Session 25: Valuation - The Final Frontier!

Key Concepts

• Drivers of Cash Flows: Revenue growth, operating margins, and sales to capital ratio.
• Valuation Metrics: Revenue growth, operating margins, sales to capital, return on equity (ROE), return on invested capital (ROIC), cost of capital, cost of equity, cost of debt.
• Growth Strategies: High growth, moderate growth, stable growth, negative growth.
• Reinvestment: Capital expenditures, working capital, R&D, acquisitions, brand building.
• Terminal Value: Perpetual growth model, finite growth period, stable growth rate, economic growth rate.
• Company Life Cycles: 20th-century companies (long-lived) vs. 21st-century companies (shorter life cycles).
• Financial Principles: Investment, financing, and dividend decisions.
• Value of Control: The potential increase in value from implementing changes in a company's management or strategy.
• Minority Interest: The portion of a subsidiary's equity not owned by the parent company.
• Management Options: Stock options granted to employees, which can dilute equity value.

Valuation Drivers and Company Examples

The discussion centers on the three primary drivers of a company's value: revenue growth, operating margins, and sales to capital ratio.

• Revenue Growth: Higher growth generally leads to higher valuation, assuming other factors remain constant.
• Operating Margins: Higher margins indicate greater profitability, thus increasing company value.
• Sales to Capital Ratio: A higher ratio signifies more efficient use of capital to generate sales, making the company more valuable by reducing reinvestment needs.

The ideal company would exhibit high revenue growth, high margins, and a high sales to capital ratio, indicating efficient growth with minimal reinvestment. The "Mag Seven" companies are cited as examples of firms that have achieved this "magic trick" at scale.

Case Studies and Company Examples:

• General Motors (GM):

  • Story: GM faces challenges with low growth potential and struggling margins (single-digit, 3-5%). High cost of goods sold and limited pricing power contribute to margin pressure.
  • Growth Pathway: Achieving double-digit growth would be a "miracle." A potential pathway to survival involves 3-5% growth, supported by continued sales of gas-powered cars and potential protection from competition.
  • Electric Vehicles (EVs): A significant hurdle is convincing consumers to buy EVs from legacy automakers. The "Chevy Volt" example suggests that traditional brand names might be a liability for EVs, with consumers preferring new, high-tech brands.
  • Reinvestment: Reinvestment needs are primarily for retooling existing factories to produce future car models.
  • Argument: The narrative for GM is likely to be one of low growth and slight margin improvement, not an "upbeat story."

• Lululemon:

  • Story: Lululemon has experienced high growth in the past but now faces increasing competition in the apparel market.
  • Growth: Double-digit growth is desired but challenging due to its size and market saturation. Moderate growth (8-14%) is a more realistic expectation.
  • Margins: Reasonable margins have been maintained due to brand strength, but the longevity of brand appeal is a question.
  • Reinvestment: Reinvestment focuses on brand building and advertising, rather than physical factories.

• Restaurants (Shake Shack, Cheesecake Factory, Chipotle, McDonald's):

  • Market: The US restaurant market is described as "saturated," with limited opportunities for significant new store openings.
  • Winners and Losers: Within this sector, companies like Cava are seen as having growth potential by taking market share from struggling competitors like Cheesecake Factory (due to high-calorie offerings).
  • Margins: Driven by food costs and labor costs. Rising minimum wages and pressure on food prices can impact margins. Companies may pass these costs to consumers, but the business faces headwinds.

• Palantir:

  • Story: A high-growth company with currently low margins (2-3% last year, single digits).
  • Growth: Grew by 30% last year and targets a large market (trillion-dollar defense budgets).
  • Margins: Significant potential for margin improvement as the company scales up, with unit economics favoring profitability once infrastructure is in place. Margins could potentially reach 30-40%, typical of software companies.
  • Reinvestment: Primarily in technology, R&D, and acquisitions.
  • Sticky Business: Defense contracts are "incredibly sticky," providing a stable revenue base.

• Baidu (BU):

  • Valuation (2014):
    • Revenue Growth: Healthy growth driven by China's 8-10% economic growth and Baidu's position as the leading search engine in a fast-growing online retail market. Projected revenues to be six times larger in year 10.
    • Margins: Sky-high margins (close to 50%) due to online advertising unit economics. However, competition from Tencent, JD, and Alibaba is expected to put pressure on margins.
    • Reinvestment: In technology, R&D, and acquisitions. Historical reinvestment patterns were used as a predictor of future reinvestment.
  • Argument: The large and growing Chinese market provided a significant tailwind.

