I went from telling a story in chapter 6 to testing that story for plausibility in chapter 7 to connecting the story to value drivers in chapter 8. In this chapter I bring the process to fruition by using the value drivers to estimate value. I begin the chapter by returning to the valuation model introduced in chapter 8 and exploring the mechanics of valuing a company and presenting that valuation. Using the companies that I introduced in chapter 8 as illustrative examples, I arrive at estimates of value that are consistent with the stories that I told about each company. In the second part of the chapter, I reverse the process and look at how you can extract stories from existing valuations (often presented just as numbers) and use these stories to judge whether the valuations make sense.
From Inputs to Value
If you have converted your stories into valuation inputs, the bulk of the heavy lifting in valuation is already done, because making the connection between value inputs into value is mechanics, for the most part.
When valuing a business, you start by valuing its existing investments and then augment that value with the value created or destroyed by growth, before adjusting for risk in the cash flows. The steps involved are described in figure 9.1.
Figure 9.1
The steps in valuation.
As you review the mechanics of this story, it is worth emphasizing that the inputs are interconnected, that is, changes in one almost always trigger changes in the others. Thus, if you decide to increase the growth rate in a valuation, you have to consider how much your reinvestment will need to change to deliver that growth and whether you will have to alter your business mix (and the risk of that mix) and financial leverage to deliver that growth.
One aspect of DCF valuation that both trips up and troubles those using it is the role of the terminal value. If you are valuing a business, it is almost inevitable that the terminal value will be a substantial contributor to the value that you estimate for the value today, accounting for 60 percent, 70 percent, or even more than 100 percent of the current value. Rather than view that as a weakness of the model, as some are apt to do, consider it a reflection of how you make money as an equity investor in a business. Equity investors generate cash flows while they hold onto their investments in the form of dividends or cash payouts, but the bulk of their returns comes from price appreciation. The terminal value stands in for this price appreciation, and not surprisingly, as the growth potential of a business increases, the terminal value’s contribution to current value will also increase. If you accept that interpretation of terminal value, the second concern you might have is about how assumptions you make in your terminal value can hijack your entire valuation. Consider again the equation for estimating terminal value, estimated for a going concern:
In chapter 7 we introduced the first constraint on this computation, arguing that the growth rate in the terminal value equation has to be less than or equal to the nominal growth rate in the economy (domestic or global) in which the company operates. I would tighten that constraint by suggesting that the risk-free rate be used as the proxy for nominal growth in the economy, thus bringing the currency choice into the growth estimate; if you are working with a higher-inflation currency, both your risk-free rate and expected growth rate in perpetuity will be much higher. There is a second constraint that needs to be considered. In keeping with the consistency argument that underlies all growth estimates, it is important that companies reinvest enough to be able to sustain their “stable” growth rates in terminal value. In fact, one simple way of estimating that reinvestment rate is to first estimate a return on capital that a company can generate in stable growth and use it to back into a reinvestment rate:
Thus, if you generate a return of 12 percent on the capital invested in new projects, you will need to reinvest 25 percent of your after-tax operating income in perpetuity to be able to grow at 3 percent a year. In fact, if the return on capital you generate is equal to your cost of capital, the terminal value will not change as growth changes, since growth becomes a neutral variable. This not only allows you to keep terminal value constrained but also leads to a strong implication. The value added by your growth estimate in stable growth is a function of whether you believe that a firm can maintain its competitive advantages in the long term. If it cannot, its return on capital will drop back to its costs of capital, and the growth rate that you assume will have no effect on value. Thus, the narrative you develop for your company needs a closing part, in which you make judgments about your firm’s capacity to sustain excess returns and continue as a growing concern.
Valuation Loose Ends
Once you have estimated cash flows, adjusted for risk in a discount rate, and computed a present value or value for the operating assets, you may think that the bulk of the heavy lifting in valuation is done, but you would be wrong. To get from the operating asset value to the value of equity in a business and from that equity to value of equity per share in a publicly traded company requires judgments on the following:
1. Debt and cash (net debt): In most valuations, the net debt is a minor and trivial detail at the end of the valuation, a number to be netted out from the value of operating assets to get to the value of equity. That does mask estimation issues with one or both of these numbers. With debt, the key question becomes what you would include in it, and the answer is that it should comprise not just the interest-bearing liabilities that you see on a company’s balance sheet but also other contractual commitments that the firm faces. Lease commitments, for instance, should be considered as debt and brought into your debt number, making a significant difference in the debt value at retail firms and restaurants, which have substantial operating leases. With cash, you have two details that need to be ironed out. The first is a phenomenon specific to the United States and largely the result of the U.S. corporate tax law. The U.S. tax code requires U.S.-based companies to pay the U.S. corporate tax rate on their foreign income, but only when that income is repatriated to the United States. U.S. companies, not surprisingly, choose not to bring their cash back to the United States, thus trapping that cash in foreign locales. In late 2015, about $120 billion of Apple’s $200 billion cash balance was trapped in its foreign operations, and bringing that cash back to the United States would result in a tax bill of close to $20 billion. When valuing Apple, you have to decide whether you, as equity investors in the company, will ever face this tax bite, and if so, when. The second is in markets where cash balances can be invested in risky securities for which the book value (reported in the financial statements) may be very different from the current value.
