Wake up! It's Monday, July 31st! To begin, I'd like to thank all of you who have joined this newsletter thus far. As we work hard to schedule interviews, we are also interested in sharing valuable content that will help you along your entrepreneurial journey.
A key moment in every entrepreneur's journey is the point of valuation. The generic reasons why entrepreneurs value their companies are because of legal reasons, or tax reasons, or perhaps to find an appropriate price to sell ownership in their companies at. However, valuation, to the knowledgeable entrepreneur can be about far more than just that. Valuation gives an opportunity for business leaders to assess the efficiency of their companies, determine what's working, and what's not. Furthermore, by gaining a personal understanding of valuations, it protects you from the dangers of relying on bankers, valuation "experts", and economists to value your company fairly.
The truth is valuation is an art, not a science. This goes for finance as a whole. Much of what financiers do is simply enhancing, but never perfecting a methodology to create the best estimates. With that being said, let's discuss the two overarching methods of effective valuation, and breakdown their differences, so one day you understand what people are saying about your company.
Absolute Valuation
The first method of valuation is known as absolute valuation. Most commonly, this is done through a DCF (discounted cash-flow) model. The goal of absolute valuation is to create a value for your company based on intrinsic characteristics. In this method of valuation, the fundamental components used to arrive at a conclusion are cash-flows, historic earnings, short-term earnings projections, and most importantly for DCF models, long-term earnings projections. The nature of equities is that there is an inherent risk of the value at some point going to zero, with the future being unpredictable. So, to account for this, all future assumptions of cash flow are discounted, or brought back to present value through applying an individualized discount rate. This discount rate is known as the Weighted Average Cost of Capital. The formula is listed below.
WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)
Essentially, the formula accounts for the balance in a given company's amount of equity, and amount of debt. If a company relies heavily on its corporate bonds, and has several outstanding payments left, the yield of those bonds will be factored more heavily into the valuation. If a company is low in debt, and has more equity and cash flow, this will provide a more favorable discount rate.
The pros of using a DCF model include:
- The precision. In this form of modeling, a final conclusion can be reached as to the real value of each share.
- It's relationship to real data. While long-term projections matter, the conclusion is anchored in historical earnings, making the valuation more realistic and stronger.
- The variety of factors. The absolute valuation method requires a disciplined thought process, which if done fairly takes into consideration each facet of a company, providing the strongest valuation.
The cons of using a DCF model include:
- The estimation. While methodologies may be strong, they are never foolproof, and this type of valuation requires that the valuer see into the future. The future may hold significant events that simply are not predictable.
- The labor. These types of models are time consuming, and can be expensive, painstaking, and an overall hassle. If you are trying to market your company with this model, you would need to do a similar process for all other companies on the market in order to prove your worth.
- The malleability of it. We live in an imperfect world, filled with those who would manipulate the methodology, fudge data, and more to manipulate the calculated value for an alternate purpose. This is one of the reasons it is important that you understand this model so as to not be the victim of a poor model
Relative Valuation
The second method of valuation is the perhaps more intuitive one. Think about how you'd value two gallons of milk at the grocery store. Both gallon's of milk are 2%, though one gallon of milk has an image of a cow frolicking on a field, while the other has a a man with a frothy old milk mustache. The two gallons of milk are approximately the same, so naturally, you decide which to buy by comparing the prices of the two jugs.
Similarly, relative valuation utilizes similar companies on the market to create insight into whether a company is valued fairly, undervalued, or overvalued. In relative valuation, a variety of key ratios and fundamentals are used to draw a comparison between another company, and finally a conclusion.
Key ratios include price-to-earnings, earnings per share, operating margins, dividend yield, and enterprise value-to-EBITDA. Based on the type of company, each of these may be given more preference in the final finding. For example, in debt heavy companies such as growth stage startups, using enterprise value-to-EBITDA makes more sense. In industrials, using price-to-book value makes more sense because of their asset heavy nature.
The first step is finding a company which feels fair to compare against yours. No company is cookie-cutter cut. Rather, each company is like a snowflake, unique in some way from every other company on the market. Thus, this type of valuation is again an art, and an estimate. You just need to find a company that is close enough. Then, by assessing the appropriate ratios and fundamentals to compare, you can reach a conclusion on whether a company is valued too high or too low. Then, you can force change yourself, or wait and see if the market corrects itself, accounting for the impact of that happening.
The pros of relative valuation include:
- Ease of understanding. Relative valuation simply makes more sense, as it is what we do with our everyday decisions.
- Simplicity of calculation. While the calculation actually is not simple, we know where to look. Then, it is a matter of deciding which ratios to use, as the calculations are generic and standard.
- Requires no long-term projection. Long-term projection gave an element of uncertainty for DCF models. In this case, no calculation is required to do that, since that is simply not considered.
The cons of relative valuation include:
- Directional. Unlike a DCF model, no final number is reached. Only whether a company is valued too far up, or too far down is concluded.
- Hard to compare. As priorly mentioned, finding a company that fits yours is difficult, if not impossible. So, compromises must be made.
- Supposes the market is right. In using this comparative strategy, we make the assumption that the company we are comparing ourselves to is fairly valued. However, there is no reason to suppose this, and we may be assigning our own value off of an unstable base.
Both of these methods have their pros and cons, and you should know that in most valuation cases, elements of both methods are used in the final conclusion. It is important to be weary of where estimates are being made, and where there is a potential for manipulation, because at the end of the day, it is your livelihood on the line.
As always, we are happy to answer any questions you may have, or find the answers if we do not already have them. Please reach out to us if you feel we have not properly summarized the basic differences in styles of valuation.
If you are interested in further learning about valuations, we recommend the following series and courses:
- Bloomberg Market Concepts Certification
- NYU professor Aswath Damodaran's free course on valuations
NEWS:
The Federal Reserve is raising interest rates to combat high inflation levels in the economy. By increasing the cost of borrowing money for consumers and businesses, the Fed aims to reduce overall economic activity, which can help bring down inflation. The trade-off is that higher interest rates mean increased costs for consumers, such as higher credit card, auto loan, and mortgage rates. However, the Fed believes that tackling inflation now is necessary to prevent it from becoming entrenched and causing more significant problems in the future. The goal is to restore price stability, which in turn supports a strong labor market and a more resilient economy in the long term. While higher interest rates may have some negative effects, the Fed believes they are necessary to control inflation and maintain economic stability.
Banks working on global standards for accounting carbon emissions in bond or stock sales underwriting have voted to exclude most of these emissions from their own carbon footprint. The decision, made by the majority of banks in the working group, would exempt two-thirds of emissions linked to their capital markets businesses from being attributed to them in carbon accounting. Environmental advocates argue that banks should take full responsibility for emissions generated by activities financed through bonds and stock sales, as they already do with loans. The accounting standard will not be mandatory but is expected to impact banks' targets for becoming carbon-neutral. The Partnership for Carbon Accounting Financials (PCAF) formed the working group, and their board will have the final say on adopting the 33% accounting share for capital markets. Some banks in the group advocated for 100% accountability. PCAF has faced challenges in establishing standards due to disagreements among banks, but any percentage agreement is considered better than further delays. The Science Based Targets initiative is also developing net-zero standards for banks.
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