Methodologies and Frameworks

Valuing Mature Companies: A Shortcut Approach

For mature companies with stable margins and predictable returns on capital, a shortcut can be used to estimate expected growth. This involves:

1. Retention Ratio: The percentage of net income reinvested back into the business (1 - Payout Ratio).
2. Return on Equity (ROE) or Return on Invested Capital (ROIC): The profitability generated by the company's investments.

• Expected Growth in Earnings Per Share (EPS): Retention Ratio * ROE.
  • Example (JP Morgan): 50% retention ratio * 18% ROE = 9% expected EPS growth.
• Expected Growth in Free Cash Flow to the Firm (FCFF): Equity Reinvestment Rate * Non-Cash ROE.
  • Equity Reinvestment Rate: Percentage of net income reinvested as an equity investor (considering net working capital changes and debt).
  • Non-Cash ROE: Net income (excluding interest income from cash) / (Book Equity - Cash). This measures returns on operating assets.
  • Example (Coca-Cola): 15% equity reinvestment rate * 60% non-cash ROE = 9% expected growth. (Note: The 60% ROE is exceptionally high and warrants investigation into its drivers, such as brand strength and capital structure).
• Expected Growth in Operating Income: Reinvestment as a percentage of after-tax operating income * Return on Capital.
  • Example (Disney): 54% reinvestment rate * 12.6% return on capital = 6.5% growth.

Caveat: This shortcut is only applicable when a company's performance has "settled in." It's not suitable for high-growth or volatile companies like Palantir.

The Role of Leverage in ROE

Leverage can artificially inflate ROE. While borrowing money can provide a tax advantage and amplify returns on equity, it also increases risk. The "real estate way" of boosting ROE through high leverage on average projects is contrasted with generating high ROE from genuinely good projects (e.g., Apple, Microsoft). The increased risk from leverage can offset the benefits of higher growth, potentially lowering overall value.

Terminal Value Estimation

Terminal value (TV) represents the value of a company beyond the explicit forecast period.

• Standard Method: Perpetual Growth Model: Assumes a company grows at a constant rate indefinitely.
  • Formula: TV = Cash Flow in Year (n+1) / (Discount Rate - Growth Rate)
  • Growth Rate Cap: The perpetual growth rate cannot exceed the long-term economic growth rate.
• Myth 1: Perpetual Growth Model is the Only Option: While a convenience, it may overestimate TV for companies with shorter life cycles. A finite growth period (e.g., 10-15 years) can be used for companies with limited lifespans.
• Myth 2: Infinite Value from Perpetual Growth: If the growth rate approaches or exceeds the discount rate, the valuation can become infinite. This is mathematically unsound and indicates an error in assumptions. The growth rate should be capped at the risk-free rate (a proxy for nominal economic growth).
• Myth 3: Growth Rate is the Biggest Assumption: The growth rate in the TV model is less critical than the assumed returns on capital in perpetuity. If a company earns its cost of capital, changing the growth rate has minimal impact on value. The key is whether excess returns (ROIC > Cost of Capital) can be sustained.
• Negative Growth Rate: Applicable for companies in declining industries (e.g., tobacco, some commodity companies facing resource depletion or regulatory changes). This implies the company will shrink over time.
• Myth 4: Terminal Value Should Not Exceed a Certain Percentage of Total Value: While TV often constitutes a large portion of total value (especially for growth companies), this is a natural consequence of equity investing focused on price appreciation. It does not invalidate the DCF model or the importance of the explicit forecast period.

Valuing Commodity Companies (e.g., Vale)

• Challenge: Commodity prices are cyclical and volatile. Using a single year's operating income can lead to overvaluation or undervaluation.
• Solution: Average operating income and returns on capital over longer cycles (e.g., 30-40 years) to capture cyclicality.
• Competitive Advantage: For commodity companies, the advantage often lies in owning reserves of the resource.
• Stable Growth Model: Often appropriate for mature commodity companies.