2. Cross holdings: It is not uncommon for a company to hold portions of other companies, and as an investor, you partake in these holdings. As a consequence, you have to bring the value of these holdings into your estimated value, and to do this, you first have to understand how the firm accounts for these holdings. With both U.S. and international accounting standards, holdings can broadly be classified into majority holdings, for which you own a controlling stake, usually (but not always) more than 50 percent of another business, or minority holdings, for which you hold a smaller stake in another business. With majority holdings, you are required to consolidate your financial statements, act as if you fully own the subsidiary, and report operating numbers (revenues, operating income, assets, debt, etc.) accordingly. That requires accountants to estimate the portion of the value of the subsidiary that does not belong to the parent and show it as a liability, which is called minority or noncontrolling interest. With minority holdings, you are generally not required to show any of your holdings in your operating numbers, but you do have to make an adjustment to net income to reflect your share of the earnings in the subsidiary. You often have to show on your balance sheet only the book value of what you have invested in these holdings. Given this confusing mix, it is no surprise that cross holdings are one of the most mangled items in valuation. There is, however, a simple rule that can help you cut through the confusion. If you can, you should value the parent company based on just parent company financials and then value each subsidiary separately (with its own growth, risk, and cash flow characteristics), take your proportionate holding in each one and add up the values. If you have access to only consolidated financials, you have no choice but to value the portion of the consolidated subsidiary that does not belong to you, using whatever minimal information you have on it and subtracting it out from your consolidated valuation.
3. Stock-based compensation: In the last two decades, many companies have begun compensating their employees with equity in the company, either in the form of restricted shares (with restrictions on trading) or options. Since these are employee compensation, there is no conceivable argument for not treating them as operating expenses at the time that they are granted, even if that involves valuing the options using option pricing models. While it took accounting rule makers a while to come to this realization, it is now standard accounting practice in much of the world. Analysts and companies, though, have routinely undercut the process by then adding back these expenses, with reasons ranging from the absurd to the ludicrous. One rationale is that these are noncash expenses, a way for companies to pay in kind or in equity to pump up cash flows. All that has occurred is a skipping of a step, since if these companies had issued the options or restricted stock to the market and then used the cash from the issuance to pay employees, it would have been a cash flow. The other is that these are unusual expenses, strange reasoning in companies where these expenses occur every year. There is a secondary problem that is created, especially from employee options grants in the past. These options, if still outstanding, represent a claim on the equity of the firm and have to be valued and subtracted out from the equity value to get to the value per share. While there are analysts who try to adjust the shares outstanding for these existing options, it is not a good practice, since not only are out-of-the-money options often treated as worthless in this adjustment, but you are ignoring the cash inflow from option exercise and the time value of options when you do this.
Though you may be tempted to deal with these loose ends (cash, cross holdings, and employee options) mechanically, you should try to incorporate their existence and effects into your story, because they represent conscious choices made by the businesses involved. After all, no business is required to borrow money, hold cash, invest in other companies, or grant options to employees. As a simple example, consider a company like Netflix. The company’s narrative, if you look at its existing business model, is built on buying the exclusive rights to movies from the content companies, often with multiyear payment commitments, and then seeking out subscribers who pay monthly fees to have access to these movies. The risk to Netflix in this story is that it can be squeezed by the content providers pushing up its broadcasting commitments, whereas it is unable to pass the costs on to the subscribers. That may be an impetus for the company’s move toward producing its own content (House of Cards, for instance), perhaps as a precursor to changing its story. In the case of Nintendo, a company that holds a cash balance that amounts to almost half the value of the company, the inherent conservatism of its management team, which leads to both the large cash balance and little or no debt, has to be woven into the story that you tell about the company and its resulting value. Finally, if you are valuing a holding company, the subsidiaries that make up the company are not the tail end of the story but the entire one, with your reading of how good the management is in acquiring these subsidiaries becoming the story of the company.
Valuation Refinements
I believe that much of DCF’s reputation for rigidity is ill deserved and that most analysts never use its most powerful features. I have used DCFs to value young and old companies, firms in different businesses and countries, and stand-alone assets, and I continue to be pleasantly surprised by how flexible the model is. Here are two features the approach offers that many practitioners are either unaware of or ignore.
1. Currency invariance: The template for DCFs works for any currency and in any interest rate environment, as long as you stay consistent in your assumptions about inflation in your cash flows and discount rates. Put simply, if you are valuing your company in a low-inflation currency, your discount rate will be low, but so will your expected growth rates (since they incorporate the same low inflation). If you switch to a high-inflation currency, both your discount rate and growth rates will increase to reflect inflation.
2. Dynamic discount rates: Most descriptions of the DCF methodology require that you estimate a discount rate upfront for the company but then leave it unchanged through your entire valuation, a practice that is neither sensible nor consistent. As you forecast changes in your company’s growth and business mix over time, you should expect your discount rate to change as the company changes. In fact, even if your company’s business mix stays static, the mix of debt and equity that it uses can change over time, and as that mix changes, so will the discount rate.
There are many venture capitalists who are dead set against the use of DCF approaches in valuing companies, and their disdain for the approach may reflect their exposure to a rigid version of the model. One reason that I have used a wide range of companies, from young start-ups to declining businesses to illustrate the connection between stories and numbers in this book, is to bring home my belief that the DCF approach is versatile enough to fit almost any valuation need.
