tmmonline.nz  |   landlords.co.nz        About Good Returns  |  Advertise  |  Contact Us  |  Terms & Conditions  |  RSS Feeds

NZ's Financial Adviser News Centre

GR Logo
Last Article Uploaded: Wednesday, December 4th, 9:26AM

Investments

rss
Investment News

Valuation methods are in the eye of the beholder

Mr Market¹ has been particularly indecisive of late, with price volatility sucking up a lot of investors’ attention.

Friday, May 5th 2023, 12:11PM

by Mint Asset Management

By Sam Arcand

As an active manager focused on generating risk-reward outcomes better than the overall market, we at Mint believe that investors need to keep their attention on value and try to ignore what prices are doing. To help investors maintain that focus we wanted to share some insight on a common tool for determining value: discounted cash flow (DCF) valuations.

In short, DCF valuation models are based on estimates of the business’ future cash flows, expressed in terms of today’s dollars using an estimate of business risk and the value of having money today vs. having it in the future. ² While there is much to say and cases to be made for using other valuation methodologies such as price multiples in certain scenarios,³ in this article we’ll focus on DCF models.

We believe that DCFs have many advantages for determining value including that:

  • They focus on the right measure of value. Ultimately, we believe the stream of cash flows generated by the business are the most relevant measure of value. Other valuation methods often don’t focus on this kind of measure of value and overlook things like working capital requirements and capital expenditures that businesses need to make to generate value.
  • Growth matters (and multiples are static). This is one of the clearest advantages for DCFs over price multiples in particular. Consider two businesses, A Co. and B Co. A Co. makes $100 a year and B Co. $10 a year. Using the same earnings multiple for both, we’d value A Co. much higher than B Co. But suppose we think B Co can grow at 50% a year for 10 years and then stop growing once its earnings are $384 per year. A prudent investor wouldn’t want to apply a price multiple to end-state level of earnings; the growth isn’t a sure thing after all. So, what to do? That kind of consideration can be difficult to express through a multiple. The difficulty is partly explained by the next point…
  • Timing matters. As alluded to above, DCFs account for the timing of cash flows. Even if we think an investment will pay out $100 with certainty, it makes a difference to the value of the investment whether it pays out next year or in 10 years’ time. DCFs explicitly account for that factor. Many other valuation methods do not.
  • They disaggregate value drivers. A good DCF will be based on key business value drivers. This can make earnings as a whole easier to predict because it chunks down overall performance into manageable pieces to form a view on. This can also be useful for managing risk because an investor can use the DCF model to identify and quantify the major risks facing a business and make their investments accordingly.

Despite those (and other) advantages of DCF valuations, they aren’t infallible. Trying to estimate a business’ cash flows is not easy for most investors, including professional investors like us at Mint. This can lead to overcomplicated models, with many variables and lots of calculations. It’s easy to let that complexity make you overconfident in your estimates and lead you to be too aggressive in your investment decisions. Moreover, being able to use more variables, including key business value drivers, is helpful, but doesn’t always lead to more correct estimates.

At Mint, we don’t exclusively use DCFs to value businesses, and our robust process helps us overcome the potential biases and traps they present. However, we do think they’re an effective tool in an investor’s toolkit and they force investors to be focused on value, not what Mr Market is telling them.

¹ If you aren’t familiar with it you can read about Mr Market in Benjamin Graham’s book, The Intelligent Investor, or get a brief summary here: Mr. Market - Wikipedia.

² This estimate is called the discount rate, and in very simple terms, this can be thought of like an interest rate in that it reflects the value of deferring consumption from today to the future and the risk that the investment amount might not be repaid.

³ In short, we think they’re appropriate for making relative inferences of value for mature businesses.

⁴ It’s not impossible, but the task gets more difficult given that the length and profile of growth can vary between businesses. This is another reason why multiples can get you stuck trying to do too much with too few variables.

 Here I would invoke and repurpose Warren Buffet’s caution on his investment process – it’s simple, but not easy.

Disclaimer: Sam Arcand is an Investment Analyst at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice.
Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement at mintasset.co.nz

Mint Asset Management is an independent investment management business based in Auckland, New Zealand. Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement at mintasset.co.nz

Tags: Mint Asset Management

« When it comes to equities, there is no hiding from the voting machineCatch 22 – Inflation vs. Earnings »

Special Offers

Comments from our readers

No comments yet

Sign In to add your comment

 

print

Printable version  

print

Email to a friend

Good Returns Investment Centre is brought to you by:

Subscribe Now

Keep up to date with the latest investment news
Subscribe to our newsletter today

Edison Investment Research
  • Termination of coverage - Tetragon Financial Group
    29 November 2024
    Termination of coverage
    Edison Investment Research is terminating coverage on Tetragon Financial Group (TFG). Please note you should no longer rely on any previous research or...
  • Bankers Investment Trust (The)
    29 November 2024
    Concentrating on best ideas only
    Following a strategic review earlier this year, the manager of the Bankers Investment Trust (BNKR), Alex Crooke, has concentrated the portfolio, reducing...
  • Partners Group Private Equity
    28 November 2024
    Seeing good demand for several of its assets
    Partners Group Private Equity’s (PGPE’s) recent portfolio realisation efforts (supported by the gradual pick-up in M&A activity and an opening...
© 2024 Edison Investment Research.

View more research papers »

Today's Best Bank Rates
Rabobank 5.25  
Based on a $50,000 deposit
More Rates »
About Us  |  Advertise  |  Contact Us  |  Terms & Conditions  |  Privacy Policy  |  RSS Feeds  |  Letters  |  Archive  |  Toolbox  |  Disclaimer
 
Site by Web Developer and eyelovedesign.com