Today's post is by Clifford S. Ang, CFA, who is an Executive Vice President at Compass Lexecon, where he specialises in valuing businesses & hard-to-value assets and analyzing complex financial statement issues. In this post, Cliff discusses his recent book Applied Valuation: A Pragmatic Approach.
Valuing a company is a highly case-specific exercise, as it is dependent on the subject company and the facts and circumstances at the time of the valuation. In Applied Valuation: A Pragmatic Approach, we approach this issue by focusing on the core principle that the value of a company is determined by the company’s expected future cash flows, growth, and risk. If information about the company does not affect any of the above three elements, then the value of the company is also not affected. This framework can then be applied when valuing a company under the facts and circumstances present at the time of the valuation. We believe this approach provides a better framework to deal with challenges that may arise in practice, as it allows for the reader to think about the proper approach that should be applied at the time of the valuation.
Applied Valuation discusses in detail each of the primary valuation components, which are developing cash flow projections, estimating the discount rate, and calculating the terminal value.
"In Applied Valuation, we do not go through the myriad of possible models and assumptions but focus on those that are conceptually-sound. We then take a deeper dive into these relevant models and their assumptions to get a better understanding of any explicit or implicit assumptions and their implications. We end the book by illustrating how these methods can be applied by using case studies of Tesla and Walmart."
One aim of Applied Valuation is to help avoid inconsistencies in the method, assumptions, and inputs used in the valuation exercise. For example, we commonly see analysts apply the Hamada formula to unlever betas and then use a cost of debt that is not equal to the risk-free rate. In Applied Valuation, we walk through the derivation of different beta unlevering formulas and show how certain assumptions lead to the variations in these formulas. For the Hamada formula specifically, we show how an implicit assumption in that formula is that the company’s debt beta is zero. A zero debt beta implies that the company’s debt is risk-free and, based on the CAPM, the cost of debt must be the risk-free rate. Accordingly, using the Hamada formula and a cost of debt that is not equal to the risk-free rate creates an internal inconsistency.
As another example, some valuation books discuss or assert the equivalence of different valuation methods.
For example, two common approaches to value a company are the enterprise discounted cash flow (DCF) approach and the adjusted present value (APV) approach. In the enterprise DCF approach, we discount the free cash flows to the firm by the weighted average cost of capital. In the APV approach, we discount the free cash flows to the firm by the unlevered cost of equity and then add the present value of interest tax shields. In theory, these two approaches should yield the same value conclusion. However, as we demonstrate, this is only true when certain additional assumptions are made and those assumptions may be violated in practice. While relying on different assumptions do not create a fatal flaw in either of the approaches, understanding what those assumptions are when we conduct our valuation may help determine which approach is more appropriate to use.
In Applied Valuation, we also discuss valuation “misconceptions.”
For example, we discuss the use of the convergence formula to determine the terminal value.
The convergence formula states that the terminal value is equal to the net operating profit after tax in the first year of the terminal period divided by the weighted average cost of capital. Because the perpetuity growth rate does not appear in the formula, some analysts believe that the perpetuity growth rate does not factor in the convergence formula (i.e., that the formula assumes a perpetuity growth rate of zero). We show why that is a misconception.
Another example is the existence of a size effect or size premium in the discount rate.
The size effect is the claim that small stocks outperform large stocks on a risk-adjusted basis. This is then operationalised in valuations by adding a size premium to the CAPM cost of equity when estimating the discount rate. However, as discussed in Applied Valuation, independent evidence shows that there has been no size effect since the mid-1980s and recent evidence suggests that the original finding of a size effect may have been caused by then-existing issues with the data that have since been fixed. Thus, when performing valuations today, there is no reliable economic basis for the size effect and, accordingly, no reliable economic basis to add a size premium to the CAPM cost of equity.
Finally, in Applied Valuation, we discuss the importance of calibrating the valuation approach used to the market price.
If the ultimate goal of valuation for investment purposes is to determine whether the stock’s value is higher or lower than the stock’s price, then it is important for us to determine what information we believe the market is pricing in the company’s stock first. After we understand how the market is interpreting material information about the company, we can then determine whether we agree or disagree with the market’s assessment and, if we disagree, arrive at our own assessment of that information. Without such calibration, we would not be able to tell if the difference between our valuation and the stock’s price is a true actionable difference (i.e., a difference that could be relied upon when making a buy or sell decision) but simply a function of modelling error.
After reading Applied Valuation, we hope that the reader will be able to develop and apply a framework by which he or she can assess the value of a company no matter what issues arise during the valuation exercise. Another aim of the book is for the reader to get a deeper understanding of valuation concepts to ensure that the assumptions and inputs they use are internally consistent and supportable by reliable economic evidence.
Disclaimer: The opinions expressed above are solely those of the author and are not the opinions of Compass Lexecon or any of its other employees or affiliates. The above statements come with an implied “usually,” “mostly,” and “generally,” which are omitted for ease of exposition.