Valuation Diagnostics
It is not surprising that when a valuation is done, the focus is entirely on the bottom line—the value you estimate for the business and for its shares, if it is a publicly traded enterprise. However, there is significant information in the output of the valuation that not only may tell you more about the integrity of the valuation but may also provide you with a sense of what you should be keeping track of, if you are an investor in the company:
1. Growth, reinvestment, and investment quality: Earlier in the book, I introduced the valuation triangle, the balance between growth, reinvestment, and risk that makes for a consistent valuation. One simple check of consistency is to aggregate the change in operating income you are projecting for a company over its high-growth phase and divide that change by the reinvestment you are estimating over that same period.
Marginal return on capital = Change in operating income/Reinvestment
This marginal return on invested capital is a rough measure of how good you think your company’s investments will be in the future. If it is too high or too low, and that judgment can be made by comparing it with the company’s cost of capital, its historical return on capital, or industry averages, it is a red flag that you should revisit your growth and reinvestment assumptions.
2. Risk and the time value of money: The process of discounting cash flows is the adjustment you make in value to reflect both the time value of money (i.e., you would like to get your cash flows early rather than late) and the operating risk in your company as a going concern. To get a sense of how much you penalize the company for time value and risk, consider adding up the nominal cash flows (with no discounting) and comparing that number to the present value of those cash flows. Even though you may be well aware of the time value of money—one of the fundamental concepts introduced early in a finance class—you may be surprised at how much waiting for a cash flow diminishes its value, especially in a risky or a high-inflation setting.
3. Cash flow value: At the risk of stating the obvious, your early cash flows can be negative and, in fact, should be negative, if you have a young, high-growth company, partly because its earnings are low or negative in the early years and partly because of the reinvestment that will be needed to deliver the high growth. Those negative cash flows, though, play a critical role in capturing the dilution effect, that is, the concern that equity investors have that their ownership will be diluted by future equity issues. Since these future equity issues are made to cover the negative cash flows, you are capturing the dilution effect by taking the present value of these cash flows into your consolidated value. Put simply, there is no need to estimate and adjust for future share issuances in your share count in a DCF valuation, because it is already in your value.
4. Negative value for equity: The sum of the present values of your cash flows is the value of your operating assets, and the difference between that number and your net debt is the value of your equity. But what if the operating asset value you obtain is lower than the net debt number you have? Can equity have a negative value? The answer is no and yes: no, because the market price cannot drop below zero, and yes, because a company can sometimes continue in existence, even in this diseased state, buoyed by hope that a turnaround can bring up the value of the operating assets. In these cases, equity takes on the characteristics of an option, and investors should treat it as such.
CASE STUDY 9.1: UBER—VALUING THE URBAN CAR SERVICE COMPANY
Lead-in case studies:
Case Study 6.2: The Ride-Sharing Landscape, June 2014
Case Study 6.3: The Uber Narrative, June 2014
Case Study 8.1: Uber—From Story to Numbers
In chapter 6 I laid out my story for Uber in June 2014, describing it as an urban car service company, and in chapter 8 I connected that story to valuation inputs ranging from revenue growth to cost of capital, all summarized in table 9.1.
Table 9.1
Inputs in Uber Valuation
| Input |
Assumptions |
| Total market |
The total size of the urban car service company in the base year is $100 billion, growing at 3% per year, pre-Uber. Uber and other ride-sharing companies will attract new users into the business and increase the expected growth rate to 6% per year. |
| Market share |
Uber will reach a 10% market share of the total market, with the market share rising each year to get to this level. |
| Pre-tax operating margin & taxes |
Uber’s operating margin will rise from 7% (base year) to 40% by year 10, and Uber’s tax rate will drift up from current levels (31%) to the marginal tax rate for the United States (40%). |
| Reinvestment |
Uber will be able to maintain its current low capital–intensity model, generating sales to a capital ratio of 5. |
| Cost of capital |
Uber’s cost of capital starts at 12% (the 90th percentile of U.S. companies) in year 1 and drifts down to 10% in year 10 (when it becomes a mature firm). |
| Likelihood of failure |
There is a 10% chance that Uber, given its losses and need for capital, will not make it. |
These valuation inputs are fed through a valuation model, and table 9.2 summarizes the output. While my estimated value for Uber is approximately $6 billion, note also how the narrative underlies every number in the valuation. It is the story that is driving this valuation, rather than a collection of inputs in a spreadsheet.
