Forum Topics Seeking some education from the community.
Slomo
Added 5 years ago

How to value a business?

Great question @PPercentages, it might be best to start by stepping back and asking why you want to in the first place.

The objective of active investment in equities is to beat the market return over the long term.

Otherwise, you can invest in the index and get the market return with no effort and little cost.

Your return will be a function of the price you pay (easily observable in the market) and the price you receive (or could receive / unrealised gain on your portfolio) at the end of the investment. This future price is unknowable.

This approach ignores any other cashflows, like brokerage and dividends, for simplicity and because any market beating returns will need to come from capital gains.

So if you can’t know the future price, how do you know if the current price is a good entry point?

Value Investing – I believe this is the only theoretically sound method of investing, anything else is more akin to speculation or gambling than investing.  The most successful investors over a long period of time have been value investors.  Value Investing is famously simple but not easy.

The simplicity comes from paying a price that is significantly less than the value of stock.  The difficulty comes from knowing the value of the stock.

Value investing also dictates that in the long term future prices will be reflective of future values – which are also unknowable but can be estimated.

Discounted Cash Flow (DCF) – This is the only theoretically sound method of intrinsically valuing an asset. Every other reputable method is an approximation of this. DCF just makes more of your assumptions explicit (you need to use them as inputs) whereas other valuation tools make assumptions implicitly (a bigger topic for another thread).

Valuation guru Aswath Damodaran (as @Tom73 mentions) covers this well in his 24 part free youtube course on this - https://www.youtube.com/watch?v=8vYQpWXQ5hE&list=RDLVznmQ7oMiQrM&index=2

DCF works very well for bonds as all the cashflows are known and fall over a finite period. DCF is used extensively to value bond portfolios as a result.

DCF is much more challenging for valuing a business because you don’t know the future cashflows and they are infinite, in theory at least. This difficulty presents itself when you value a business using DCF and you realise:

1) There are a huge amount of assumptions you need to make about the cashflows that extend well into the future.

2) The Terminal Value (present value of all cashflows in the longer term, say after 5 or 10 years) is the least reliable part of the valuation and is usually the biggest part.

3) Small changes to the inputs leads to large changes to the valuation.

4) Using DCF alone to determine a value for a business is predominantly quantitative whereas (I believe) much of the future value of a business is qualitative in nature.

So why use DCF at all? There are a number of good reasons:

1) Most market participants don’t use it so must be using something less theoretically sound. This can be a source of edge over the market.

2) It forces you to think more deeply about the sources of cashflow (inflows and outflows) so you should end up with a better understanding of the business.

3) You can see the sensitivities to the valuation of a particular business by varying the inputs that might arise under different scenarios.

4) Just because it’s hard, doesn’t mean you should ignore it.

5) There are ways to modify DCF to make it more user friendly (eg. Reverse DCF and using exit multiples).

6) It allows you to project how value might change over time (which should be a driver of that unknowable future price mentioned above).

Hopefully this is more helpful than confusing. It’s a huge topic that has filled many books and university lecture rooms. Still I don’t think we pause to reflect on it enough.

As always if you want the facts, go to the source - Aswath Damodaran has a tonne of great free stuff online, it will just cost you time and attention.

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PPercentages
Added 5 years ago

I am relatively new to investing and Strawman.
I want to learn how to form an opinion of the prospects of a company - just the basics to start with. 
How do I put a value on a company (I know this is different for different types of companies at different stages)?

The brokerage platform I have access too provides the usual metrics, but I don't really know how relevant various numbers are.
If anyone would be so kind to perhaps outline a formula that I can start with, I would be very appreciative.

For a company that is still trying to get profits rolling in, I understand it can be a bit trickier, in this instance can I propose FLC (Fluence Corporation Limited) as a test case to help me make sense of what is important. Where do I start, what are the basic calculations I should be making?

About FLC:
Fluence Corporation Limited (FLC) is involved in the decentralized water, wastewater and reuse treatment markets, with its Smart Products Solutions, including Aspiral, NIROBOX and SUBRE. Fluence also offers an integrated range of custom engineered services across the complete water cycle, from early stage evaluation, through design and delivery to ongoing support and optimization of water related assets, as well as Build Own Operate Transfer (BOOT). Fluence has experience operating in over 70 countries worldwide.

 

I think demand will only grow for this type of product. I'm aware of a couple of other competitors, but I thinnk FLC are reasonably placed. I like the fact they manufacture their own product, are continuing to develop product, that the product is modular and can be added to and that there is some recurring revenue within the business model.
 

-They have spent some years losing money, they have picked up some contracts over the last couple of years (but it has been a bit stop start) and now their earning per share is close to zero, creeping towards a positive figure.


-They have built manufacturing facilities in China (I'm not sure if their progress is impacted by international politics).


-Shares outstinandg have grown over the years, I don't think this is good, but I really don't know what this means.


-Under the category of Capitalisation, long term debt would seem important to me, but in context to what other figures?


-With respect to Management and Leverage, what sort of numbers would be concerning?

