The Science and Art of Business Valuation

The Science and Art of Business Valuation

By Michael J. Highfield

As a finance professor, it is not uncommon to have a student, even a senior majoring in finance, ask for my opinion about the price of a stock even when they have the tools necessary to answer the question. In the process of taking coursework for an undergraduate degree in finance, students often find themselves “unable to see the forest for the trees.” That is, they often focus on learning the accounting, economics and statistical tools without seeing how these tools work cohesively to make financial decisions such as determining if a stock is underpriced or overpriced.

Paul Whitmire, an MSU alumnus and one of my former students, discussed this issue with a group of Mississippi State students at a New York City steakhouse on 52nd Street, right around the corner from his Seventh Avenue office. It was mid-March 2018, and news of a late season nor’easter was the talk of the city. However, our students were intently listening to Paul’s description of working for a Wall Street firm and the office he would return to after dinner – after already putting in a 12-hour day. During the course of the conversation, Paul remarked that MSU should bring Training the Street (TTS) to campus. He had gone through the TTS program during his MBA studies at Vanderbilt University, and he explained that TTS courses are used for training at investment banks, consulting firms and Fortune 500 companies.

Following Paul’s advice, the Department of Finance and Economics brought TTS to Starkville on February 22-23 this year. The Finance Immersion Workshop was led by Zachary Beukema, a Boston College graduate with experience at Raytheon Company and investment banking firm Jefferies LLC. Approximately 40 students from across campus and four faculty members participated. The Friday session covered accounting information from the perspective of an investment banker, valuation methodologies used by Wall Street firms and related questions often seen in interviews for finance-related internships and jobs. The Saturday session included useful shortcuts in Microsoft Excel and a detailed valuation of Cadbury when it was acquired by Kraft Foods in 2010.

The TTS session was a great success. Students shared that the workshop showed how the skills they were learning from their finance faculty at MSU were applicable in the “real world” of Wall Street firms. The students also shared that, although we routinely hear about “Buy, Sell, or Hold” ratings and “stock price targets,” most of us don’t know the process used by analysts to develop these important opinions that influence our retirement and savings portfolios. The TTS workshop helped our students see this process more clearly.

Below is a brief summary, or 10,000-foot view, of the stock price valuation process.

1. Warren Buffett, Chairman and CEO of Berkshire Hathaway and one of the most famous investors of all time, said, “Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.” So, following the advice of the Oracle of Omaha, we start with the three basic financial statements.

• Income Statement – Summarizes revenues, expenses and profit for a defined period of time such as one quarter or fiscal year.

• Balance Sheet – Reports the balances of the assets (tangible and intangible items the firm owns), liabilities (debts the firm owes creditors) and owners’ equity (the net worth or “book value” of the firm) at a specific point in time such as the end of a fiscal year.

• Cash Flow Statement – Reports the sources of a business’s cash inflows and outflows between two balance sheet dates.

Using these financial statements, an analyst will value a company on an intrinsic value basis and a relative value basis.

2. Intrinsic Valuation – The objective process of determining the theoretical value of a company based on the interest rate and time adjusted value (present value) of the cash flows available to all capital holders.

• First, the analyst will compute the Weighted Average Cost of Capital (WACC), the required rate of return for both equity and debt investors commensurate with the risk of the investment weighted by the respective percentage of debt and equity held by the firm. While this value can be computed by an analyst, estimates can often be obtained through a Google search. Note that higher discount rates imply greater risk, thus driving down the present value of cash flows.

• The analyst then forecasts Free Cash Flow (FCF) – EBITDA (earnings before interest, tax, depreciation and amortization) less capital expenditures (change in fixed assets) less additions to intangible assets less (plus) increases (decreases) in net working capital – using the income statement and balance sheet.

• Making assumptions, the analyst will estimate FCF for a forecast period of five to seven years. At the end of the forecast period, the analyst will estimate a Terminal Value to represent the present value of all FCFs the firm will accrue after the forecast period.