Table 9.2
Uber, the Urban Car Service Company
| The story |
| Uber is an urban car service company, drawing new users into the car service sector. It will enjoy local networking benefits while preserving its current revenue sharing (80/20) and capital intensity (don’t own cars or hire drivers) model. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Story link |
| Total market |
100 billion |
Grow 6.00% a year |
Grow 2.50% |
Urban car service + new users |
| Gross market share |
1.50% |
1.50% →10.00% |
10.00% |
Local networking benefits |
| Revenue share |
20.00% |
Stays at 20.00% |
20.00% |
Preserve revenue share |
| Operating margin |
3.33% |
3.33% → 40.00% |
40.00% |
Strong competitive position |
| Reinvestment |
NA |
Sales-to-capital ratio of 5.00 |
Reinvestment rate = 10% |
Low capital–intensity model |
| Cost of capital |
NA |
12.00% |
12.00% → 8.00% |
8.00% |
90th percentile of U.S. firms |
| Risk of failure |
10% chance of failure (with equity worth zero) |
Young company |
| The cash flows (in $ millions) |
| |
Total market |
Market share |
Revenues |
EBIT (1 − t)* |
Reinvestment |
FCFF† |
| 1 |
$106,000 |
3.63% |
$769 |
$37 |
$94 |
$(57) |
| 2 |
$112,360 |
5.22% |
$1,173 |
$85 |
$81 |
$4 |
| 3 |
$119,102 |
6.41% |
$1,528 |
$147 |
$71 |
$76 |
| 4 |
$126,248 |
7.31% |
$1,846 |
$219 |
$64 |
$156 |
| 5 |
$133,823 |
7.98% |
$2,137 |
$301 |
$58 |
$243 |
| 6 |
$141,852 |
8.49% |
$2,408 |
$390 |
$54 |
$336 |
| 7 |
$150,363 |
8.87% |
$2,666 |
$487 |
$52 |
$435 |
| 8 |
$159,385 |
9.15% |
$2,916 |
$591 |
$50 |
$541 |
| 9 |
$168,948 |
9.36% |
$3,163 |
$701 |
$49 |
$652 |
| 10 |
$179,085 |
10.00% |
$3,582 |
$860 |
$84 |
$776 |
| Terminal year |
$183,562 |
10.00% |
$3,671 |
$881 |
$88 |
$793 |
| The value |
| Terminal value |
$14,418 |
|
| PV (terminal value) |
$5,175 |
|
| PV (CF over the next 10 years) |
$1,375 |
|
| Value of operating assets = |
$6,550 |
|
| Probability of failure |
10.00% |
|
| Value in case of failure |
$— |
|
| Adjusted value for operating assets |
$5,895 |
Venture capitalists priced Uber at $17 billion at the time. |
* EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
† FCFF = Free cash flow to firm
CASE STUDY 9.2: FERRARI—VALUING THE EXCLUSIVE AUTO CLUB
Lead-in case studies:
Case Study 6.1: The Auto Business, October 2015
Case Study 6.4: The Ferrari Narrative, October 2015
Case Study 7.2: Ferrari, the Exclusive Auto Club
Case Study 8.2: Ferrari—From Story to Numbers
My story for Ferrari in chapter 6 is that it will remain an exclusive auto company, settling for low growth with high margins and low risk. I also looked at an alternative higher-growth story for Ferrari in chapter 7, albeit with lower margins and higher risk. In chapter 8 I connected both stories to valuation inputs, and table 9.3 summarizes those numbers.
Table 9.3
Ferrari Valuation Inputs
| |
My exclusive club |
Rev it up |
| Currency choice |
Euros |
Euros |
| Revenue growth |
4.00% for next 5 years, dropping to 0.70% in stable growth. |
12.00% for next 5 years, dropping to 0.70% in stable growth. |
| Pre-tax operating margin (and taxes) |
Operating margin stays at 18.20% (current level), tax rate of 33.54%. |
Operating margin drops to 14.32% over the next 10 years, as a result of lower-price cars and increased marketing costs. |
| Reinvestment |
Sales-to-capital ratio is 1.42, but reinvestment is low, because revenue growth is low. |
Sales-to-capital ratio 1.42, but much more reinvestment is needed, since sales increase more. |
| Cost of capital |
Cost of capital is 6.96%, reflecting superrich customers. |
Cost of capital is 8.00%, since very (but not super) rich are more affected by economy. |
Using these inputs, I first valued Ferrari as an exclusive club in table 9.4 and then did a valuation based on the faster-growth narrative in table 9.5. I estimate the value of Ferrari’s equity to be €6.3 billion in the former and €6.0 billion in the latter. If you are surprised that the higher-growth story does not deliver a higher value, it is because it is weighed down by the lower operating margins and higher cost of capital.
Table 9.4
Ferrari, the Exclusive Club
| The story |
| Ferrari will remain an exclusive club, selling relatively few cars at very high prices and with no advertising, to the superrich, who are unaffected by economic ups and downs. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Story link |
| Revenues (a) |
€2,763 |
CAGR* = 4.00% |
4,00% → 0.70% |
CAGR* = 0.70% |
Low growth to stay exclusive |
| Operating margin (b) |
18.20% |
18.20% |
|
18.20% |
High prices + No advertising costs = Current |
| Tax rate |
33.54% |
33.54% |
|
33.54% |
Stays unchanged |
| Reinvestment (c) |
|
Sales-to-capital ratio of 1.42 |
Reinvestment rate = 4.81% |
With little growth, little reinvestment |
