Assigning a Terminal Value to a business

Accelerated Learning
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That is why there are other ways to get our hands around this extremely important aspect. Valuation is NOT a Science, it is an ART form (as we tried to bring out quite well in our ART of Valuation thread) - part of Hall of Fame threads at VP

I am sure, Vinay Parikh used “Terminal Value” as a conjunct to make us THINK !! (Not to try and dismiss the utility of what is an excellent Valuation conjunct;)

Not to get stuck in the Semantics but to never UNDERESTIMATE the fact that Higher the Sustainable Valuations I assign a Business, the longer I am assuming this business will last!! That is the central moot point, I thought he was making.

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Reproducing Summary of the Michael J. Mauboussin PE paper (referred earlier)

Here are some conclusions from this discussion:
1.Multiples are not valuation; they are shorthand for the process of valuation. The value of a financial asset is the present value of future cash flows. Accordingly, it is essential to understand the components of a multiple and to have a sense of what those components imply about a company’s future financial performance.

2.In assessing capital allocation, consider incremental returns on capital first and growth second. Growth only creates value if the investments generate a return in excess of the cost of capital. Note that this return need not be immediate. But no company should pursue growth solely for the sake of growth, and the research shows that rapid asset growth is correlated with weak shareholder returns.

3.Compare companies based on their business models, not their line of business. For companies to be truly comparable, they must have similar outlooks for incremental returns, growth, and investment
_opportunities. They must also be financed in a similar fashion for a price-earnings multiple to be useful. _

4.Be very careful using the past to understand the future. Past multiples are only relevant to the degree to which the underlying drivers of value are consistent through time. In fact, many of these drivers have changed, greatly diminishing the utility of past averages.

5.This discussion applies to all multiples. While we limited our comments to price-earnings multiples, the basic concepts apply to any multiple. The most commonly used multiples after price-earnings are
enterprise value-EBITDA (EBITDA stands for earnings before interest, taxes, depreciation, and
amortization) and price-to-book value.

6.Be mindful of the quality of earnings. We delved into our discussion using techniques and definitions (e.g., net operating profit after tax, investments, and cost of capital) that come from a discounted cash flow (DCF) model. The goal of a good DCF model is to avoid accounting vagaries and to zero in on the cash flow. Earnings fail to do this, and managements have a great deal of discretion in determining the earnings they report. As Alfred Rappaport’s quotation at the beginning of this report reminds us, “cash is a fact, profit is an opinion.”

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Appendix A: Equivalence of Unlevered and Levered Free Cash Flow Valuation Models
The Michael J. Mauboussin and Dan Callahan paper does talk about this on Page 17.

And to drive home the central point Vinay Parikh and Prof Bakshi were really making - Multiples and Expectations
This is what the Authors have to say

The key to making money in markets is to distinguish between expectations and fundamentals. The
expectations in a stock reflect a company’s anticipated financial results. This is the stock price. Fundamentals are the future financial performance of the business, including future return on incremental invested capital, growth, and sustainable competitive advantage. That is value. When price and value get out of line, there is opportunity.

The expectations investing process has three steps. The first is to understand what expectations are reflected in today’s stock price. We can use a metaphor of a high jumper’s likely success, where the level of the bar represents the expectations in the stock, and how high the jumper can leap reflects the company’s fundamental results. Step one tells us simply where the bar is set.

The second step is to determine the company’s likely financial performance. This requires strategic and financial analysis. Strong financial results are consistent with a lofty jump and poor results with an inability to take off.

The final step flows from the first two. It is to make buy, sell, or hold decisions based on the difference between expectations and fundamentals. We want to know if the company will outperform expectations and, if so, whether there is a margin of safety.

All things being equal, low multiples indicate low expectations
My edits (about Longevity and financial performance). Conversely, High Multiples indicate high expectations about Longevity and sustained financial Performance

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Now to get back to the central issues brought out in this thread:

  1. Do we even UNDERSTAND what we are doing when we assign a high Multiple to a business?

  2. Unlike the salad days when VP started - and you had so-called quality emerging businesses - consistent 30%+ growers, with consistent 30% + RoCE, available at 5-6x earnings, today’s so-called quality emerging businesses are quoting at 30-40x Earnings

  3. So, today when we are comfortable buying/holding such so-called quality emerging businesses at such (lofty) valuations, are we even aware of the Implications??

  4. High Multiples - the implicit assumption is business is going to last for a long enough time, grow at a high rate, at a superior rate of return

  5. In so-called quality emerging businesses, how can you have a view how long it can sustain its competitive advantage, how can you assign a terminal value or Intrinsic Value to these kind of businesses?

Is there a secret sauce? Why, or why not?

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Let’s FOCUS back attention to exploring and questioning about the implicit assumptions we are making about businesses we own and/or are interested in owning.

Om is one of our most “original” thinkers and insightfully remarked to some of us - isn’t is amazing how “we hear ONLY what we want to hear” - many of us are missing the POINT!!

This exercise should be about thinking deeply about Valuations and how we make them - first become AWARE. Only then can we endlessly QUESTION the assumptions (that we make), in a bid to first sanitise our existing Portfolios .

Let’s try and present both confirming and disconfirming evidence - keep our eyes and ears OPEN, that is.

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