The very fact that I am emboldened to post at this thread again - after a big gap of 4 months - can only mean two things:
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We had reached the end - in illustrating our ART of Valuation incremental learnings at VP (from 2011-2013); needed time off to take things forward and imbibe new stuff
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there wasn’t anything original that we could come up with that DROVE HOME another (may not be new) exciting & insightful ART of Valuation Tenet - something very simple and powerful - that everyone could look to implement
I am excited, again. Think we got hold of something simple - something powerful - something that you and me can immediately put to use with (I think) telling effect. Really??
It all depends on my ability to reproduce my conversation with Mr S exactly as it went ;). So pardon me if I can’t get you equally excited immediately - but eventually we will get there.
VALUATION ART #4
Mr S: (A Senior Fund Manager & Friend) How would you incorporate (assess) Future Value creation in a Business and assign a Valuation multiple - with sound economic reasoning?
I must say I didn’t provide a satisfactory answer - how could I - we are still grappling with these things. I told him we toiled hard in trying to decode Business Value Drivers with the very promising Economic Profit = Invested Capital *(RoIC - Cost of Capital); We also played around with lots of lots of examples (Nestle, Colgate, ITC, HUL, Page and scores of others in the FMCG pack) but clarity eluded us.
Mr S: How about breaking the Business Value into 2 components: a steady state value & a future value creation? [Merton Miller and Franco Modigliani - Foundational paper on Valuation
A much simpler read Mauboussin: What does a P/E Multiple mean
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Business Value = steady-state value + future value creation
Steady-State Value = (Net Operating Profit after Tax (Normalised))/(Cost of Capital ) + Excess Cash
Future Value Creation = [Investment *(RoIIC - Cost of Capital)*competitive advantage period]/[Cost of Capital * (1+ Cost of Capital)]
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Seen another way
Value of Firm = Debt + Equity, then
Equity Value = Steady-State Value + Future Value Creation + Excess Cash - Debt
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Steady state Value: calculated using teh perpetuity method assumes that current NOPAT is sustainable indefinitely and that incremental investments will neither add nor substract value
Future Value creation boils down to how much money a company invests, what spread that investment earns relative to the cost of capital, and for how long a company can find value-creating opportunities