the discount rate, year 3 free cash flow and a terminal growth rate.

The terminal growth rate is an approximation that reflects the ongoing growth potential of the company’s cash flows. The company’s growth rate will fluctuate with economic and industry cycles with the terminal growth rate representing an average growth rate.

Key terminal growth considerations

• Historic growth rates
• Forecast 3-year growth rates
• Terminal capital expenditure (e.g. how much is the company investing in R&D)
• Competitive advantages (e.g. long-term contracts, rights or patents)
• Current and potential market size
• Industry dynamics (e.g. competition and barriers to entry)
• Macroeconomic factors (e.g. GDP growth and inflation)

When determining the terminal growth rate it is important to ensure the assumption is consistent with the terminal capital expenditure estimate, e.g. How much capital expenditure is required to support Apple’s forecast 5.75% terminal growth rate?

The argument is often made that a company’s stable growth rate cannot exceed that of the economy. This constraint does not apply to the Valuecruncher terminal growth rate. The Valuecruncher terminal growth rate reflects a combination of the intermediate growth potential beyond year 3 and the company’s stable long-term growth rate.

The table below shows an implied terminal growth rate assuming the company’s year 3 growth rate converges to a stable growth rate by year 10.

Critics of the discounted cash flow methodology often cite the sensitivity of the valuation to subjective assumptions such as the the terminal growth rate as a weakness. Any methodology that recognises that valuation is a function of the company’s future cash flows should be sensitive to the company’s terminal growth rate. It is important to understand the growth implied by the valuation. Valuecruncher allows you to easily understand and quantify a valuation’s sensitivity to the company’s terminal growth rate.

If you have any questions on how to implement the Valuecruncher terminal growth rate don’t hesitate to contact us.

This Newsletter continues Valuecruncher’s series on the valuation of early stage companies. We have previously covered alternative methods for valuing an early stage company (here and here) and now look at how that valuation is distributed across different equity instruments. Early stage companies generally have a number of different equity instruments in their capitalisation tables. Typically Founders will have common stock, employees will hold stock options and Investors (Venture Capitalists) will hold preferred stock. Each of these instruments represents different claims on the company’s equity.�
 

Part 1 of the analysis of the liquidation preferences outlines common preference terms in early stage term sheets and looks at their payoff profiles. An interactive Excel workbook that allows users to consider the payoff profiles of different liquidation preferences accompanies this analysis.

Valuecruncher Newsletter – Liquidation Preferences

Excel Workbook: Valuecruncher Preference Stock Payoff Tool *
 

*This workbook uses Macros. If Excel’s macro security is set to High the functionality will be limited. To utilise the full functionality of this workbook:       �
 

1. On the Tools menu, click Options.
2. Click the Security tab.
3. Under Macro Security, click Macro Security.
4. Click the Security Level tab, and then select the Medium security.                 �
5. Excel must be restarted before these changes to take effect.                       �
6. When opening the workbook select enable macros.

Related Reading:
 

Ask the Wizard
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A VC
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This Newsletter is a follow-up to the 30 March 2007 Newsletter Early Stage Valuations – A Venture Capital Approach. Since then we have extended our framework for the valuation of high-growth/pre-revenue companies. The Valuecruncher valuation report for early stage companies incorporates the Venture Capital (VC) approach and a detailed discounted cash flow (DCF) based scenario analysis. This Newsletter focuses on the appropriate DCF framework to use for early stage companies. Read more…

Valuecruncher Early Stage Valuation Report (Example) – Click Here

Over the last couple of months Valuecruncher has received a number of queries asking how to value early stage companies. The majority of these early stage valuations have been for the purpose of capital raising. Valuecruncher’s March Newsletter provides an outline of how venture capital (VC) investors approach valuation.

Typical valuation methodologies have limited or no use when attempting to value early stage companies.

• Discounted Cash Flow (DCF)

The uncertainty surrounding the financial projections of early stage companies limits the effectiveness of DCF valuations. Using a scenario analysis can provide an idea of value across a series of potential outcomes but the subjective nature of the scenario construction and relative probability of each scenario make it difficult to make an investment based on these outputs.

• Comparable Company Analysis

The absence of publicly available information and the loss making nature of early stage companies voids the use of comparable company analysis.

• Asset Based Valuations

Asset based valuation methodologies such as net tangible assets typically do not capture the value of the growth potential of early stage companies.

Valuecruncher has constructed a new valuation report that uses DCF scenario analysis to provide three alternative scenario based valuations reflecting a range of potential outcomes for the company. These scenarios are designed to highlight the value impact of not achieving projected targets. The new report template complements the DCF valuation with a VC valuation. The VC approach assumes that the investor requires a 10 x return on investment over 3-5 years. Valuecruncher estimates the value of the company at the 3-5 year horizon using the financial projections of the client and market data of comparable established companies. Working backwards from this estimated exit value Valuecruncher estimates a valuation today based on the VC investors required return.

The VC approach is designed to give a robust indication of the post-money valuation VC investors will place on early stage companies. It is important to note that the VC valuation represents a post-money valuation (value after any required capital has been raised), this valuation will generally be lower than the DCF base case but should fall within the range defined by the scenario analysis.

This new Valuecruncher valuation report uses the standard Valuecruncher Input Sheet.

Valuecruncher Early Stage Valuation Report (Example) – Click Here

Valuecruncher Valuation Reports include three approaches to valuation: economic (DCF), comparable and accounting (NTA). This newsletter discusses the role comparable company analysis plays in valuation.

Where DCF (discounted cash flows) and NTA (net tangible assets) focus on the specific characteristics of the company being valued comparable company analysis uses a relative approach. This relative approach values the company based on the market valuation of similar companies.

Comparable company valuation uses the valuation ratio of a publicly traded company or from the sale of a company and applies that ratio to the company being valued. The valuation ratio typically expresses the valuation as a function of a measure of financial performance (e.g. revenue, EBITDA or EBIT), occasionally operating metrics such as number of employees, customers or register users will be used in valuation ratios. The valuation figure used generally reflects the enterprise value (EV) or the value of the equity in the business; the equity value is usually represented by the share price.

Click here for a full pdf version of the Valuecruncher Newsletter.