I am reading the B2B Institute’s B2B Trends, which is excellent so far. But on p.14, while I agree with their point about long-term brand building, I question a supporting statement:
« Good CFOs understand that businesses are valued not on current cash flows but on future cash flows. By some estimates, 80% of the value of your stock is based on sales 10+ years in the future. »
So I posted the question of Twitter and got some insightful responses.
Participants:
- Matt Bergman, an attorney with extensive experience in bankruptcy law and business valuation. (USA)
- Louis Gudema, author of Bullseye Marketing (USA)
- Andrew Everett, Editor, The Key Point (USA)
- Colin Lewis, Fellow with the Marketing Institute (Ireland)
- Rick Nason, finance professor and author of several books including It’s Not Complicated, Rethinking Risk Management. (Canada)
- Alastair Thomson, accountant and author of Cash Flow Surge (U.K.)
Andrew Everett Really? Each $1 of earnings today is worth more than $1 in five years, which is worth more $1 in ten years, based on the discount rate. So, it seems backwards: near-term earnings should have more weight on stock price than distant-future earnings. The missing factor is growth rate. I guess if you had low near-term earnings then hockey-stick growth for 10 years, conceivably the statement could be true. But it doesn’t sound typical. Again, I’m not disagreeing with the value of building brand equity. But I’m intrigued by the question raised about stock valuations.
Rick Nason: I believe point they r making (have not read article) is companies r supposedly long term entities & given that, most of the valuation comes from the very long term. You are correct, $1 today>$1 tomorrow. Rest of comments in thread about long term forecasts (WAGS) also correct
Matt Bergman: from a pure #valuation standpoint, using discounted cash flow, it is actually the case that the terminal value accounts for *most* of the estimated value. BUT, done properly, estimating terminal value requires deciding when you expect a firm to reach steady state growth (big constraint – steady state growth can’t be higher than growth of the economy at large). Many mature firms may well be in steady state growth now whereas, of course, a startup – if it survives – is likely many years off. A good DCF, IMHO, while specifically forecast 5-10 yrs of free cash flow & then turn to terminal value (it’s cheating to do terminal value by just inserting a multiple).
In modeling, one has to make some decisions about how to handle growth, specifically whether to use a multi-stage model. IMHO, Aswath Damodaran is the foremost expert on the planet on this stuff. You may want to see [PDF], starting at slide 35.
your instincts are def right – ultimately, terminal value accounts for bulk on sheer mechanics: TV captures long time period (let’s say 15 yrs). So even tho cash flows that far out=more heavily discounted, cumulated 15 yrs of FCF > ~5 yrs of granularly projected FCF.
BUT & I should have noted this earlier, getting a terminal value via steady growth doesn’t work if the firm is at the end of its life-cycle, i.e. of course many firms that don’t have a yr to live, let alone 20. In that case, TV usually=liquidation value.
Andrew Everett: Thanks for all of your tweets! Lots to think about. Interesting point about of cumulative value of heavily-discounted future earnings > near-term earnings. That assumes companies will survive that long. Hard to predict changing conditions 15 years out.
I appreciate the help understanding the logic. I remain skeptical of long term cash flow forecasts. 15 years ago, how would one have forecast future value of MySpace or Washington Mutual or any the retailers that went out of business in 2020? Wrongly.
Matt Bergman: Oh for sure, absolutely a major reason why #valuation is as much art as science
Alastair Thomson: Andrew… I know what you mean. It’s one of those statements which can be true but isn’t necessarily always true I’d endorse the points Matt Bergman has already made, but would observe some current valuations require some truly heroic assumptions about future growth rates.
Matt Bergman: A great point – tho I’m myself a DCF purist, essentially think that if working exclusively with multiples, you’re pricing rather than valuing (even tho in theory same fundamentals that explicitly drive DCF ought to implicitly drive multiples). No doubt some multiple insanity
Alastair Thomson: Good point on the pricing vs valuing Matt…
I’d also observe the role played by ultra low interest rates (and therefore discount rates) in valuations. At more traditional rates of say 5-7% cash flows more than 10 years out play a very small role in a DCF calculation. At 0.5% they form a much larger part in a valuation.
Matt Bergman: Absolutely – IMHO, jury’s out on whether we’re in such a different secular interest rate regime that higher valuations – while surely still stretched in many current cases – are indeed new normal
Alastair Thomson: Agree with you there, Matt. Who knows what the future might bring… (My personal bet is higher interest rates, but it might take a while…)
Matt Bergman: I hope you’re right – at least to an extent – feel like it’d be a sign of a more fundamentally healthy economy
Alastair Thomson: Yes, that’s my perspective too. In a sense I don’t want it, but in a sense I do…
Colin Lewis: Even in MBA classes where sometimes things are disconnected from real world,10 yr horizons are not talked about.I always found DCF a bit odd as its time horizon is longer than most corporate planning cycles.I guess that’s why a 1 or 2 yr ROI is much more in vogue for investments
Rick Nason: Very true, but equally distorting to discount the future value to zero. ROI has its own flaws – which are many. DCF, aka NPV, while not perfect is still the best method in my opinion.
Matt Bergman: It’s a good point on time horizons, for sure. Also agree that most MBA courses aren’t – and shouldn’t – be explicitly talking about 10 yrs. certainly no cares about a guess on random line items, i.e. inventory.
