Photo: Dave Meier. Source: Picography
Once you have a sense of a firm’s business-lines, how do you put numbers on those realities? Financial theory states that the fair value of an ongoing business is the present value of its expected cash flows. This requires that an analyst estimates the cash flows, the discount rates, and how fast a company can grow. Simple, right? All you need to know is the cash from here to eternity.
That’s the rub. Because nothing ever works out according to plan. So we use probabilities and higher discount rates to account for the risk. We also need to estimate the growth rate. On paper, accounting for all these variables can look intimidating.
Source: CFA Institute
In theory, this looks like a lot of advanced math. But in practice, it’s actually pretty simple. The way a only way company can increase its value is to increase the level of cash flow available to investors. It can do this by increasing sales, decreasing expenses, or decreasing the cost of capital. Of these three, increasing sales is the only sustainable way to grow, since costs can’t fall below zero.
This is why the market value of a stock may fall even after they report a bang-up quarter. The market is more concerned with their prospects going forward, and how sustainable those prospects may be. The reported results are simply history—a way to evaluate management’s credibility, if they hit their numbers or not. History isn’t bunk, but it is in the past. What matters to investors is the prospect for future cash flows.
There are no shortcuts in valuation. Either a company can pay money to is owners or it can’t. In the end, valuation depends on value-added.
Douglas R. Tengdin, CFA
Chief Investment Officer