As a corporate adviser carrying out valuations or seeing valuations of others in the industry, for example,analysts, I always applied a two stage methodology: use forecasts to project future free cashflows, discount them to present value and adjust for debt and existing cash on hand.
Then, in stage 2, to balance this out (or to perform a “reasonableness test”) I compared the resulting valuation parameters with the discounted cash flow figures. The figures were always miles apart (discounted cash flows always being much higher than peer relative valuations), so back we go to the discount to rate to find some economic reason to justify why they were too low or we went back to the business model to see whether there were any errors in managements assumptions.
Nearly always the projected performance of the company would exceed its historical performance and any suggestion to management that the past was an acceptable basis to value cash flows in the future would be a personal insult to the management team. “This is about the future, not the past! They would say.” We always looked on the brighter side of life.
Here is an extract from my favourite book The Intellient Investor in its chapter, Security Analysis for the Lay Investor. I recommend you buy this book.
“The higher the growth rate you project, and the longer the future period over which you project it, the more sensitive your forecast becomes to the slightest error. If, for instance, you estimate that a company earning $1 per share can raise that profit by 15% a year for the next 15 years, its earnings would end up at $8.14. If the market values the company at 35 times earnings, the stock would finish the period at roughly $285. But if earnings grow at 14% instead of 15%, the company would earn $7.14 at the end of the period—and, in the shock of that shortfall, investors would no longer be willing to pay 35 times earnings. At, say, 20 times earnings, the stock would end up around $140 per share, or more than 50% less. Because advanced mathematics gives the appearance of precision to the inherently iffy process of foreseeing the future, investors must be highly skeptical of anyone who claims to hold any complex computational key to basic financial problems. As Graham put it: “In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.”
“All investors labor under a cruel irony: We invest in the present, but we invest for the future. And, unfortunately, the future is almost entirely uncertain (more so in Africa). Inflation and interest rates are undependable; economic recessions come and go at random; geopolitical upheavals like war, commodity shortages, and terrorism arrive without warning; and the fate of individual companies and their industries often turns out to be the opposite of what most investors expect. Therefore, investing on the basis of projection is a fool’s errand; even the forecasts of the so-called experts are less reliable than the flip of a coin. For most people, investing on the basis of protection—from overpaying for a stock and from overconfidence in the quality of their own judgment—is the best solution.”
My key point in all of this is the absence of readily available information to carry out a more Benjamin Graham type valuation or indeed, a more educated investment decision. I have never completed a valuation with 10 years of historical statistics for the peer group with which I was working. I should have. Its about access to information.
My message to listed companies today is to track the long-term performance of your peers, ensure that your long-term performance table is at the back of your annual reports (10 years of balance sheet, income statement and cash flows and say, 5 bullet points summarising the performance of each year). Also ensure that you have submitted your past 10 years of annual reports to Africanfinancials.com. If your financial performance is NOT ahead of your peers, do something about it!
Africanfinancials.com is a good place to start to get an idea of comparing yourself with peers. So is buying the Intelligent Investor and reading it.