Valuing Disney (Case Study)

• Explicit Forecast Period (10 years):
  • Growth: Assumed growth higher than stable growth but not excessively high (e.g., 6.8% for the first 5 years, then declining).
  • Reinvestment Rate: Based on historical capital budgeting decisions (e.g., 54% for theme parks, movies, acquisitions).
  • Return on Capital: Assumed to remain above the cost of capital due to brand strength.
  • Cost of Capital: Based on existing debt and equity ratios, reflecting management's conservative approach.
• Transition Period (Years 6-10): Gradual decline in growth rate and reinvestment rate towards stable growth levels.
• Stable Growth Period (Year 11 onwards):
  • Growth Rate: Set below the risk-free rate (e.g., 2.5%).
  • Return on Capital: Expected to remain above the cost of capital due to brand persistence, but at a lower level than during the growth phase.
  • Reinvestment: Sufficient reinvestment to sustain the stable growth rate.
  • Cost of Capital: Adjusted for a more mature company profile.
• Loose Ends:
  • Cash: Added to the operating asset value.
  • Minority Holdings: Value of stakes in other companies (e.g., Hong Kong theme park, Indian TV company) added.
  • Minority Interest: Subtracted to correct for over-consolidation of subsidiary financials.
  • Management Options: Subtracted as they represent a claim on equity.
• Value per Share: Calculated after accounting for all claims on equity.
• Value of Control: The difference in valuation achieved by implementing changes (e.g., optimal capital structure, improved reinvestment policy) versus the current management's approach. This highlights the potential value creation from active management.

Logical Connections and Synthesis

The lecture progresses from the fundamental drivers of value (growth, margins, capital efficiency) to specific methodologies for estimating these drivers. It emphasizes that valuation is not about finding a single "right" number but about building a coherent story supported by assumptions.

• Growth Assumptions: The discussion on growth moves from the generic approach (revenue, margins, reinvestment) to shortcuts for mature companies, highlighting the importance of understanding the drivers behind these numbers (e.g., brand strength, competitive advantages).
• Terminal Value as a Bridge: Terminal value is presented as a necessary tool to provide closure in DCF models, but with a critical examination of its underlying assumptions and common misconceptions. The shift from 20th-century company models to 21st-century companies with shorter life cycles necessitates a re-evaluation of TV methodologies.
• Interconnectedness of Decisions: The lecture concludes by reinforcing that investment, financing, and dividend decisions are not isolated but are interconnected and collectively drive a company's value. Understanding these relationships is crucial for effective business management and valuation.
• The Role of Storytelling: Throughout the discussion, the importance of a compelling narrative that justifies the quantitative assumptions is stressed. The numbers must tell a story about the company's future prospects.

Data, Research Findings, and Statistics

• Mag Seven Companies: Cited as examples of companies achieving high growth, high profitability, and low reinvestment at scale.
• GM Margins: Single-digit margins, 3-5%.
• China's Economic Growth (2014): 8-10%.
• Baidu's Online Advertising Margins: Close to 50%.
• JP Morgan ROE: 18%.
• Coca-Cola Non-Cash ROE: 60%.
• Disney Reinvestment Rate: 54%.
• Disney Return on Capital: 12.6%.
• Disney Cost of Capital: Approximately 7.81% (in 2013 valuation).
• Vale Return on Capital: 17.25% (in the example valuation).
• Vale Cost of Capital: 8.2% (in the example valuation).
• Vale Operating Income (Example): 17.626 billion.
• Vale Value of Operating Assets (Example): 203 billion.
• Vale Equity Value (Example): 167 billion.
• Vale Value per Share (Example): $32 (stock trading at $13).
• Disney Value per Share (2013): $62.56.
• Disney Value per Share (with proposed changes): $74.91.
• Risk-Free Rate: 2.75% (US Treasury).
• Disney Beta: 1.0013.
• Equity Risk Premium: 5.76%.
• Disney Debt Ratio: 11.5% (current), 40% (optimal).

