We have been fairly quiet when we have released changes to Valuecruncher.com in the past and thought it was high time that we started sharing more about the enhancements.

Homepage enhancements

Over the last few months we have overhauled the design of the company and valuation pages and it was time for the homepage to get a face lift. In this most recent release we have made the following tweaks:

• A larger list of recent valuations
• More visible help on how to create valuations
• A link to our private company valuation service
• Generally improved the visual appearance of the homepage

Valuation enhancements

Previously, if you updated an existing valuation it would replace your old valuation. We decided it would be more helpful to users to be able to compare new and older valuations they had created and therefore updating valuations will now cause a new one to be created.

Many other small tweaks

There have been many other small changes made around the site that are designed to improve your experience with the Valuecruncher site.

We appreciate any feedback that users have about the site and actively take it into account when planning new features (of which we have many on the way!). Drop a comment and tell us how we could help you better find stocks to buy or sell.

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.

Like others - we here at Valuecruncher are being asked how we are following the current developments in international financial markets.

There isn’t a single source of information we are leaning on heavily - but we are amazed by the depth of the coverage from a wide range of sources. But such is the financial media scape in 2008.

We are following what we would call traditional financial media such as The New York Times, The Wall Street Journal, FT and The Economist. Interestingly it is totally consumed on-line - print media is just too dated. This was especially true today.

The coverage in the traditional financial media has been generally very strong - but it has been the new media players in the finance space that have been the revelation through this period. Some examples:

Henry Blodget’s Clusterstock has had a reporter in Washington giving sports-style updates and answering questions from readers via comments.

There is fantastic analysis coming from very smart on-line commentators such as Nouriel Roubini, Barry Ritholtz, Paul Kedrosky and Roger Ehrenberg. Some very insightful input is also coming from people commenting on these posts. Before blogs we would never have had access to these types of minds in these situations. Amazing.

There are also access to deep strategic thought on the issues we are facing today - and a track record of asking hard questions before this all began (from April 2008).

Scary times - but we have never been so fortunate in the access to analysis we have today.

With the turmoil in the world’s financial markets over the last few weeks we have been asked why we don’t have valuations of financial institutions here at Valuecruncher.  The last few weeks have actually shown exactly the reason why we don’t.

When we launched Valuecruncher our objective was: “making the valuation methodologies used by corporate finance professionals more accessible to a wider audience”.  To achieve this we provide a three-year discounted cash flow (DCF) calculator.  This approach works well for most companies.  However there are several instances where it does not.  One of these is financial institutions.

For financial institutions (such as Goldman Sachs) a key to understanding their intrinsic value is the value of assets and liabilities held on their balance sheet - in the form of different financial securities.  These assets and liabilities are difficult to value (as an outsider) in normal times - and almost impossible at the moment.  This isn’t the case for a company like Microsoft - where balance sheet items (such as cash) are important but easy to measure.  Microsoft’s value is driven by the cash it generates from selling software - and adjusting for cash and any debt on the balance sheet.  Goldman Sach’s earnings are important - but not as important as changes (both positive and negative) to the securities they hold on their balance sheet.  As the current financial conditions illustrate - the value of these assets can move quickly and dramatically.

Some quick numbers:

Microsoft: 2008 revenues US$60.4bn, operating income US$22.2bn, total assets US$72.8bn, total liabilities US$36.5bn, total equity US$36.3bn.  Market Capitalization US$250bn.

Goldman Sachs: 2007 revenues US$88.0bn, operating income US$17.6bn, total assets US$1,119bn (US$1.1 trillion), total liabilities US$1,077bn (1.1 trillion), total equity US$42.8bn.  Market Capitalization US$54bn (Note: this market capitalisation is approximately 55% of the 52 week high).

Two companies with comparable revenues and operating income (and total equity) - but very different balance sheets.

Valuecruncher will help you to value Microsoft - but not Goldman Sachs.  Here at Valuecruncher we are focused on providing tools for valuing listed companies.  If the tools we provide are not appropriate for a particular company or industry (i.e. financial institutions) then we will exclude those companies.

Note: the other significant industry that we don’t cover at Valuecruncher is natural resources companies.  This is for a similar reason.  The value of natural resources companies is driven by the assets they hold (i.e. oil and gas deposits) not near-term cash flows.  Hence we don’t cover natural resources companies either.

Here at Valuecruncher we have been a contributor to SeekingAlpha for close to 18 months.  SeekingAlpha aggregates on-line finance content fromsources such as Valuecruncher (for US stocks only).  SeekingAlpha then syndicate this content to other on-line finance sites such as Yahoo Finance.

