The good news, when investing in an unlisted company is that you should be furnished with significantly more information than a listed company can provide to investors. The bad news is that the justification of the valuation of the company for your investment is more often than not based on a Discounted Cash Flow analysis, or “DCF” provided by the company.
The DCF is the cornerstone of most valuations of emerging growth companies and yet it is often nothing more than a little guesswork disguised by a huge amount of numbers across a vast spreadsheet. It is all too easy, therefore, to dismiss a DCF valuation a company comes up with as a waste of time, but that would be to ignore the story that the numbers tell about a company’s business, its strategy, its management and its likelihood for success. It takes you into the minds of the management team, if you care to look close enough.
A discounted cash flow analysis takes the expected cash flows for a company over a fixed period (normally three to five years) plus a terminal value of the profits thereafter and discounts all of these cash flows back to a net present value (NPV). This presents several challenges in claiming to be an objective value of the business.
Firstly, there is the question of whether the projections are in any way close to representing a realistic picture of the likely future of the company. Rapidly growing companies are almost impossible to forecast, and their eventual size, shape and strategy will always vary enormously from original expectations.
Secondly the terminal value will usually have a disproportionate impact on the value of the business, and being based on an assessment of the profitability of the company in three or five years time will almost certainly be wrong by a significant magnitude.
Finally, there is the discount rate that is applied. As someone that has read analysts’ reports for thirty odd years (and as an analyst, wrote more than a few myself), I find it extraordinary the range of discount rates that are applied to similar businesses. The cynic would point to the fact that the discount rate applied somehow always gives the NPV that the author is seeking. Whilst many do try to come up with an objective level for a discount rate, I must admit that I have read a lot of reports that do appear to have had the benefit of the “Goal Seek” function in Excel.
So why on earth would anyone bother with looking at a DCF if it is wildly inaccurate and subject to manipulation by the person compiling the numbers? I would argue that the output of the DCF can often be dismissed but an analysis of the process can be highly instructive.
On the first point, that the forecasts will be wildly inaccurate, I cannot dispute that the numbers will be wrong, but that misses the point. The forecasts are the result of many hours spent crafting a model for how the management see a company. It tells a story that can be unpicked with a judicious eye.
Each line in the income statement, that provides the basis for the eventual cash flow, tells its own story of the assumptions that the management has about its business and the way that it will grow. Whilst most attention will be on the revenue line, I would suggest that this in isolation tells only part of the story. The revenue line does show how ambitious, realistic or delusional the management team is in relation to the business segment in which they are operating. I have often seen wild expectations of market share gains that for a new entrant were unrealistic, or demonstrated a complete misunderstanding of the true size of the addressable market. However, how the related costs develop over the years tells you much more about whether the management actually understand what they are trying to do.
Revenues often somehow grow without the related marketing or distribution costs rising, which is the equivalent of inventing a perpetual motion machine. Yes, in a handful of technology-related cases that might be true, but in the real world, revenue does not just appear because you hope it will. Products and services need to be marketed and that takes time and effort, meaning marketing spend and increased headcount.
Margins are also an area where the over-optimism of many managements shines through. Margins are often predicted to be sustainably above the sector average, without any response from larger competitors, or the management will claim there is not and will never be any competitors. If someone starts to make money, there are sure to be competitors in the future. The question should be how to address those challenges and how that has been factored into the model.
On the terminal value this will give a good indication of the size of the egos that are running the company. I have seen some unbelievable numbers over the years from management teams so sure of themselves that they confidently predict stratospheric terminal values in three to five years’ time. This is not to say I would not back a management team with such high confidence of achieving extraordinary things, but it would make me want to ensure that the corporate governance was extremely robust, to rein in that over-exuberance now and again and ensure that the management has sufficient constructive challenge to keep decisions rational. If a CEO believes he can walk on water he is likely to come unstuck, unless he has a Board that can remind him that he is human.
Finally, on the discount rate, it should be high enough to reflect the very high degree of uncertainty in the model, and the rationale be able to be explained coherently by the management team. Any explanation that sounds like a number plucked from the air should be a warning sign that the valuation basis is likely flaky and that the management team care more about getting the highest possible valuation as soon as possible than they do about driving a successful business.
I don’t think any of my more successful investments felt it necessary to come up with extravagant claims to justify unrealistic valuations in the early stages of their growth cycle, but I have passed on many other opportunities because the numbers showed that management could not comprehend how their business was going to develop. Most of those I passed on did not make it, and although a few did succeed, investing in emerging growth companies is as much about avoiding losses as it is making profits. In this endeavour, the DCF can be a great help.