The 3 Hacks you can use to simplify your DCF valuation

 Does this sound familiar?

Your vice president pops into your cubicle, drops a bunch of papers and pops the dreaded question: “Hey, do you think this company is a go or no go? “Before heading out he ominously adds, “by the way, we are due to meet on this in 15.”

You were just handed a set of financial statements for a company that is up for equity infusion, a process where a firm sells a stake in itself to raise capital, and you are asked for your quick opinion.

In buy-side business, we are often expected to express our opinions on fast developing opportunities. Conflicted between a deep study and a quick glance, an analyst is left with no choice but to admit defeat. But over the years and after analyzing hundreds of businesses for investment, I have devised 3 quick hacks to assess an opportunity quickly and reliably. The following 3 mental shortcuts, can help simplify the filtering process. 

#3. Discount Rate as an Opportunity Cost

To value an asset, analysts weigh cash flows from an asset with a measure of its riskiness. Deciding the riskiness of an asset is difficult and needs time and judgment to do so.

An effective shortcut is not to go down that path at all. Do not calculate risk. Instead, use the expected return of the current best opportunity in the portfolio as the discount rate. This will help an analyst to understand where does a potential opportunity stand. 

When Charlie Munger, the famed right-hand man of Warren Buffett was asked if all businesses were treated the same, different business ask for different treatments, he replied “No, of course not. Different businesses get different treatments”. He went on to add “they’re weighed one against another”.

The reason behind this is simple. Determining the discount factor at one point needs one to estimate the beta of an asset, the tendency of the investment to move lockstep with the broader markets. This decides the overall riskiness of the cash flows. Higher the beta of an asset, higher the returns. But is that so?

Eugene Fama, a Nobel Prize winning economist disagrees. “The relation between beta and average return”, Fama says, “is completely flat”. So if, beta doesn’t decide the riskiness, why should you even go down that path? Discount the cash flows by the expected returns of the second best opportunity and move on!

Time Taken: 5-7 minutes

#2 Economic Value Added

A quick and handy tool to decide on an investment’s attractiveness is to judge the economic value added(EVA) by an investment. EVA is the equity buy-side world’s best kept secret and smart analysts leverage this number to assess valuations. EVA methodology is simple (Aswath Damodaran’s notes on Economic Value Added) and requires only three numbers - return on capital, cost of capital and growth rate. Its simplicity is its strength and thus it is picking up its own champions in the buy-side. With some license, you can safely substitute the cost of capital with opportunity cost and assume no growth.

Time Taken: 10 minutes

#1 Entry Multiple, Exit Multiple

This is the most elaborate of the three hacks but still, you can get it done within 15 minutes. Let it’s simplicity not misguide you. Noted investor, Charlie Munger has referenced it in his talk “Practical Thought on Practical Thought”

So the idea is this. Your returns will flow from three drivers: volume growth, pricing growth, and valuation multiples expansion.

Volume growth implies the number of units the business is selling per year. A rising number is good, a falling number is bad. Pricing growth means the increase in the price of each unit the business is selling. It is a rare business which is able to grow volume and price together. You need to be cautious in putting a number or extrapolating the past. Finally, multiples expansion, the value markets assign to each $1 of profits earned, plays the role of final runner who will push your returns beyond the finish line.

Remember though, the warning of Bruce Flatt, the CEO of $350B real estate private equity firm, Brookfield Asset Management. Flatt advises, "growth does not necessarily add value". So be wary of cyclical and commodity industries where growth is value destructive.

• Assess the volume growth percentage
• Assess the rise in price for a single unit of the product
• Use the return metrics to pin the exit Price-Earnings multiple of the business on a fair ground (neither bubble territory, nor depressive prices)

Add all the three and you will have an effective growth number for the next 5-6 years (the usual holding period for a buy-side firm). If this number is higher than the best opportunity in the portfolio, it is worth taking another look at it.

Time Taken: 15 minutes

Its time to rush to the meeting. Good luck!

#valuation, #buy-side, #PE, #DCF, #EVA, #ExcessReturns