Monday, February 11, 2008

Off-topic: DCF modelling still undervalued

During the last week of January I attended an Amsterdam Institute of Finance course, Advanced Valuation. I shortly cover it here, just because I felt it was so much worthwhile for anybody in the finance industry, or with an interest in business in general. It had little to do with the topics per se, covered over here at Communications Breakdown, but obviously it takes little effort to make some connections.

Professor Kevin Kaiser is a compelling story teller, to the point where nobody present seemed to need a single coffee break. His background is very diverse, from teaching (INSEAD, AIF, etc.) to consulting (McKinsey, as well as his own Amphia firm) and setting up a business ( The only thing missing on his resume is writing a book, but I am sure sooner or later he will commit to this.

The course was more about concepts and true understanding than the mechanics of building a DCF-model ("a chimpanzee can do that"). A rather characteristic, if insignificant, example arose when he condemned the use of multiples for doing a valuation (see below). You often see those in Wall Street reports, and to Kaiser’s utter dismay analysts even calculate the average value of a multiple. He then asked the question, "what does it mean", as the average of values that are not supposed to be equal is totally meaningless.

It is absolutely striking to see how DCF got to take over Wall Street reports, over the past 15 years or so. Unfortunately, Kaiser finds 99% of them are garbage, as most reverse engineer the numbers to come up with the desired share price.

Another example of Kaiser poking our true sense of understanding came at the end, when we discussed the required rate of return which we use to discount the cashflows. It seems to be common practice to think of this percentage as the weighted average of the cost of equity and the cost of debt, but this runs counter to the original intentions of Modigliani and Miller. The way a company is financed should have no influence on the discount rate, but instead should show up in the cashflow calculations. The discount rate is much more of a conceptual thing that is linked to what Kaiser calls ‘Gaia’ (earth), through beta.

Here are some key concepts and other issues Kaiser discussed, which ring a bell in a Communications Breakdown context. It is by no means a representation of the course. If you really want to learn more and shake up your understanding, sign up for the course!
Don't be averted by the basic nature of these topics. Be surprised - Kaiser originally did the course in a single day, but in order to increase the impact he decided to let the discussions in the group run for some time. Now, it’s a four day thing.

Value v. Price
“What is the value of my PC that I just bought for $3,000?.” The typical answer is: something like $2,000.
But if I just bought it for $3,000, the value to me is at least $3,000. However, in the hands of my 5 year old son it’s close to zero. It all depends on what you will do with it, and the cashflows it’s going to generate.
This implies that the value of company doesn’t sit in it’s ‘tangible intangibles’ (software, patents, licenses, contracts, brands), but in its ‘intangible intangibles’ (relationships, knowhow, quality of management, reputation, company culture, etc.).
Hence, what Interbrand does therefore is ‘total nonsense’. It is also very relevant for the Microsoft offer for Yahoo!

Indicators v. Objectives
There are many indicators, including EVA, multiples, growth, margins, market share, R&D cost, share price, productivity, employee satisfaction, etc., but there is just one objective: value creation.
Companies issuing ‘guidance’ are typically doing share price management, instead of value-based management. The share price should never be an incentive to a management team, nor should it be part of any strategic plan.

Predictions v. Expectations
Expectations reflect all the potential outcomes (Kaiser made a physics comparison here). When you flip a coin, with a $0 value attached to heads and $1 attached to tails, the expected outcome is $0.50, even if this outcome can never materialize and thus would never be a 'prediction'.
Hence, what we try to make our DCF-value close in on, is The Expected Value.
Kaiser discussed the ‘Value Test’ from the GE annual report. If the expected outcome is 50, you spend 40 and your return is 30 (i.e. -10), you are basically doing OK. You underspent and simply were unlucky to get a poor return. Continuing on this path, you are bound to create value in the long run, because returns are bound to improve (you will typically expect to see a normal distribution around 50). The guy who spent 60 and got a 70 return (i.e. +10) did a poor job but just got lucky. In the long run, he will be destroying value.
“A good idea that turns bad isn’t the same as a bad idea.”

