With so much negativity around closed-up economies, city lockdowns, finding a vaccine, one can't help but wonder why valuations - especially for tech firms - are sky rocketing.
Long term over short term
In any asset pricing exercise, there are two fundamental parameters to look at: future free cash flows and the discount rate.
The future free cash flows of the assets are whatever anyone thinks it to be: three, five or even ten years out. The discount rate addresses the question of "what is my expected return for purchasing a certain stock vs putting my money into a safe haven such as a government bond".
If you look at consensus data over the next 12 months, nearly every analyst on Wall Street is predicting a decline in revenue and earnings, for a good reason - sluggish economic growth, deferred order books, and overall lower discretionary spending. This indirectly tells us that:
The performance of the NASDAQ shows that no one is bothered with what happens over the next 12 months when it comes to valuation.
Because investors are not relying on the near-term outlook for guidance, the pricing of today's tech stocks are driven by one of the two:
Future cash flows over the longer term, or
Just pure hokum.
If you think about it intuitively, valuing businesses based on the data estimates looking out 3 to 5 years becomes a more viable alternative because no one can meaningfully price any business under circumstances today. Times are unprecedented; It is an anomaly, a black swan scenario. Applying the 1-year forward multiple to value a business just does not make any sense. This is similar in 2000 where the surge in prices of technology and Internet firms resulted in many investors rushing in to cash-in on the tremendous growth opportunities offered.
Therefore the pricing observed in the current market is a reflection of investors projecting incomes based on estimates 2 to 3 years out. The DCF models are for 10-years and they are willing to pay even if the earnings today were crappy.
Discount rates reflect opportunity costs
Government bonds have been widely accepted as the basis for pricing assets. It is considered to be default-free and therefore commonly used as the "risk-free" rate in valuation models. All cash flow valuation models that use the discount rate are based off this simple concept. At the peak of the dot com bubble, the 10-year treasury yield - which was the benchmark for a "safe haven" and a default-free investment - hovered at between 5 to 6%.
At some point of time, investors started to doubt the rich valuations of these Internet firms, and decided they were much better off putting their money in either government bonds that gave decent returns of 6.0%, or invest in the broader market, represented by the S&P 500. One thing led to another and the bubble burst.
The key difference between 2000 and now is that treasury yields today are trading at 0.72%. Which means that investors who decide to cash out from their richly valued stocks get effectively next to nothing if they buy bonds or other fixed income instruments. That, in part, is what is keeping the bubble inflated today.
In addition to that, city and country wide lockdowns from the pandemic have posed a serious risk for global trade and growth. Essentially, no trading = no growth. No growth = no inflation. To climb out of this economic rut, governments around the world have committed to keeping the near-to-mid-term interest rates low (read the Fed's recent announcement in August about its inflation rate policy).
So it is against this backdrop of a grim economy, the lack of other options in putting money to work and choice of taking a much longer term view on cash flows, that many investors are dumping money in equities.
As I am writing this, I do realize that there are wide ranging perspectives from different people out there, as well as numerous datasets that when aggregated and analyzed, could also be used to explain the current phenomenon. But the market is irrational, inefficient, unpredictable. And I have never been a good trader. Only time will tell if we are in the early stages of a new age of growth or if bubble will eventually burst.
Use this WACC (weighted average cost of capital) calculator to derive an indicative value for the discount rate.
The underlying datasets are being obtained from various sources: Equity risk premiums and un-levered industry betas from Damodaran Online, 10Y government bonds from Bloomberg and the Trading Economics website for the tax rates.
Reach me directly if you want a copy of this file. Can't make sense of or disagree with the result? Read this article too.
Buy to hold or buy to sell?
The underlying rationale for deriving terminal value is largely attributed to the fact that:
Most businesses will continue to re-invest their cash flows to expand and therefore credit has to be given to the future cash flows beyond the initial forecast period.
Not all investors acquire to expand, some buy a business with a mandate to sell later on such as PE funds.
Calculating the terminal value allows stakeholders to account for value in the business beyond the forecast period in a DCF, which would otherwise not be captured in the market multiples.
It reflects the intrinsic value of the company over a much longer term.
Therefore, when using the DCF approach to value a business, we add:
The value of the cash flows generated by the business during the growth phase and;
The value of all future cash flows in the terminal/stable phase.
Along with it comes a few hairy issues to contend with:
The duration of the growth phase (forecast period);
Finding an appropriate FCFF in the terminal phase; and
The assumptions on what the owners plan to do with the business in the terminal stage
How long should I forecast?