Alastair Thomson: Thanks, Colin. I think it depends on whether you’re talking about business valuation (in which case some DCF-type cash flow appraisal is vital) or project approval on the inside of a business, in which case I agree a 1-2 year RoI or cash breakeven is much more in vogue.
Matt Bergman: Agreed 1000% – the “value” of the biz is in theory simply the summation of current & future free cash flow adjusted for risk – tho in practice, of course, most deals are priced w a multiple (comp companies or precedent transactions)
Alastair Thomson: Very true. I like to have a stab at a DCF valuation, though, even on a back-of-an-envelope basis, as that’s a useful perspective to have (agreed that in practice multiples are usually how it’s done, though)…just helps put some of the wilder valuations in context… 😉
Rick Nason: For one of the few times I will argue against Alastair. For project analysis, I believe that NPV is clearly superior to ROI methods. Breakeven (payback) may be the worst method (for any type of analysis).
Alastair Thomson: To be fair Rick, I wasn’t saying I supported those methods…apologies if I gave that impression…just that those were the methods I saw most often in practice… Don’t worry, we’re still on the same page, my friend…!
Rick Nason: Agree then. Yup, ROI and payback are still frequently used – although why for payback beats me. (Do these people not realize that we no longer have to do all of the calculations by hand?)
Louis Gudema: 10+ years into the future? Who can predict that with even a massive margin of error?
Matt Bergman: Surely no one. Re steady state growth, fairly common practice to start by setting it = to risk free rate. It keys off last specifically projected yr. For early stage firms, inevitably will wrong. Fully mature firms that are already-or near steady state=easier but less interesting
Also looking to produce a range, though many will regrettably offer one “very precise” number to like, the third decimal
Alastair Thomson: Yes, that always makes me laugh…our operating expenses in 10 years’ time will be 43.975% of sales revenues. That’s when I know I’m dealing with an idiot. (Although that can be useful information in and of itself, of course…)
Louis Gudema: When I look at the fate of many “fully mature firms” over the past 20 years, I don’t think steady state is all that it was once cracked up to be. With the acceleration of tech innovation disruption in industry after industry will only accelerate.
Matt Bergman: Great point & fully agreed. In #DCF #Valuation, in estimating terminal value, for starters, you’d only use a steady state framework if you expect the firm has room to run in its life cycle (otherwise, might use liquidation value).
entire “steady state” construct emanates from mathematical simplicity of estimating PV of constant perpetuity. Of course reality is different & good modeling *tries” to account for it. e.g. TV can be computed by taking initial steady growth % & systematically decreasing it to 0
can also set “steady state” growth % as negative. Louis, no doubt life cycle of firms has been shortened. evidenced in all sorts of ways. & models need to try to account. E.g. in estimating long term growth, need to analyze moat/sustainability of existing competitive advantage
Accelerated life cycles, IMHO, call for more robust consideration of hybrid #valuation approach that brings in #real #options where appropriate. not always applicable. But in such fast moving climate, think options to expand, delay, defer, abandon etc. are relevant more often
Louis Gudema: This is not my area of expertise, so I’ll just toss in another uninformed comment: a company is worth what someone is willing to pay for it. For example, if there’s a strategic fit it may be worth a lot. If not, little/nothing. I recall ~20 yrs ago British Telecom offered $21B for MCI. Shareholders didn’t like it so they renegotiated to $18B. Then Worldcom and another company separately offered ~$30B, which Worldcom ultimately won w more cash. And then went belly up. ¯\_(ツ)_/¯
When I sold my agency the offers were all over the place, and we were a SaaS company with recurring revenue!
Matt Bergman: Thanks as always. Hugely important and fundamental distinction you raise in the purpose of the valuation in the first place, i.e. is to assess going long a stock, an enterprise sale, a prospective merger, or even appraisal for tax or divorce.
For me, when investing in public equities it’s worth it to get my best estimate of “intrinsic value” which I believe exists but isn’t knowable w certainty. if I think both that price is below intrinsic value AND reasonable to expect convergence over my time horizon, worth a look.
But in valuing businesses for purposes of a reasonably imminent major event: sale, merger, liquidation etc., I’d def primarily rely on market pricing w an eye toward a multiple based on comp companies or precedent transactions.
I’d still take a best crack at DCF, but that’s fundamentally trickier w a private firm & certainly more likely it’s simply not useful given horizon constraints. as you personally know, selling a biz isn’t an academic exercise, hopefully it needn’t be rushed but real world timing
Andrew Everett: This also makes the value of $0 dividend stocks more dubious. Price = DCF of earnings that investors will never see. DEC comes to mind. Invincible #2 computer company for decades until it fizzled out quickly. Never paid dividend.
Matt Bergman: That’s an important point. There was a time when really the only true DCF model in use was dividend discount model, under which – strictly – if no dividend, pv=discounted liquidation value. Free cash flow models look to what a firm *could* pay out
Alastair Thomson: This is why ultimately valuation of any co is only what someone’s prepared to pay for it. Hence the BT/MCI situation Louis mentioned…there are plenty of theories as to what it *ought* to be, but if nobody’s prepared to stump up the cash for that, it’s not relevant…
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