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## Revaluing Shares In A Downward Market

As I watched share prices fall today, I’ve been considering how my previous calculations were all based around an expected minimum return of 5% pa after tax and whether or not this is valid anymore. The reason for this consideration is that there are some defensive stocks that I believe will continue to be profitable during the oncoming fray which appear as bargains using my previous formulae.

Before discussing this further I will share how I arrived at the value of an expected minimum return of 5% for my calculations. The value of 5% was basically the sum of the Risk Free Rate (which is the rate you can invest your money with theoretically zero risk – in my case my mortgage rate) plus a generic Risk Premium (representative of risks to the economy, outside of those factored into expected future return for the specific company) plus the amount I would like to make for taking that risk after considering tax (because my investment proposition is based on the return I want to make for myself, not the IRD).

In the derivation of the value of the 5% lies the problem, which is that the Risk Free Rate has increased and is set to increase in the coming year or more; hence the cause for concern over inflation for investors. Additionally the Risk Premium has also increased to reflect the level of uncertainty and negative sentiment for the future economy. Therefore it seems obvious that shares cannot be valued using my previous calculations.

I’ve already talked about how PE is no longer a good way to value stocks because it assumes a linear, constant progression of company earnings, but as you can see, there are some fundamental components to the way PE should be used that are also falling apart because it’s harder to assign a Risk Premium and Risk Free Rates are changing and unpredictable in the term that I look to invest in (years).

There are two components to calculating value in a company using PE: Firstly calculating the PE, then calculating what PE is appropriate for that particular company.

Lewis Hurst

The problem with investing in your Risk Free Rate option is that there’s also no risk of upside. This may change my financial models if we spend too long in these doldrums. Whatever the state of my modelling, it seems that I have no other course of action than to wait until the future of OCR changes becomes clearer, which will be preceded by tamed inflation; inflation being a sign of how the Risk Premium will be affected, also.

Categories

## Why PE Is No Longer A Good Way To Value Shares

Long time readers of my blog will have realised by now that I love to use PE to value shares (with the exception of angel investment, because it’s more complicated). I have a very handy set of graphs I use to show the value in PE over time, which I use to discern what PE is appropriate for any given growth. I like this method because it’s quick and easy so I’m less likely to make a mistake. It’s also shortsighted, looking only a few years ahead, which is great because my experience of business tells me that predictions looking further than a year are guesses anyway.

Unfortunately, given the downward outlook for the economy, my graphs have become irrelevant as they all model positive trajectories. I contemplated making new graphs assuming negative growth, but figured that there’s no point without calculating future growth beyond the negative – otherwise where is the value in buying such a stock?

A poster on ShareTrader.co.nz (I think it might have been Winner69) stated that a PE valuation is just an abstraction of a DCF valuation (or words to that effect), and I wholeheartedly agree with that statement and it’s something I’ve opined to myself before, though I would append just two extra parts to that:

A PE valuation is an abstraction of a DCF valuation, that is shortsighted and only accounts for unidirectional growth at a constant rate.

Lewis Hurst

It is in this statement that belies the fault in using PE for valuations in the current stock market; growth will likely be neither unidirectional or constant.

Therefore I posit that presently some form of DCF valuation is a more appropriate way to value listed shares in the current market, though it’s also worth remembering that any valuation methodology would have to be selected / designed with your investment strategy in mind. On that note, I feel that dividend / income investors (such as myself) should also be considering value based on a DCF rather than potential dividend value, because as profits diminish and business risks increase, dividends can be cut disproportionately to the market value of the stock; hence a dividend based valuation could price you out of the market and cause you to invest later than you otherwise would, which would end up reducing your dividend yield.

Categories

## How To Do A Business Valuation

There are a number of different ways to value a business, and although there are a few recognized methods, business valuations are as much of an art than a science.

This article discusses the types of valuation available, when to use each type and links to other articles showing how to do each respective type of business valuation. By the end of this article you still won’t know how to do a business valuation because there are many significant subtleties that are unique to the business you are valuing, but you’ll have a good start from which to grow your knowledge.

## Choosing The Right Type Of Valuation

The outcome of a valuation will depend on the type of valuation chosen, the values used in the valuation and the reason for the valuation. That’s why the first step in valuing a business is to choose an appropriate method of valuation.

### The Football Field Approach

The Football Field approach isn’t really a type of valuation, more of a method of helping to choose a valuation type. Ironically, given that choosing the type of valuation is the first thing to do, a Football Field can only be done once you’ve done every other type of valuation available.

This isn’t my favorite way to choose what type of valuation to use, but it’s something that I do because it helps get your head around the valuation and give some sense of how the chosen valuation method fits in with alternative ways to value the business.

When I do a Football Field, I perform each type of valuation that can be done on the business thrice; once with a pessimistic view, once with an optimistic view, and once with a view of what the most likely outcome is. Then I place them all in a graph so I can see how each type of valuation compares.

You can then use this to see any commonalities between the different types of valuations and where the upper and lower values are.

## Valuation Methods

Here follows a synopsis of various valuation methods, their appropriateness to different types of business and a link to a more in depth description of how to value a business using the respective method.