| Cost of capital (d) |
|
8.00% |
8.00% → 7.50% |
7.50% |
Lightly affected by macroeconomic forces |
| The cash flows (in € millions) |
| |
Revenues |
Operating margin |
EBIT (1 − t)† |
Reinvestment |
FCFF†† |
| 1 |
€2,876 |
18.20% |
€348 |
€78 |
€270 |
| 2 |
€2,988 |
18.20% |
€361 |
€81 |
€281 |
| 3 |
€3,108 |
18.20% |
€376 |
€84 |
€292 |
| 4 |
€3,232 |
18.20% |
€391 |
€87 |
€303 |
| 5 |
€3,362 |
18.20% |
€407 |
€91 |
€316 |
| 6 |
€3,474 |
18.20% |
€420 |
€79 |
€341 |
| 7 |
€3,567 |
18.20% |
€431 |
€66 |
€366 |
| 8 |
€3,639 |
18.20% |
€440 |
€51 |
€389 |
| 9 |
€3,689 |
18.20% |
€446 |
€35 |
€411 |
| 10 |
€3,715 |
18.20% |
€449 |
€18 |
€431 |
| Terminal year |
€3,740 |
18.20% |
€452 |
€22 |
€431 |
| The value |
| Terminal value |
€6,835 |
|
| PV (terminal value) |
€3,485 |
|
| PV (CF over the next 10 years) |
€2,321 |
|
| Value of operating assets = |
€5,806 |
|
| −Debt |
€623 |
|
| −Minority interests |
€13 |
|
| + Cash |
€1,141 |
|
| Value of equity |
€6,311 |
|
* CAGR = compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
Table 9.5
Ferrari, Rev It Up
| The story |
| Ferrari will go for higher growth with a lower-cost car model, backing up this strategy with more marketing, but becoming more exposed to macroeconomic forces. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
| Revenues (a) |
€2,763 |
CAGR* = 12.00% |
12.00% → 0.70% |
CAGR* = 0.70% |
| Operating margin (b) |
18.20% |
18.2% → 14.32% |
|
14.32% |
| Tax rate |
33.54% |
33.54% |
|
33.54% |
| Reinvestment (c) |
1.42 |
Sales-to-capital ratio of 1.42 |
Reinvestment rate = 4.81% |
| Cost of capital (d) |
|
8.00% |
8.00% → 7.50% |
7.50% |
| The cash flows (in € millions) |
| |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
€3,095 |
17.81% |
€366 |
€233 |
€133 |
| 2 |
€3,466 |
17.42% |
€401 |
€261 |
€140 |
| 3 |
€3,881 |
17.04% |
€439 |
€293 |
€147 |
| 4 |
€4,348 |
16.65% |
€481 |
€323 |
€153 |
| 5 |
€4,869 |
16.26% |
€526 |
€367 |
€159 |
| 6 |
€5,344 |
15.87% |
€564 |
€334 |
€230 |
| 7 |
€5,743 |
15.48% |
€591 |
€281 |
€310 |
| 8 |
€6,043 |
15.10% |
€606 |
€211 |
€395 |
| 9 |
€6,222 |
14.71% |
€608 |
€126 |
€482 |
| 10 |
€6,266 |
14.32% |
€596 |
€31 |
€566 |
| Terminal year |
€6,309 |
14.32% |
€600 |
€35 |
€565 |
| The value |
| Terminal value |
€8,315 |
|
| PV (terminal value) |
€3,906 |
|
| PV (CF over the next 10 years) |
€1,631 |
|
| Value of operating assets = |
€5,537 |
|
| −Debt |
€623 |
|
| −Minority interests |
€13 |
|
| + Cash |
€1,141 |
|
| Value of equity |
€6,041 |
|
* CAGR = Compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
CASE STUDY 9.3: AMAZON—VALUING THE FIELD OF DREAMS
Lead-in case studies:
Case Study 6.5: Amazon, the Field of Dreams Model, October 2014
Case Study 7.3: Amazon—Alternative Narratives, October 2014
Case Study 8.3: Amazon—From Story to Numbers
With Amazon, my Field of Dreams model is built on the presumption that Amazon will continue to focus on revenue growth by following its current strategy of selling products and services at below cost and that it would push toward profitability, though new competitors would keep margins at moderate levels. In chapter 7 I did list two alternative narratives, one a pessimistic one in which Amazon’s focus on revenue growth leads it into a wasteland where profits remain a mirage, and the other an optimistic one (at least for investors) in which Amazon’s pricing drives much of the competition out of the businesses it is in, allowing it substantial pricing power. Table 9.6 captures the differences in valuation inputs under the three narratives.
Table 9.6
Inputs for Valuing Amazon—Alternate Narratives
| |
My Field of Dreams narrative |
Pessimistic doomsday story |
Optimistic rules the world story |
| Revenue growth |
15.00% for next 5 years, dropping to 2.20% in stable growth. |
15.00% for next 5 years, dropping to 2.20% in stable growth. |
20.00% for next 5 years, dropping to 2.20% in stable growth. |
| Pre-tax operating margin |
Operating margin rises to 7.38%, the median for retail/media sectors. |
Operating margin rises to 2.85%, 25th percentile of retail/media sectors. |
Operating margin rises to 12.84%, 75th percentile of retail/media sectors. |
| Reinvestment |
Sales-to-capital ratio stays at current level of 3.68. |
Sales-to-capital ratio stays at current level of 3.68. |
Sales-to-capital ratio stays at current level of 3.68. |
| Cost of capital |
Cost of capital is 8.39%. |
Cost of capital is 8.39%. |
Cost of capital is 8.39%. |
In table 9.7, I estimate a value of $175.25 per share in October 2014 for Amazon, using my Field of Dreams story, and follow up in table 9.8 with a value per share of $32.72 under the pessimistic scenario and finish with table 9.9 with a value per share of $468.51 under the optimistic scenario.
