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…

Valuecruncher has had a significant number of new subscriptions to the newsletter over the last month. For the benefit of new subscribers Valuecruncher would like to take the opportunity to highlight some of the most popular past newsletters.


What is a share price?

Premium for Control – 42 Below

Early Stage Valuations – A Venture Capital Approach

Comparable Company Valuations

The Cost of an IPO in New Zealand

The recent initial public offerings (IPOs) of Xero and BurgerFuel have cast the spotlight on the capital raising options for growth companies in New Zealand. This newsletter examines on the costs of an IPO for a growth company in New Zealand. This analysis focuses on growth companies that cannot raise significant amounts of debt due to the uncertainty surrounding their expected earnings. Read entire newsletter.

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.

Often at first glance the process of valuing your business can appear time consuming and intimidating. At Valuecruncher we have streamlined the process to the point where all that is required is a 1 page Excel worksheet and Valuecruncher will provide you with a 5 page valuation report within 48 hours. This post outlines the 5 steps involved in the Valuecruncher valuation process.

1. Collect the relevant information
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The starting point for Valuecruncher valuing a business is the latest financial statements. The business’ accountant should be able to provide you with a copy of these.
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Financial statements include:
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1. Profit & Loss Statement        

2. Statement of Cash Flows        

3. Balance Sheet
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Some accounting jurisdictions don’t require a Statement of Cash Flows – that isn’t a problem.  The profit and loss statement and balance sheet are the key starting point for completing the input sheet for a Valuecruncher valuation.  The only component we require from the Statement of Cash Flows is the capital expenditure for the business.  If there are any questions about the relevant information required – please don’t hesitate to contact the Valuecruncher team (http://www.valuecruncher.com/contact/).
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2. Input relevant information into the Valuecruncher 1-page input sheet
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Profit and Loss Statement
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We start with the Profit and Loss Statement.  We are interested in four inputs from the Profit and Loss Statement and information on capital expenditure: revenues, profitability, depreciation and amortisation charges, and capital expenditure.
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Compiling the Valuecruncher valuation input sheet: Profit and Loss Statement items – Example

Cash Flow Statement
The Cash Flow Statement provides the information required to compile the capital expenditure inputs.
Compiling the Valuecruncher valuation input sheet: Cash Flow Statement items - Example

Projections
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The next step is then projecting forward key numbers – revenues, EBIT, depreciation and capital expenditure.  Valuation is a forward-looking exercise, even if the business mature and stable it is still important to compile projections.  Valuation is based on future performance of the business.  This may be the same as the current performance but it can also be materially, or slightly, different – either better or worse.  For a Valuecruncher valuation the Profit and Loss Statement projections are the key input.  The key projections required for valuation purposes are revenues, profitability, depreciation and capital expenditure.
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Each business is different and has different expectations of future performance.  If the business is stable and not expecting to grow significantly then making projections is reasonably straightforward.  When the business is going through significant growth or the market the business operates in is uncertain – then the process is slightly more difficult.  It is however a good process for a business to look at what financial results it expects over coming years.  Making financial projections is subjective exercise that reflects the best estimate of an uncertain future. Don’t be intimidated by the uncertainty involved in compiling projections, they are only meant to represent the best estimate. Valuecruncher valuation reports provides sensitivity analysis that illustrates how alternative projections impact on the business valuation.
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At Valuecruncher we often see a reasonably high-level approach taken to valuation – which is just fine.  It is typical for a business owner to say something like “we expect revenues to grow at 10% per annum over each of the next three years with profitability (at the EBIT level) margin (as a percentage) remaining the same as it is today.  We expect depreciation and amortisation to remain about where they are today.  We will be spending an additional $50,000 in capital expenditure next year but then expect capital expenditure to remain at the current level”.  With information even at that simplified level – the Valuecruncher input sheet can be completed.  If a business has detailed financial projections then these should be utilised.  Most businesses do not however have detailed projections.  High-level assumptions are all that is required for completing the Valuecruncher input sheet.
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Some more tips for making projections
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Revenue projections – a simplified approach to revenue projections involves estimating the short-term (next 3 years) revenue growth as a percentage. The estimated percentage growth can be based on historic growth rates or incorporate any expansion plans the business has. Valuecruncher can assist to covert projected growth rates into actual revenue figures if required.
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Profitability projections – the best starting point for projecting profitability is the current levels. If the business is planning to introduce new technology or has recently increased production capacity it is possible that profitability will increase in the future – but there is usually an increase in costs associated with additional profitability. If a business has an owner that works in the business at a below market salary – this should be adjusted to market levels.
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Businesses run at break-even – Valuecruncher often sees businesses that are run at break-even.  Our approach to valuation with these companies is to look what the level of profitability that companies in the industry typically operate at.  Then we will extrapolate that industry average profit performance to the business’ sales.  This approach provides a reasonable assessment of the value of the business even when the business is operating at break-even.  We have a table of average industry EBIT margins (click here).  If you are unsure or have questions about the appropriate EBIT margin to potentially use Valuecruncher is happy provide assistance.
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Capital expenditure projections – when estimating capital expenditure required by a business it is important to consider the current status of the business’ assets and any investment that may be required for replacements or upgrades. Other examples of potential capital expenditure include research and development expenses.  The Valuecruncher input sheet also requires a terminal capital expenditure amount – this is simply the “typical” level of capital expenditure that the business would anticipate into the future.  We include this amount to ensure that capital expenditure figures do not get inflated by current spending and truly reflect the on-going capital expenditure of the business.
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Depreciation – the starting point for projecting the depreciation charge is the current amount. If the business plans to invest in fixed assets the depreciation charge can be expected remain constant and potentially increase. If the business has no plans to invest in its assets the depreciation charge can be expected to decrease.