Capital Markets
Kaiser hailed the capital markets for making the public the owner of the earth’s assets, taking over from ‘kings and queens’ (relationship-based economy). “Governments mismanage”, whereas the capital markets (in-human, value driven and transparent) , where nobody is in charge and thus everybody is, tend to be a much more efficient place for assigning capital.
Investors (have cash, lack ideas) and entrepreneurs (have ideas, lack cash) took over for the benefit of consumers, employees and communities (hence the importance of CSR).
The only downside is the separation of ownership and control – enter agency costs. Managers (lack cash, lack ideas) are only human.
Food for thought for those who think munifiber or muniwifi can be a viable business (Viviane Reding is not among them, and I may have to rethink).

Value Drivers
What it all boils down to is customer value, even ‘customer happiness’. The Gerstner Questions, questions Louis Gerstner asked RJR Nabisco or IBM management when he was hired as CEO, all circle in on this.
Ultimately, there are four drivers in a DCF-based model. “Capture these, and you can do the valuation.” Toyota time and again served as a prime example of a superior company:
  1. Customer focused
  2. Value driven
  3. With integrity
  4. Standards of behavior/performance
Sustainable Competitive Advantage
This what it’s all about. When Jack Welch came to GE, the first thing he did was sell businesses that weren’t market leaders or at at least the number 2 (with a chance of becoming #1) in their market. This strategy is copied by KPN, which is disposing of Getronics parts that aren't (and never will be) market leaders.
It all goes back to Adam Smith’s ‘invisble hand’, in his 1776 ‘The Wealth of Nations’. Economic forces tend to drive your economic profit (EVA) to zero, in other words: ROIC will converge to OCC (opportunity cost of capital). "Value ends up in the hands of customers and employees". If you want to defy the economic forces, you need to have a sustainable competitive advantage (which implies: access to NPV positive projects). Only the market leader can have this.

Natural Ownership
Sometimes a unit has poor performance, but it’s better to strengthen it than to sell it at a firesale valuation. Perhaps you are the natural owner who is best positioned to make it work. The reverse can also be true. If you’re not the natural owner, and somebody else is willing to pay a good price (i.e. above the value that you attach to it), you might as well sell it.
This view of the world could be a strong case for telcos hanging on to their networks. Even their role of service providers could be 'less core' than network build and maintenance. Not to mention venturing off in other directions.

Vertical Integration
Take TomTom + Tele Atlas. In the short run it may enhance TomTom's profit, by killing competition. However, Tele Atlas is set to loose any incentive to innovate, and TomTom will be held to buy from them, even if they could theoretically shop around. In other words, a new company (outside the so-called Tele Atlas/Navteq duopoly) will arise.

Procurement Synergies
Large companies theoretically can negotiate better terms with their suppliers. However, they tend to be ‘stupider and lazier’, resulting in negative synergies and worse supplier deals.

The Market
"Shareholders are like bacteria; stupid on their own, but smart in large quantities."
A KPMG poll showed that 43% of managers are prepared to lie about budgets. "To make it to be a CEO, you have to be a good liar."

A set on not-literal quotes: "Multiples are for braindead clueless stupid people (…): total nonsense (…) confusing and deceiving. Wall Street feeds them to CEOs to keep M&A going. Multiples are based on price and fabricated earnings numbers, and hence tell us nothing about value. They won’t help you ask the right questions."

Takeover Premium
When buying a company, you add together the current value ('as is'), value created from improved management/operation, synergies and the value of 'winning' the asset (instead of somebody else). If this sum is more than the current market price, you pay a 'takeover premium'. Keep in mind however that this is the result, not the starting point of your valuation. Also, there is absolutely no direct relationship between this 'premium' and the synergies.
Again, compare the Microsoft/Yahoo! case.

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