Table 9.7
Amazon, Field of Dreams
| The story |
| Amazon will go for revenue growth in the near term, selling its products and services at close to cost in the media, retail, and cloud computing businesses, and will use its market power to earn higher margins in the future, albeit with new competitors acting as a check. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Story link |
| Revenues (a) |
$85,246 |
CAGR* = 15.00% |
15.00% → 2.20% |
2.20% |
Focused on revenue growth |
| Operating margin (b) |
0.47% |
0.47% → 7.38% |
7.38% |
Retail + media business average margin |
| Tax rate |
31.80% |
31.80% |
|
31.80% |
Stays unchanged |
| Reinvestment (c) |
|
Sales-to-capital ratio of 3.68 |
Reinvestment rate = 22.00% |
Reinvests more efficiently than competitors |
| Cost of capital (d) |
|
8.39% |
8.39% → 8.00% |
8.00% |
Media + retail + cloud |
| The cash flows (in $ millions) |
| |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
$98,033 |
1.16% |
$776 |
$3,474 |
$(2,698) |
| 2 |
$112,738 |
1.85% |
$1,424 |
$3,995 |
$(2,572) |
| 3 |
$129,649 |
2.54% |
$2,248 |
$4,594 |
$(2,346) |
| 4 |
$149,096 |
3.23% |
$3,288 |
$5,284 |
$(1,996) |
| 5 |
$171,460 |
3.92% |
$4,589 |
$6,076 |
$(1,487) |
| 6 |
$192,790 |
4.62% |
$6,069 |
$5,795 |
$274 |
| 7 |
$211,837 |
5.31% |
$7,667 |
$5,175 |
$2,492 |
| 8 |
$227,344 |
6.00% |
$9,300 |
$4,213 |
$5,087 |
| 9 |
$238,166 |
6.69% |
$10,865 |
$2,940 |
$7,925 |
| 10 |
$243,405 |
7.38% |
$12,251 |
$1,424 |
$10,827 |
| Terminal year |
$248,790 |
7.38% |
$12,520 |
$2,755 |
$9,766 |
| The value |
| Terminal value |
$168,379 |
|
| PV (terminal value) |
$76,029 |
|
| PV (CF over the next 10 years) |
$4,064 |
|
| Value of operating assets = |
$80,093 |
|
| −Debt |
$9,202 |
|
| + Cash |
$10,252 |
|
| Value of equity |
$81,143 |
|
| Number of shares |
463.01 |
|
| Value per share |
$175.25 |
Amazon was trading at $287.06 at the time of the valuation |
* CAGR = Compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
Table 9.8
Amazon, Stockholder Doomsday
| The story |
| Amazon will go for revenue growth in the near term, selling its products and services at close to cost in the media, retail, and cloud computing businesses, but will be unable to use its market power to improve operating margins in any of its businesses by much. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Link to story |
| Revenues (a) |
$85,246 |
CAGR* = 15.00% |
15.00% → 2.20% |
2.20% |
Focused on revenue growth |
| Operating margin (b) |
0.47% |
0.47% → 2.85% |
|
2.85% |
Retail + media business, 25th percentile |
| Tax rate |
31.80% |
31.80% |
|
31.80% |
Stays unchanged |
| Reinvestment (c) |
|
Sales-to-capital ratio of 3.68 |
Reinvestment rate = 22.00% |
Reinvests more efficiently than competitors |
| Cost of capital (d) |
|
8.39% |
8.39% → 8.00% |
8.00% |
Media + retail + cloud |
| The cash flows (in $ millions) |
| |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
$98,033 |
0.71% |
$473 |
$3,474 |
$(3,001) |
| 2 |
$112,738 |
0.95% |
$727 |
$3,995 |
$(3,268) |
| 3 |
$129,649 |
1.18% |
$1,046 |
$4,594 |
$(3,548) |
| 4 |
$149,096 |
1.42% |
$1,446 |
$5,284 |
$(3,838) |
| 5 |
$171,460 |
1.66% |
$1,941 |
$6,076 |
$(4,135) |
| 6 |
$192,790 |
1.90% |
$2,495 |
$5,795 |
$(3,300) |
| 7 |
$211,837 |
2.14% |
$3,086 |
$5,175 |
$(2,089) |
| 8 |
$227,344 |
2.37% |
$3,681 |
$4,213 |
$(532) |
| 9 |
$238,166 |
2.61% |
$4,243 |
$2,940 |
$1,302 |
| 10 |
$243,405 |
2.85% |
$4,731 |
$1,424 |
$3,308 |
| Terminal year |
$248,790 |
2.85% |
$4,835 |
$2,755 |
$3,771 |
| The value |
| Terminal value |
$65,024 |
|
| PV (terminal value) |
$29,361 |
|
| PV (CF over the next 10 years) |
$(15,260) |
|
| Value of operating assets = |
$14,101 |
|
| −Debt |
$9,202 |
|
| + Cash |
$10,252 |
|
| Value of equity |
$15,151 |
|
| Number of shares |
463.01 |
|
| Value per share |
$32.72 |
Amazon was trading at $287.06 at the time of the valuation |
* CAGR = compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
Table 9.9
Amazon, World Domination
| The story |
| Amazon will go for revenue growth in the near term, selling at close to cost in the media, retail, and cloud computing businesses, and use its market power to drive out competition and earn very high margins in the future. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Link to story |
| Revenues (a) |
$85,246 |
CAGR* = 25.00% |
25.00% → 2.20% |
2.20% |
Obsessed with revenue growth |
| Operating margin (b) |
0.47% |
0.47% → 12.84% |
12.84% |
Retail + media business, 75th percentile margin |
| Tax rate |
31.80% |
31.80% |
|
31.80% |
Stays unchanged |
| Reinvestment (c) |
|
Sales-to-capital ratio of 3.68 |
Reinvestment rate = 22.00% |