The general rule of thumb is 5 to 7 years but it really depends on how dynamic the forecasts are. The idea here is to construct a forecast which closely reflects how the company plans to grow over the foresee-able period. Since most companies usually have a "five year" plan, those underlying assumptions can be used as a basis for the cash flow projections.
Obviously longer is better, but after 5 to 7 years, it's really anyone's guess how the business will evolve. We assume the status quo thereafter.
For PPP projects involving core infrastructure such as power plants, toll roads and other utilities, the forecasts can run as long as the concession - up to 20 to 25 years. This is realistic because the revenues, in most cases, are contracted (such as take or pay mechanisms) and the costs are usually either pass-through or relatively fixed.
The irony here is:
Despite spending a significantly more time deep diving into the forecasts around the first 5 years of free cash flows, we end up chucking the terminal value into a simple equation that forms the bulk of the value (approximately 60-70% of the total value). Most of this is hinged on the value of the free cash flows in the final year of the forecast.
How do the cash flows look like in the terminal phase?
So, the FCFF in the final year of the DCF forecast effectively forms the basis for the terminal value. Some general guidelines to getting a more accurate estimate of this:
The underlying revenue and profitability is assumed to be fairly stable, but one must make a judgement call on what the market dynamics are expected to be like in the longer term. Will there be a consolidation resulting in 2 or 3 dominant players? Is it likely to remain fragmented because the barriers to entries are relatively low? This can be a subjective and challenging task given how quickly technology and competition can change in the current day.
Working capital cycles should be stable i.e. the credit terms for customers are closely adhered to and predictable and therefore no big fluctuations. This can be driven by a % of sales in the final year, based on observing that the ratios are words the terminal stage
Capex = depreciation, which loosely means that the company will 'replenish' or maintain a sustainable economic level of operating assets to continue functioning for the longer term.
Basis for estimating terminal value in the stable phase.
Two scenarios can happen here:
Buyer continues to operate the business till the "end of time".
Buyer (in the case of PE funds) sells the business in the future.
1. Buyer continues to operate the business and receives the cash flows from the business every year to perpetuity. This is essentially the dividend growth model applied in the final year of the forecast and calculated as:
where g is the growth rate of the cash flows to perpetuity, and r is the discount rate. There are tons of scientific literature on this.
How to estimate g?
Because the result of estimating the cash flows to perpetuity is significant, one has to take an extremely realistic view of this will pan out over a very long period of time. And since there are no models that can accurately predict how a business (or the global economy) will grow forever, the closest proxy would be to observe historical trends over as long a period as possible (as far back as the data goes...)
As economic cycles can be volatile, it would be too aggressive to use the long-term GDP growth rates as the basis for g. Economic cycles also reflect the growth rates of all businesses, which may not be representative of the underlying cash flows. Therefore, we expect the nominal growth in the risk-free rate to be ultimately driven by inflation in the longer term, making the economic long-term inflation rate a better proxy for g. And because investors will always expect a return that will compensate for inflation, g will also always be less than r, the discount rate.
Putting it all together.
A simplified illustrative calculation involving a 5-year growth phase with year 6 onwards as the terminal phase is shown below:
Take note that the terminal value is discounted based on year 5's discount factor because we assume that all those cash flows are coming in at the end of year 5. The way the info is laid out in the excel can be slightly misleading as the terminal value is placed after year 5.
Perhaps an easier alternative way to understand the cash flows is to look at the graph below.
The year-5 discounting factor is used as the basis for valuing all cash flows starting from year 6.
2. Buyer sells the business in the future.
In my opinion, this is probably a better scenario to estimate terminal value because it is largely 'market driven' i.e. the approach is based on either precedent M&A transactions or publicly traded market multiples - both of which are easily understood and referenced by investors. This is also a realistic and appropriate scenario in the case of PE funds since they really have a hard mandate to dispose the business.
The idea here is to derive a 'sale value' for the business at the end of the forecast period. To do this, we need to use today's 1-year forward multiples and apply it to the following year's income based on the last forecast year. This is also commonly called the exit multiple approach.
If today's forward EV/EBITDA multiples are 6.0x, the terminal value of the business at year 5 would be 6.0x on Year 6 EBITDA.
In reality, you will have to make some assumptions on when the terminal value is realized e.g. sale processes tend to take some time - investor search, due diligence, SPA negotiations, deal closing - and the actual cash proceeds may only come in in year 6.
Cross checking.
Arriving at the terminal value using the exit multiple approach allows us to also cross check our calculation results using the perpetual growth model.
In the stable phase, both results should yield approximately the same results as we expect the exit multiple approach to price in investors' sentiments towards the long term growth of the company.
