Tool Box
Issue No. 27 - February/March
Hitchhikers guide to valuations II
by Mr Geoff Thomas
Thanks for coming back for part 2 of this guide. In part 1, we looked at ways of measuring the past performance:
- Net Tangible Assets – how much the company is worth if it were wound up
- Amount spent on Research and Development – a measure of how much it would cost to re-create the intellectual property base
- Multiple of past earnings – use of some form of multiple on current or past earnings results.
While the past is all we know, it is the future that we want to know. Ultimately, companies are worth the sum of their future free cash flows — that is, how much cash they can distribute to their shareholders.
For this reason, the most correct form of valuation is a valuation of discounted future cash flow. In fact, the ‘multiple’ method of past earnings is really an expectation that companies in a similar sector will achieve a certain rate of growth, and be subject to a similar discount rate for future earnings.
Discounted Cash Flow
The challenge of discounted cash flow analysis is the uncertainty of the future forecasts, and the choice of discount rate.
While companies such as Woolworths or David Jones may be able to accurately forecast sales, margins and costs; for high growth firms, introducing new products into new markets, sales forecasts are highly uncertain.
Anyone who can click and drag in Microsoft Excel can create fantastic growth rates, most of which do end up to be fantasies.
When creating models of future income, it is vital, if they are to be believed, and if they are to be useful measures of future performance, that they are based on as sound a foundation as possible.
Some key attributes are:
- Sales figures bas based on ‘bottom up’ projections, such as estimates from distributors, application to new markets of known growth curves from old markets, and individual orders
- Cost of g...
