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How To Value A Company – Redux

How am I supposed to value a company? That’s a question a few investors asked us in our Ask a Foolish Question exercise. We’ve often, and will always, preach about the importance of buying the shares of a company only if we think it proves to be a discount to its estimated underlying intrinsic value.

Of course,  the problem for many comes when they’re trying to estimate that value, hence the question. It must be said that valuing a company on your own might seem intimidating. Companies are large, complex entities, and each seems to have its own nuances. So, how are you supposed to look at all of the pieces and determine what a company is worth?

My Foolish colleague Sudhan gave a great rundown on some valuation measures that could be used, but he also cautioned on the need to be aware of the assumptions and inputs we use when trying to value a company.

In here, we’ll expound on another valuation method in addition to illustrating how our assumptions can change the valuation-picture drastically.

The discounted cash flow model

The discounted cash flow (DCF) model assumes that the value of a company is the sum of the present value of all the cash that the company will make in the future.

That sounds simple enough but probably the trickiest part of the DCF model is the concept of discounted value or present value. This concept becomes clearer when you consider how the value of money changes over time.

Suppose that we’re willing to give you S\$20 either today or in 10 years. Most likely, you’d choose to have the money today. After all, there will likely be inflation over the next decade, so you’ll be able to have more chicken rice with that S\$20 now than you’d be able to buy in 10 years. Or perhaps you like money more than you like chicken rice so you decide to invest that S\$20 in Singapore government 10-year bonds earning annual interest of around 2.5%. In 10 years, that S\$20 will have grown to S\$25.60. Thus, S\$20 now is worth 28% more than S\$20 in 10 years.

Now turn the question around. What is the present value of S\$20 in 10 years? In other words, how much money would we need to leave in 2.5% bonds to have S\$20 at the end of 10 years? The answer is S\$15.62 (S\$20 divided by 1.025 to the power of 10). 10 years in the future, you could consider an IOU for S\$20 as worth only about S\$15 today, because the discounted value of S\$20 is S\$16. In this case, 2.5% would be the discount rate.

The DCF model uses this method to calculate a company’s value by discounting to present value the money that the company will make in the future.

The Devilish Details and why assumptions matter

Now that we have the big picture overview of what a DCF is, let’s get down to where all the fun is: the details.

Vehicle testing and commercial inspection firm Vicom (SGX: V01) earned S\$26m in free cash flow in 2012, so if we assume that it would earn that amount every year for the next 30 years, we can calculate its value, using a 2.5% discount rate, as follows:

 Year Free Cash Flow Discount Discounted Value 1 S\$26,000,000 1.0250 S\$25,365,854 2 S\$26,000,000 1.0506 S\$24,747,763 3 S\$26,000,000 1.0769 S\$24,143,584 29 S\$26,000,000 2.0464 S\$12,705,193 30 S\$26,000,000 2.0976 S\$12,395,310 Total S\$544,187,607

The company had 88.227m shares outstanding at the end of 2012, so the value of a share would be about S\$6.17 (S\$544m divided by 88.227m shares).

But, if you now play around with the DCF model, you’ll find that the company’s value can change dramatically depending on the inputs. Before you freak out, bear in mind that this is normal and acceptable.

The core of the calculation is an estimation of the cash that the company is likely to produce in the future. This is known as a company’s free cash flow.

If the most recent year has unusually high or low free cash flow, you can use an average of several years, or just a reasonable estimate. This could be justified if, for instance, the most recent year had unusually large capital expenditures. When doing these calculations, remember that we’re making an estimate, and that precision has little value. We just want to be roughly right, so don’t stress out over trivial details.

Of course, free cash flows do not remain constant. They change over time and we’ll ideally want to see it growing in the companies we own shares of. When building a DCF model, we typically assume that the company will grow at a particular rate for the next 10 years and then continue to grow at the rate of inflation. After all, it’s difficult to estimate what cash flow will be 10 years in the future, and as a company gets bigger, it becomes increasingly difficult to grow.

A simple way of estimating growth rates is to start with analysts’ estimates and discount them by 10% to 20%, since analysts tend to be unrealistically optimistic. If analysts think a company will grow by 15%, I’d use 13%, for instance. Be wary of estimated growth rates of more than 25% – companies have a difficult time sustaining such levels.

The discount rate should reflect inflation, your confidence in the sustainability of the company’s growth, and the price of no-risk investments. The riskier the business, the higher the discount rate should be. We can usually use discount rates between 9% and 16%, with most companies falling near the high end of the range.

To illustrate how different assumptions can lead to widely varying estimates of values, let’s play with these different scenarios for telecom operator Starhub (SGX: CC3), which earned S\$326.4m in free cash flow for the last 12 months and had 1.721b outstanding shares:

1) Scenario A – 10 year growth rate of 10%, followed by a 3% inflation rate. Discount rate of 9%

2) Scenario B – 10 year growth rate of 15%, followed by a 3% inflation rate with a discount rate of 9%

3) Scenario C – 10 year growth rate of 10%, followed by a 3% inflation rate with a discount rate of 16%

The calculated ‘values’ for Starhub based on these three scenarios are given below:

 Value Per Share Scenario A S\$5.56 Scenario B S\$8.14 Scenario C S\$2.32

Foolish Bottom Line

As you can see from the table above, our estimates of value for Starhub’s shares can vary wildly depending on the inputs. The telco’s current trading at around S\$4.30 a share, so slight tweaks in our inputs can spew out a number that shows the company to be either overvalued or under-valued.

Thus, the most important factor – and the one thing you should remember – in the determination of a company’s value is in the quality of our inputs. There just aren’t hard and fast rules that we can apply to every situation and say that a company’s undervalued.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.