### Discounted Cash Flow (DCF) Analysis

A DCF Analysis is primarily used by accountants to calculate the value of a business in terms of its total worth across a 5 year period. This valuation method is typically used when determining the monetary value of a business for the purpose of arbitration or contractual value. For example, it may be used to calculate the equivalent cash value of a shareholders stake in a company if that shareholder were to be subject to a Call or Put Option.

A DCF Analysis is less frequently used as a method to calculate the market value of a business because (while it may factor opportunity cost or depreciation of the value of money invested in the return in the business – AKA the “Discount”) it typically doesn’t consider a margin of profit for the buyer to entice a purchase.

That said, a DCF Valuation does provide the benefit of factoring in future growth of a company and therefore may be argued as a suitable way to value high growth companies; hence I use my own version of a DCF Analysis when valuing growth companies, which includes a margin of profit – a model that alters based on the exit strategy for the investment.

A DCF is probably the most complex method of performing a business valuation and is not relevant when profit is low compared to revenue (or if profit is negative), as there is value in such a company that is not apparent through the profit (such as goodwill, IP, etc.).

Here’s a Wikipedia article on how a DCF Valuation works.

### Comparable Market Analysis

The Comparable Market Analysis (AKA Comparables Market / CM Valuation) involves finding historic sales prices of comparable businesses and using these to deduce what the business might be worth.

The Comparable method is typically used where there is a lot of sales data available in an open market – such as in a stock market or business broker.

The Comparable Market Analysis is heavily influenced by market sentiment and can result in wildly different valuations depending on when it’s done. This can lead to a Greater Fool scenario and also be subject to market manipulation. In the absence of these issues and a short investment time-frame, this is arguably one of the best valuation methods because it tells you what the business is worth at that time.

The problem I have with this type of analysis is that it doesn’t consider the return an investment can give you relative to the performance of the company in the absence of a sale or change in the market conditions, and it relies of the analysis of others.

Therefore, I posit that this type of valuation is most appropriate for stock market traders (but not stock market investors) and business brokers who have access to historic sales data and have some control over the market.

### Discounted Dividend Model (DDM)

This is basically a DCF valuation based on dividend return instead of NPAT, which gives the perspective of value of a business based on the return to the investor in the absence of a sale. Truthfully I don’t use this method and don’t know much about it. There’s a really nice Wikipedia article on DDM if you’re interested to learn more.

I suppose this method could be useful for a retiree who wants to calculate Return On Investment (ROI).

### Price-to-Earnings (PE) Ratio

The PE value of a company is calculated by dividing the Market Capitalization (MC) of the company by its earnings (Net Income – dividends). This can be done as a backward PE (where the last reported annual figures are used to calculate earnings) or a forward PE (in which the forecast earnings are used in the calculation).

Also, check out my own proprietary method for calculating PE.

### Multiples Of Revenue

This is a common method of valuing businesses for sale by business brokers. It’s sort of a lazy method because it doesn’t attempt to calculate the value of a company in any depth. It doesn’t consider the effort required of the company to be profitable or the value of the assets that the company holds (though often business brokers will add the value of stock to this number). There are other methods of valuing a business that business brokers use, many of which consider a salary component for the owner, though these methods are beyond the scope of the type of investing I do; hence will not be discussed here.

The benefit of using multiples of revenue is that it does place some value on the company that is relative to its capacity to become profitable if that is not currently the case. Also the value of the goodwill, IP and other aspects could (lazily) be considered to be relative to the revenue of the company, which otherwise may not be recorded in the company’s profit.

This type of valuation is also often used when valuing companies whose customer base is on an Annual Recurring Revenue (ARR) pricing scheme.

I like this valuation method when based on multiples of ARR, but prefer to derive my own valuation method based on the component of a company’s ARR that has the capacity to be profitable (I blend elements of DCF in this method).

This is because I only want to invest in companies that are capable of being profitable so they can offer multiple exit opportunities (sale, Put Option, dividend return, etc.). Also, while theoretically a company could give a positive return on investment if the valuation is based on multiples of ARR, while the cost of growth is less than the multiple of ARR growth, this could lead to a Greater Fool scenario with no other exit than a sale.

## Summary

There are a lot of methods to value a business, and I’m sure there are more than I have listed here, and after reading this you can probably appreciate why it’s important to chose a type of valuation that’s relevant to the purpose of your valuation.

Whether you’re valuing your business for sale, looking for investment or trying to decide what the business is worth so you can buy out a business partner at a fair price for all parties involved, there are many valuation methods to chose from. Though given the number of scenarios of requiring a business valuation and the variable nature of finding value in different businesses, there’s no single method for every case.

This is why I suggest that if you are an investor, you should come to your own conclusion about the method of valuations that you use, or make your own valuation methods as I have.

Addendum: An investor should also consider soft aspects of value in a business (such as IP or value in directors). An investor should also watch out for creative accounting and consider the reliability of forecast profit projections. There are a number of things to consider when valuing a business that are not discussed here, and they are learned with experience; hopefully this article sets you up with the basics to get started and my analysis of stocks on this website will help fill in the gaps and grow your knowledge on the subject of valuing businesses.