Any thoughts and direction around how I can begin to form an opinion of a companies value by using some objective data would be greatly appreciated. Best wishes to all Strawman investors.  :)

 

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Tom73
Added 5 years ago

Hi PPercentages,

What you ask is why we are all here, to form a value on companies and as roycameron points out there are lot of ways of doing it which is part of the reason why prices are volatile and a lot of money can be made by forming a better view of value than others in the market.

They first thing to understand is that the market provides a price, which is very different to value and that is because value is different for everyone in the market.  Value is personal to you.

In terms of education, there is a valuation forum on Starwman which has many suggestions, I particularly like Noddy74’s reference to Damodar who is a lead educator in valuations:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/webcastinvphil.htm

 

I also suggest looking at valuations published on Strawman to see how others do it and find a style that works for you because valuation method needs to align with how you think and the types of investments you are interested in.  Given you are looking at FLC for instance a P/E approach to valuation isn’t going to be much good because they don’t have any stability of profits or growth.  Sales multiples are popular and if you can make an educated guess on future cashflows then a DCF can be useful.  But don’t think any method is “THE” method which if master will path the way to riches… if there is one don’t expect those who know it to share it.

 

Some brief (very) thoughts on things to consider for FLC:

·         Ownership: 53.45% insider ownership according to YahooFinance, generally a good sign, but trading volumes are light so volatility is likely to be high on news and key an eye on insider purchases and sales to help get a feel for their ability to achieve their targets.

·         Shares count growth: If the share count is growing and the company value isn’t that is a warning sign for a capital killer…  Growing companies need additional capital so a rising share count is not bad if associated with business value growth (sales growth generally).  According to ComSec the sharecount has been stable for a couple of years so FLC may be coming good but you need to look into this.

·         Leadership: look for skin in the game which there is and also experience and length of tenure which seems ok to judge commitment, also look at old announcements to see if they have meet previous commitments or targets and how they disclose bad news.  I also look at the length and complexity of remuneration reports – it they are really long and complex I get the feeling they are spending more time managing their own remuneration rather than shareholders (particularly if they don’t own many shares themselves).

·         Balance sheet: Net cash position (cash less debt) is part of any valuation but outside of that all you want to see on the balance sheet is that there aren’t any land mines.  Debt can be ok for certain businesses but generally you want little or none, for FLC a bit of debt can be ok given they have manufacturing assets and inventory.  However, looking at FLC I would want to know why Trade receivables and Payable are so large relative to income and operating expenses, in addition the high deferred revenue figures.  You need to understand these figures and how they work for this company to make sure they are not a major problem.

·         Business model: Is it one you understand and if so what are the drivers of business success – these are key things to focus on if you are predicting future cashflows for a DCF.  FLC manufactures their products so they have control over supply, but growth is limited by their capital and margins are mid to low in manufacturing.  If they have significant IP they can charge higher prices and margins even in the face of competition.

·         Risk: think about the issues they face when compared to most businesses.  They are all over the place in terms of market (US$20m in revenue in Q2 from the Ivory Coast…) and manufacture (China as you mention) so massive geo-political risks and they are dealing in 3rd world markets and customers .  Their FY21 sales guidance says it all, a ridiculously large range of $35-50m in sales, not sure how they can also guide for EBITDA positive.

·         10 year view: Often the simplest way to look at a company is to say what do you think it could look like in 5-10 years, apply a market multiple for similar businesses that are mature and discount that value back at an appropriate discount rate (10% for average market risk, 15-20% for high risk small caps yet to make a profit – but a personal choice).

·         Value: no idea, I just know it’s not the type of company that suits what I look for in an investment so it’s not likely to be much value to me.

 

I hope this helps, but take my thoughts on FLC as just quick reflections that need a lot more work.  You need to know the company well to form a reasonable view of value, this will also tell you the method you should use to view its future prospects

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Noddy74
Added 5 years ago

Hi PPercentages,

There have been a couple of good replies already.  I'd also point you to the Forum tab, where you can search for previously discussed topics as this and related topics come up from time to time.  For instance I'd recommend this one (https://strawman.com/forums/topic/5252) and suggest you look at CanadianAussie's post, which I found really useful.

At the end of the day there's no right answer to this and no perfect methodology.  I'll use DCF's alot but they are only useful so far and in so many circumstances.  Ratios are another useful tool, such as Price:Earnings, Price:Sales, ROI. Debt:Equity etc...  All of those tools will only get you so far and then you need to look at more qualitative information and make judgements on that (such as Tom73 alluded to his post on this topic).  

The last thing I'd recommend is to look at the valuation on AFL by Greenblatt earlier today.  He/she did an extremely good job at outling the business case without getting too bogged down in the valuation and really only brought in the valuation at the end - almost as an afterthought (which is something alot of professional investors I listen to also do).  So no right answer...but there are plenty of wrong ones (if you see a valuation followed by rocket ship and eggplant emojis it's a pretty good indication you're looking at a wrong one).

 

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