Valuecruncher author page on SeekingAlpha

Because SeekingAlpha has a large audience and host edited copies of our content on their site with the ability for users to comment - we typically see a lot more comments on our content there than on our own site.  For example - this valuation of Apple ($AAPL) has 26 comments.

This week we had a classic comment on another valuation we did on Apple ($AAPL).  The comment was “Valuecruncher reminds me of the Transmogrifier from Calvin and Hobbes”.  We thought this was genius.

So for all those that don’t know Calvin and Hobbes from the great Bill Watterson - the Transmogrifier:

Favourite line: “it is amazing what they do with corrugated cardboard these days”.

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:
 

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This post started as a comment on HipMojo’s post Does Google Deserve to be Worth more than Walmart or Toyota Corp? but as the response passed 500 words I thought it warranted a post in its own right. Market capitalisation only represents the value of the equity of a company. The appropriate metric for comparing the value of companies is the enterprise value (EV), using the EV accounts for the differences in capital structure.

Google’s EV is currently approximately $170 billion (Google’s EV is lower than its market cap due to the cash and cash equivalents on their balance sheet) compared to Wal-Mart’s $220 billion. Wal-Mart is worth approximately $50 billion more than Google but the gap is closing. In the last financial year Google had revenues of $10.6 billion and EBITDA of $4.6 billion. The current price implies an EV/EBITDA multiple of approximately 34 for Google. Correspondingly Wal-Mart had revenues of $348.5 billion and EBITDA of $26 billion. The current price implies an EV/EBITDA approximately 8.3 for Walmart. Care must be taken when comparing valuation multiples. The two key reasons for Walmart’s EV/EBITDA multiple being 25% of Google’s are that Walmart does not have the same growth potential as Google and Walmart’s significant capital expenditure (~$15 billion per annum). To answer the question does Google deserve to be worth more than Walmart or Toyota Corp depends on whether the current Google price is justified.

Google’s performance to date has been driven adwords (87% of net revenues in 2006). Adwords is an excellent business that generates great margins and still has significant growth potential. Two key factors in the success of the adwords business model are the technology (Google’s search algorithm) and content (the web). Google’s focus on developing and refining its search algorithm in its formative years has resulted in it obtaining over 80% of the search market. The second factor in the success of the adwords model is that the content is the web, which is effectively free; the free content drives the great margins generated by adwords. Google will continue to dominate search at least until the next breakthrough in search technology and depending on the nature of the breakthrough they may still maintain the dominant position.

The success of adwords has allowed Google to build an inventory of text ads that they have been able to leverage through adsense. The key difference with adsense is that the content is not free and Google must share this revenue with the 3rd party sites resulting in significantly lower margins. Google are looking to broaden their ad serving capabilities with the Double Click acquisition.

Google’s current value is driven by expectations of the future online advertising spend. This growth is being driven by the increasing amount of time we are all spending online. The more people and more time spent online will result in more searches for Google to monetise and more click throughs on their adsense servings. A significant portion of the projected growth in the online advertising spend is not paid search or contextual text ad placements. As individuals consume more and more media online as opposed to traditional mediums such as print and television the advertisiers will follow. The question is how much of this non-search advertising revenue can Google capture.

As Google builds its advertising inventory it is well placed to monetise product lines such as Google Apps. The key difference between these opportunities and search is Google doesn’t yet have the superior product and faces significant competition. Google can still get a take a slice of the action from third party products via adsense but the margins are significantly lower than if they were being served on Google websites.
Google sites such as YouTube have potential to monetise premium content but they are still developing an advertising model. The key issue around Google’s potential non-search advertising revenues is the margins. How much of the projected online advertising spend will end up at Google’s bottom line in other words how much will Google have to pay to content providers? The internet offers the ability to distribute content through one channel to a far greater audience than print or television but will the cost of this content as a percentage of revenue be any different in an online world (this is the content cost not distribution costs)?

Google has the ability to serve ads around user generated content but unless this content is on Google websites the margins will be in line with those currently being achieved by adsense.
The point of this is that Google’s adwords business is a great operation. They are very well placed to capitalise on the increase in online advertising given their advertising inventory and ability to leverage users of their existing services. The two issues differentiating these opportunities from search are the absence of a technological advantage and cost of content.

Google’s current price is consistent with analyst’s estimates. These estimates are based on significant growth (22% EBITDA CAGR over the next 10 years and a terminal growth rate of 7%). I think Google’s adwords business still has significant growth potential and they are well placed to grow their non-search business but I think the market is over pricing this growth potential and the current price does not fully reflect the potential for significantly lower margins in new business lines, competition in non-search segments and the general uncertainty as these new business models emerge.

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…