• The forecasted FCFs and Terminal Value will be “discounted” back to the present (today) using the WACC as the discount rate to arrive at the Total Enterprise Value (TEV).

• The analyst will then subtract total debt, preferred stock and non-controlling interests (firm ownership of a subsidiary without control over decisions of the subsidiary) from TEV and add back cash and equivalents from the balance sheet to get Equity Value.

• Equity Value (EV), also known as Market Capitalization, is the value of owners’ interests in the firm. Dividing EV by the Diluted Shares Outstanding results in an estimate of the stock price we call the intrinsic, or fundamental, value of the stock. If the actual stock price is below (above) the intrinsic value, the stock is considered undervalued (overvalued) and should be purchased (sold).

3. Relative Valuation – The process of using publicly available data to compare a firm with similar companies through value relationships known as Key Multiples.

• The Price-Earnings (P/E) Ratio – Price per share relative to earnings per share (EPS) – is commonly used as a key multiple. Other examples are the Price-to-Sales (P/S) and Total Economic Value-to-Sales (TEV/S) Ratios.

• Comparable firms are identified based on operations and financial similarities. Fortunately, companies typically identify their competitors in their annual reports, which can be accessed through the Security and Exchange Commission’s (SEC) EDGAR database: www.sec.gov/ edgar.

• From the financial statements for each firm, the analyst identifies several important variables. A few variables deserve special attention:

o Sales is Revenue reported on the Income Statement. However, analysts are more interested in the estimate of next year’s revenue figure. Thus, sales is typically a forward-looking, estimated sales figure.

o Diluted Shares Outstanding (DSO) is the total shares of stock issued to investors plus shares that could be claimed through conversion of other financial instruments to equity shares. o Earnings per Share (EPS) is Net Income (revenue minus expenses) or Profit divided by DSO. This is a measure of profitability per share of ownership. Use of last year’s Net Income in this computation leads to a “trailing EPS.” However, an analyst will typically forecast Net Income for the coming year and compute ratios using a “forward EPS.”

• Using the average Key Multiple for comparable companies, the analyst will estimate a price of the firm’s stock. If a firm is trading a premium or discount relative to its peers, the analyst will examine the company more closely to determine if this premium or discount is justified.

o For example, assume that an analyst estimates that Apple Inc.’s forward EPS will be $11.50. If Apple’s current share price is $205.50, an analyst will compute the PE Ratio as $205.85 / $11.50 =17.9x. That is, Apple is trading at 17.9 times future earnings.

o If comparable firms are trading at a PE Ratio of 17.5x, the analyst will conclude that the relative price of Apple is 17.5 × $11.50 = $195.50. Thus, Apple is currently trading at a premium ($205.85 > $195.50) relative to its peers.

The outline above is just a brief summary of valuation process to illustrate the science and art behind business valuation. While the intrinsic valuation process to derive a theoretical price is fairly scientific and mathematical, the relative valuation process relies on the artful selection of comparative companies as well as the post-estimate judgment of pricing differences. In the end, there is no guarantee that either method will arrive at the correct value. However, as Aswath Damodaran wrote, “Success in investing comes not from being right, but from being wrong less often than everyone else.”

Dr. Michael J. Highfield

Dr. Michael J. Highfield, PhD, CFA, CTP, a former faculty member at Louisiana Tech University, returned to his alma mater as an MSU faculty member in 2005. As Department Head of Finance and Economics from 2009 to 2018, Highfield oversaw 22 full-time faculty, established a departmental advisory board, secured more than $4.5 million through development activities, hired 13 tenured/tenure-track faculty and guided the tenure and/or promotion of 11 faculty members. His teaching interests include corporate finance, banking and real estate finance, and his research is concentrated in securities issuance and real estate finance. Highfield serves as Vice President of Curriculum for the Graduate School of Banking at Louisiana State University and as a volunteer and consultant for the CFA Institute. He is past President of the American Real Estate Society and is currently on its Board of Directors. Highfield is a member of the Investments Committee for the MSU Foundation and of the Oktibbeha Educational Foundation, Inc.