...is what I constantly tell the folks in my practical valuation and financial modelling classes. I sometimes feel bad for saying this.
But I see myself as a practitioner of valuation and finance. As far as finance theories go, 90% of the people I deal with don’t understand the academic workings of capital markets. Even if they do, most deals are done largely based on the “directive” of someone higher up.
The consequences, good or bad, are irrelevant to those who do not have skin in the game.
I once worked on a deal that was priced based on a valuation report that had been outdated for at least two years. The numbers were stale and these figures weren’t even related to discount rates. These were input costs e.g. construction costs, equipment prices, etc. This deviation wasn't significant but the project sponsor simply refused to refresh those numbers because they didn’t want to raise any eyebrows when submitting the documents to the regulators.
Do you really think that adding up discounted cash flows will help you decide whether to invest or not? Chances are, even before running the numbers, you most likely have already made up your mind. You are just looking for enough agreeable accomplices, or a scientific way to justify the decision to yourself (or someone else) - just in case you end up with an egg on your face.
Don’t get me wrong. I have nothing against finance theories.
People often misunderstand the objective of valuing a business as the end result of a series of carefully curated mathematical formulas. In reality, the process of doing valuation is more important than the result.
As far as the weighted average cost of capital (WACC) goes, the result of combining the cost of debt and cost of equity is only as relevant to the extent of how you are trying to raise capital. And I’m not talking about the proportions involving the amounts of debt and equity. I’m referring to the nature of those capital.
A large multi-billion asset manager that buys public equities will have a very different expectation of investment returns as compared a private equity fund, even though their cost of funds might be roughly the same. Fundamentally, their investment mandates are also very different, and because of that, the way they approach valuing a business differs. CAPM models are irrelevant when I want a 30% annualised return on investment. And who cares about the “optimal debt-to-equity ratio” when I am confident of gearing up the company on cheap debt?
We also adapt the dividend discount model to derive terminal value. The math is sound. The irony here is spending the bulk of the work digesting profitability, working capital, capital expenditures and what drives the cash flows for the first five to seven years, only to cast approximately 70% of it into the terminal value, which is ultimately driven by just one year of cash flow data, a discount rate and a long term growth rate (which I always felt was somewhat arbitrary).
Again, I discredit the finance academics too much by underplaying the way we look at valuation.
The theories of financial markets that are taught in schools are robust.
But most of the ways in which we learn valuation and deal structuring originated from the West - leveraged buyouts, senior debt, subordinated debt, junior debt, mezzanine debt, etc. We have fanciful financial jargon such as ‘bullet’ repayments, ‘balloon’ repayments, cash sweep, debt sweep, cash flow waterfalls, valuation football fields, etc. We also have all these funky methodologies relating to how to accurately price an asset: Two-stage DCF, three-stage DCF, Adjusted Present Value, Merton Model, Economic Value-Added, etc. Most people in Asia are less sophisticated and more sentimental: I’ll do the deal if I like you. I know you got my back when shit hits the fan. Full stop.
Try putting a price tag on that.
So does this mean that we abandon the math behind business valuation? Should we avoid building financial models at all? I don’t think that’s possible.
Financial models exist to allow us to simulate an outcome of a decision based on certain parameters, perhaps more specifically, those parameters which potentially result in losing money.
By varying those parameters, we test our tolerance towards uncertainties in the forecasts, the thresholds of our risk appetite and also how far we are willing go in order to get the deal done.
But there is also another more important aspect of building models which is highly underrated: Gaining a deeper insight into the inner workings of a business.
Spreadsheets help facilitate the way we organise and analyse data. Using Excel, we can easily work out price x quantity over a period of time. By linking up the various cells in a spreadsheet, we are embedding business logic into meaningful numbers. And by iteratively questioning and challenging the underlying assumptions, we are subconsciously forcing ourselves to understand what really impacts the revenue and the costs.
There are so many factors that can drive a business.
Sometimes knowing what drives a business is more important than the outcome of its financial model.