Balance Sheet

The Balance Sheet inputs for the Valuecruncher valuation are only historic numbers – there are no projections required.

Compiling the Valuecruncher valuation input sheet: Balance Sheet items – Example

3. The valuation calculation
 Valuecruncher incorporates the projections and balance sheet values supplied by client (via the input sheet) into a discounted cash flow (DCF) model. Valuecruncher estimates the long-term growth rate and the required rate of return for the business. Valuecruncher will calculate the sensitivity of the valuation to the projected revenue and profitability supplied by the client. The sensitivity analysis provides an indicative valuation range.  The DCF valuation is supplemented by comparable company analysis and an asset based valuation.
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Comparable Company Analysis – Valuecruncher has an extensive database of information on companies in a wide range of industries around the world. Using the database Valuecruncher will compare the DCF valuation output with the implied valuation based on prices comparable companies have sold for and trading prices of publicly listed companies. Comparable company analysis is a relative measure of value that provides a check for the DCF valuation. The comparable company analysis does not incorporate the unique features and opportunities of a business but provides a market-based estimate of value.
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Asset Analysis – Valuecruncher calculates the value of the business’ net tangible assets (NTA). This is a purely accounting based measure that incorporates the current book value of the business’ assets.  NTA is not a forward looking approach and it does not evaluate the earning potential of the assets. The NTA methodology is often impacted by the accounting treatment of assets (i.e. depreciation policies).
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These three valuation methodologies form the cornerstone of the valuation frameworks used in global investment banks and major accounting firms.
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4. Valuecruncher review the valuation
 Upon completing the valuation calculations a member of the Valuecruncher team will independently review the valuation including the projections and inputs provided by the client and the assumptions applied.
Common issues identified with valuations include:

• Client revenue projections are overly optimistic reflecting a “best case” scenario opposed to an expected case.
• EBIT margins are too high because all costs are not being incorporated. Often the “actual” owner’s salary is not fully reflected in the financial statements.
• EBIT margins are too low because the company is being run at breakeven point with the owner expensing items through the business that are not part of the business’ operations.
• Projected capital expenditure does not reflect the investment required to generate the projected growth.
   

If Valuecruncher identifies an issue that materially impacts the valuation the client will be contacted to clarify the issue before the valuation report is generated.
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5. Valuecruncher provide the valuation report
 Valuecruncher compiles the inputs provided and the valuation outputs into a five-page valuation report. The valuation is expressed as an indicative range based on the DCF sensitivity analysis with a mid-point reflecting the inputs and projections supplied by the client; this is supplemented by the implied comparable company and NTA valuations. The report includes a summary of the valuation outputs and highlights any assumptions that may need to be reviewed. If after inspecting the report and assessing any potential issues raised by Valuecruncher the client wishes to revise the initial inputs provided, Valuecruncher will provide an updated valuation report for no additional fee.

Get a Valuecruncher valuation - click here

Download a PDF version of 5 Steps to Valuing a Business - click here