Reinvests more efficiently than competitors |
| Cost of capital (d) |
|
8.39% |
8.39% → 8.00% |
8.00% |
Media + retail + cloud |
| The cash flows (in $ millions) |
| |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
$102,295 |
1.71% |
$1,190 |
$4,632 |
$(3,441) |
| 2 |
$122,754 |
2.94% |
$2,464 |
$5,559 |
$(3,094) |
| 3 |
$147,305 |
4.18% |
$4,200 |
$6,670 |
$(2,470) |
| 4 |
$176,766 |
5.42% |
$6,531 |
$8,004 |
$(1,473) |
| 5 |
$212,119 |
6.65% |
$9,627 |
$9,605 |
$22 |
| 6 |
$246,992 |
7.89% |
$13,293 |
$9,475 |
$3,819 |
| 7 |
$278,804 |
9.13% |
$17,358 |
$8,643 |
$8,715 |
| 8 |
$304,789 |
10.37% |
$21,547 |
$7,060 |
$14,487 |
| 9 |
$322,345 |
11.60% |
$25,508 |
$4,770 |
$20,738 |
| 10 |
$329,436 |
12.84% |
$28,848 |
$1,927 |
$26,922 |
| Terminal year |
$336,684 |
12.84% |
$29,483 |
$6,486 |
$22,997 |
| The value |
| Terminal value |
$396,496 |
|
| PV (terminal value) |
$179,032 |
|
| PV (CF over the next 10 years) |
$28,427 |
|
| Value of operating assets = |
$207,459 |
|
| −Debt |
$9,202 |
|
| + Cash |
$10,252 |
|
| Value of equity |
$208,510 |
|
| Number of shares |
463.01 |
|
| Value per share |
$450.34 |
Amazon was trading at $287.06 at the time of the valuation |
* CAGR = compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
The divergence in values in Amazon across narratives is one reason that the company is often the subject of heated debates among investors, with some contending that those who buy the stock are naïve victims of a con game and others arguing that those who do not invest in it are old fogies who don’t understand the new economy.
CASE STUDY 9.4: ALIBABA—THE CHINA STORY
Lead-in case studies:
Case Study 6.6: Alibaba, the China Story, September 2014
Case Study 7.4: Alibaba, the Global Player
Case Study 8.4: Alibaba—From Story to Numbers
In my narrative for Alibaba, I described a company that has not just promised but delivered on the China story. Adapting exceptionally well to the needs and fears of Chinese retailers and consumers, the company dominates online retail traffic in China while delivering solid profits. In my story, Alibaba continues to grow at a rate of 25 percent with the Chinese market, with only limited slippage in the operating margin to 40 percent, but I see it as a China-centric company that will not travel well into other locales. The valuation, summarized in table 9.10, yields a value for Alibaba after its IPO.
Table 9.10
Alibaba, the China Story
| The story |
| Alibaba will stay China-centric, maintaining its high market share and growing with the Chinese online retail market. Its margins will come down somewhat because of competition, but still stay high. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Link to story |
| Revenues (a) |
$9,268 |
CAGR* = 25.00% |
25% → 2.41% |
CAGR* = 2.41% |
Grow with Chinese market |
| Pre-tax operating margin (b) |
50.73% |
50.73% → 40.00% |
40.00% |
Increased competition |
| Tax rate |
11.92% |
11.92% |
11.92% → 25.00% |
25.00% |
Move to statutory tax rate |
| Reinvestment (c) |
NA |
Sales-to-capital ratio of 2.00 |
Reinvestment rate = 30.13% |
Industry average sales/capital |
| Cost of capital (d) |
|
8.56% |
8.56% → 8.00% |
8.00% |
Advertising + retail risk |
| The cash flows (in $ millions) |
| Year |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
$11,585 |
49.66% |
$5,067 |
$1,158 |
$3,908 |
| 2 |
$14,481 |
48.58% |
$6,197 |
$1,448 |
$4,749 |
| 3 |
$18,101 |
47.51% |
$7,575 |
$1,810 |
$5,765 |
| 4 |
$22,626 |
46.44% |
$9,255 |
$2,263 |
$6,992 |
| 5 |
$28,283 |
45.36% |
$11,301 |
$2,828 |
$8,473 |
| 6 |
$34,075 |
44.29% |
$12,899 |
$2,896 |
$10,002 |
| 7 |
$39,515 |
43.22% |
$14,149 |
$2,720 |
$11,429 |
| 8 |
$44,038 |
42.15% |
$14,891 |
$2,261 |
$12,630 |
| 9 |
$47,089 |
41.07% |
$15,012 |
$1,525 |
$13,486 |
| 10 |
$48,224 |
40.00% |
$14,467 |
$567 |
$13,900 |
| Terminal year |
$49,388 |
40.00% |
$14,816 |
$4,463 |
$10,353 |
| The value |
| Terminal value |
$185,205 |
|
| PV (terminal value) |
$82,731 |
|
| PV (CF over the next 10 years) |
$54,660 |
|
| Value of operating assets = |
$137,390 |
|
| −Debt |
$10,068 |
|
| + Cash |
$9,330 |
|
| + IPO proceeds |
$20,000 |
|
| + Nonoperating assets |
$5,087 |
|
| Value of equity |
$161,739 |
|
| −Value of options |
$696 |
|
| Value of equity in common stock |
$161,043 |
|
| Number of shares |
2,440.91 |
|
| Estimated value/share |
$65.98 |
Alibaba was first priced at $68 and then repriced at $80/share. |
* CAGR = Compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
Adding on the value of the proceeds from the IPO, anticipated to be $20 billion, the value of equity that I get is $161 billion, translating into an equity value per share of $65.98.