Key Arguments and Perspectives

• Valuation is Forward-Looking: The core of valuation lies in forecasting future cash flows and discounting them back to the present.
• No Perfect Forecasts: It's acknowledged that forecasting the future is inherently uncertain, and all projections will be "wrong." The goal is to make the "best estimate" and base decisions on that estimate.
• Storytelling is Crucial: Numbers alone are insufficient; they must be supported by a logical and compelling narrative about the company's business model, competitive advantages, and future prospects.
• Mature Companies vs. Growth Companies: Different valuation approaches and assumptions are required for companies at different stages of their life cycle.
• Terminal Value is Important, Not Mystical: While often a large component of value, TV is not an arbitrary number. It's derived from underlying assumptions about growth, profitability, and reinvestment in the long term.
• Leverage is a Double-Edged Sword: While it can boost returns and potentially lower the cost of capital, excessive leverage increases risk and can ultimately decrease value.
• Value of Control: Management decisions and strategic choices can significantly impact a company's value, and this potential for improvement can be quantified.
• Interconnectedness of Corporate Finance: Investment, financing, and dividend decisions are deeply intertwined and must be considered holistically.

Notable Quotes and Significant Statements

• "You're definitely wrong. In fact, you're going to be wrong 100% of the time. Why? Because you're trying to forecast the future." (Regarding forecasting accuracy)
• "The value of an asset is the present value of the expected cash flows in the asset." (Fundamental valuation principle)
• "The terminal value allows you to put closure by looking at what happens after year five year 10. You say I'm tired of estimating cash flows. The terminal value captures what those cash flows will be forever."
• "The 21st century company doesn't look like the typical 20th century company." (Regarding shorter corporate life cycles)
• "If you obey the basic rule that your growth cannot exceed the growth rate of the economy, you will never get a terminal value." (On capping growth rates)
• "The growth rate is not the big assumption. It's what you assume about returns and capital forever." (On the drivers of terminal value)
• "Debt is a double-edged sword. It can help you. It can push up your growth. It can make your return equity great. But you got to walk in with eyes open which is also makes your equity riskier."
• "The endgame in in in corporate finance? To maximize the value of the business."
• "The investment principle... make sure you earn a return on those investments that exceeds a minimum acceptable hurdle rate."
• "The financing principle... find a mix of debt and equity that minimizes your hurdle rate."
• "The dividend principle... if you cannot find investments to take with those cash flows, return the cash back to the investors."

Technical Terms, Concepts, and Specialized Vocabulary

• Revenue Growth: The rate at which a company's sales increase over a period.
• Operating Margins: Profitability relative to revenue, typically expressed as a percentage (e.g., Operating Income / Revenue).
• Sales to Capital Ratio: Measures how efficiently a company uses its capital to generate sales (Sales / Capital Invested).
• Return on Equity (ROE): Net Income / Shareholder's Equity.
• Return on Invested Capital (ROIC): Net Operating Profit After Tax (NOPAT) / Invested Capital.
• Cost of Capital: The weighted average cost of a company's debt and equity.
• Cost of Equity: The return required by equity investors, often calculated using the Capital Asset Pricing Model (CAPM).
• Cost of Debt: The interest rate a company pays on its borrowings, adjusted for tax shields.
• Beta: A measure of a stock's volatility in relation to the overall market.
• Retention Ratio: The proportion of net income that a company reinvests in its business.
• Payout Ratio: The proportion of net income paid out as dividends.
• Terminal Value (TV): The estimated value of a company beyond the explicit forecast period in a DCF analysis.
• Perpetual Growth Model: A method for calculating terminal value assuming a constant growth rate into perpetuity.
• Discount Rate: The rate used to discount future cash flows to their present value, reflecting the riskiness of the investment.
• Free Cash Flow to the Firm (FCFF): Cash flow available to all capital providers (debt and equity holders) after all operating expenses and investments.
• Free Cash Flow to Equity (FCFE): Cash flow available to equity holders after all expenses, debt payments, and reinvestments.
• Minority Interest (Non-controlling Interest): The portion of a subsidiary's equity not owned by the parent company.
• Value of Control: The potential increase in a company's value resulting from changes in management or strategy.
• Optimal Capital Structure: The mix of debt and equity that minimizes a company's cost of capital.
• Hurdle Rate: The minimum acceptable rate of return for an investment.

Conclusion

The lecture provides a comprehensive overview of valuation principles, emphasizing the interconnectedness of financial decisions and the importance of a well-supported narrative. It moves from the fundamental drivers of value to practical methodologies for estimating them, including advanced concepts like terminal value and the value of control. The case studies illustrate how these principles are applied in real-world scenarios, highlighting the challenges and nuances of valuing different types of companies. The overarching message is that valuation is an iterative process of making informed assumptions, building a story, and understanding the underlying business drivers.