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This story originally appeared on ValueWalk
The age of NFTs makes crypto and Tesla valuation seem passé. If history has shown us anything it will be relevant again. It is important to be prepared for the day when valuation will really start to make a difference. Here are five easy steps to help you value your company.
Profit from the right revenue forecast
Revenue is the foundation of any business. Revenue is the most important item in valuation, and if you get the revenue forecast wrong, you’ll get the valuation wrong. The most important questions you need to ask when conducting revenue research outside of the office are:
- What is the number of people on your sales team?
- Which person is responsible for the management of the sales department?
- How do you plan to grow?
- Which are the obstacles to growth in sales?
The average revenue growth is 6%
In 2002-2020, revenue growth for all listed companies in the world averaged 6%, the fastest year was 2010 at 12%, and the slowest was 2009 at -9%. Forecasting revenue growth by looking at short-term trends is not a good idea. No statistical tool can accurately predict it.
Forecast revenue by looking at the marketing and branding of your company. Is market share rising? Has management done a market analysis? Is the brand communicating the value clearly?
For a forecast of revenue, consider the company’s products, selling process, and service.
How do you see the future growth of existing products? Which new products is the company planning to launch? How can the company overcome the obstacles in its sales processes? Are the revenues scalable? Are customers being followed up on?
The revenue forecast is crucial for your valuation. Spend most of your time on the construction process. Don’t underestimate the importance of marketing, branding and products. Also, don’t overestimate your selling processes and customer service.
Learn about the company’s cost structure
Analysts often underestimate costs and make unrealistically large profits. To help you understand how much the P&L is cost, we have examined the financial statements for approximately 15,000 businesses. The cost of goods and services (COGS), is 71% on average of a company’s revenues. This means that $71 of every $100 a company earns goes towards COGS.
Five-Point Six Percent
Guess what 5.6% is? This is the average net profit margin of all companies between 2002 and 2020. Although these ratios can vary across countries and sectors, they provide a baseline to help you avoid underestimating a company’s cost.
Focus on COGS
COGS account for approximately 71% of revenues. Therefore, you should focus your forecasting on COGS and revenue. Understanding that changes in gross margins are not likely to occur is important. Tell the truth if you forecast significant changes.
Increase Assets in Line with Revenue
Many years ago, when I was a Head of Research, one of my analysts showed me a company forecast where the free cash flow to the firm (FCFF) jumped massively in the fourth estimated year. After looking at the detail of the analyst’s forecast, I noticed that there had been no Capex in the years four through five. I then asked the analyst.
He replied that the company provided Capex guidance only for three years.
He asked me rhetorically, “Do you believe the company will stop investing in its businesses?”
Analysts don’t think that companies will stop investing. You shouldn’t either.
For revenue growth to occur, it takes investment
It is difficult to predict a company’s ability to increase its revenue while growing its assets. I teach my students in the Valuation Master Class Boot Camp to avoid this mistake by looking at the asset turnover ratio to assure the asset forecasts keep pace with revenue. You should revise or tell a story if your asset turnover ratio is not as shown in the below chart.
Use Pizza To Estimate Your Discount Rate
As the price the market will pay in return for taking on the stock’s risk, the discount rate is the amount that the market considers to be the best value. You will undervalue the value of the company if your discount rate assumption exceeds its limits. Your value estimate will not be accurate if your discount rate assumption falls too low.
Depending on your valuation method, your discount rate might be the cost of equity (COE) or the weighted average cost of capital (WACC). COE, however, is part of WACC and has generally a greater impact than the cost of debt on the WACC.
Analysts get caught up in the components and miss their real task – to use The Right COE
Various calculation methods and assumptions are used to “build” a COE; a standard approach to estimate the COE is the Capital Asset Pricing Model (CAPM). CAPM states that the COE can be calculated from three factors: the market risk premium and the beta. This supposedly takes into account the premium associated with company-specific risks.
These components can be thought of as the building blocks for your COE estimate. Analysts often get too caught up in the details of COE, and lose sight of the bigger picture. It doesn’t really matter what the component do; it is important that you get to the right COE.
Yogi Berra Orders Pizza
Yogi Berrios, an American professional baseball pitcher, wasn’t just 18-time All-Star, he also won 10 World Series titles as a player. He was super smart and funny!
Once, Yogi Berra was at a restaurant and ordered a pizza when he asked:
How many pizza slices should you make?
The waitress responded, “Six”
Yogi replied, “You’d better make four slices of pizza because I don’t have the stomach to eat six,” Yogi.
The cost of equity is like the pizza Yogi Berra ordered
You can slice pizza in many different ways.
The COE is the size of your pizza. The way you cut COE is irrelevant; it’s the “size” that counts, and not the different slices.
Like we mentioned, a COE that is too high or low can dramatically change the firm’s fair market value. However, it is important to avoid using too low COE.
Prognostication of a Diminished Return
A firm can’t maintain high levels of profitability for ever, and it is nearly impossible to sustain losses. Therefore, fading return on invested capital (ROIC) down (or up in the case of low profitability firms) reflects the idea that firms can’t sustain excessive returns to infinity.
We analyzed about 11,000 companies in 10 sectors to understand how ROIC for a company changes over time. This decay analysis was performed by dividing firms into deciles, and then tracking the ROIC over a period of 10 years. These findings can be used to help with valuation as they will allow us to better determine how the ROIC should change over the period of three stages.
The concept of Fading ROIC To WACC is based on the belief that companies cannot maintain excessive returns to infinity. Low profitability firms grow in profitability while high-profitable firms lose profitability.
Bonus Step: Yaaw
To help you value your company like a professional, there’s one last lesson that I’d like to impart to you. It’s called YAAW. Finance can be both an art and a science. It is impossible to know the right or wrong answer. Only time will reveal. You can’t be right all the time. In fact, it is almost impossible.
Join the Valuation Master Class Boot Camp – the only program that trains you exactly how to value actual companies like a pro and get your dream job in finance.
About the Author
Andrew Stotz CFA left his management job at Pepsi-Cola, California, to become a teacher of finance in Thailand in 1992. He found his calling in 1993 as a financial analyst. This job was the one that landed him voted number 1 in Thailand.
Dr. Stotz spent the last half of his career as an investment banker. He was Head of Research and managed teams of financial analysts. CFA Society Thailand elected him two terms. He now heads A. Stotz Investment Research. This firm provides tools and research for high-net worth investors as well as assistance to CEOs in making their company financially successful.
Publiated at Tue 31 August 2021 22.19:57 +0000