In chapter 7 I outlined an alternative story for Alibaba as a global company able to grow at 40 percent a year for the next five years, more than the 25 percent at which Chinese online retail is growing, by expanding into other countries. In the plausible version of this story, this growth is accompanied by a drop in operating margin to 30 percent and increased investment, captured in a sales-to-capital ratio of 1.50. The resulting value per share is $92.52, and the details are shown in table 9.11.
Table 9.11
Alibaba, the Global Story
| The story |
| Alibaba is able to expand into overseas markets, allowing its revenues to grow 40 percent per year for the next five years. Its profit margins will come under pressure as it competes in foreign markets and it will need to reinvest more to grow. |
| The assumptions |
| |
Base year |
Years 1–5 |
Years 6–10 |
After year 10 |
Link to story |
| Revenues (a) |
$9,268 |
CAGR* = 40.00% |
40.00% → 2.41% |
CAGR* = 2.41% |
Global expansion + China growth |
| Pre-tax operating margin (b) |
50.73% |
50.73% → 30.00% |
30.00% |
Stronger global competition |
| Tax rate |
11.92% |
11.92% |
11.92% → 25.00% |
25.00% |
Move to statutory tax rate |
| Reinvestment (c) |
NA |
Sales-to-capital ratio of 1.50 |
Reinvestment rate = 30.13% |
More reinvestment globally |
| Cost of capital (d) |
|
8.56% |
8.56% → 8.00% |
8.00% |
Advertising + retail risk |
| The cash flows (in $ millions) |
| |
Revenues |
Operating margin |
EBIT (1—t)† |
Reinvestment |
FCFF†† |
| 1 |
$12,975 |
48.66% |
$5,561 |
$1,158 |
$3,089 |
| 2 |
$18,165 |
46.58% |
$7,453 |
$1,448 |
$3,993 |
| 3 |
$25,431 |
44.51% |
$9,970 |
$1,810 |
$5,126 |
| 4 |
$35,604 |
42.44% |
$13,308 |
$2,263 |
$6,527 |
| 5 |
$49,846 |
40.36% |
$17,721 |
$2,828 |
$8,227 |
| 6 |
$66,036 |
38.29% |
$21,611 |
$2,896 |
$10,817 |
| 7 |
$82,522 |
36.22% |
$24,762 |
$2,720 |
$13,772 |
| 8 |
$96,918 |
34.15% |
$26,552 |
$2,261 |
$16,954 |
| 9 |
$106,540 |
32.07% |
$26,522 |
$1,525 |
$20,107 |
| 10 |
$109,108 |
30.00% |
$24,549 |
$567 |
$22,838 |
| Terminal year |
$111,738 |
30.00% |
$25,141 |
$7,574 |
$17,567 |
| The value |
| Terminal value |
$314,262 |
|
| PV (terminal value) |
$139,116 |
|
| PV (CF over the next 10 years) |
$63,071 |
|
| Value of operating assets = |
$202,186 |
|
| −Debt |
$10,068 |
|
| + Cash |
$9,330 |
|
| + IPO Proceeds |
$20,000 |
|
| + Nonoperating assets |
$5,087 |
|
| Value of equity |
$226,535 |
|
| −Value of options |
$696 |
|
| Value of equity in common stock |
$225,839 |
|
| Number of shares |
2,440.91 |
|
| Estimated value/share |
$92.52 |
Alibaba opened for trading at $92/share. |
* CAGR = Compound annual growth rate
† EBIT (1 − t) = (Revenues* Operating Margin) (1 − tax rate)
†† FCFF = Free cash flow to firm
A few days after this valuation, the bankers set the offering price for Alibaba at $68, but the stock opened at $95 a share. In January 2016, as this book was being written, the stock was back down to $65.
In the last few chapters, I have talked about how a story about a business can be converted into a value. This presupposes that you are in control of the sequence and are doing the valuation. But can you reverse the process? In other words, can you take a DCF valuation, which is all numbers, and back out a story from those numbers? Yes, and there are reasons that you might want to do so. First, once you extract the story from the numbers, you can assess whether it is a story with which you are comfortable. After all, it is not just the numbers that should be driving your investment decision when you are looking at a company, but the story behind the numbers. Second, you can use your backed-out narrative to question the person doing the valuation about the underlying assumptions. One test of whether an analyst is mechanically plugging numbers into models or has a serious story will come out in how he or she responds to your questions.
The process of deconstructing valuations is simple if you use the structure that was developed to convert stories to numbers. Thus, when you see projected revenues for a company in a valuation spreadsheet or model, your questions will have to zero in on what the analyst who did the valuation sees as the total market for the company and the market share that he or she has given the company. That then opens the discussion to the business or businesses that the company operates in and what networking and competitive advantages it brings to these businesses. Figure 9.2 provides some questions, albeit not a comprehensive list, that you may ask about a valuation to understand the story behind it.
Figure 9.2
Deconstructing a valuation.
Conclusion
Once you have a story for a company and have converted the story into valuation inputs, the process of converting these inputs into value is more mechanical, though some details still need attention. Rather than get lost in the details, though, you will be better served if you use your narrative to decide the specifics on which you want to spend the most time and resources. In my valuation of Amazon, for instance, where it is the future operating margin that is the most contested input in the valuation, I spent more time looking at Amazon’s history on this statistic and the differences across companies in both the retail and media sectors than I spent on assessing cost of capital. With Uber, where the key question is the size of the market that Uber is going after, the part of the story I examined most was the question of whether Uber was just a car service company or something more, and I will come back to it in the next two chapters.
