Simple heuristics should also enable private investors to assess the value of companies. In practice, however, a serious disadvantage prevents sensible use.
The most well-known way to determine a company's value is probably as follows: An investor estimates all the payments to shareholders that a company will make from now to the distant future. Then these payouts are converted to their current value and added up.
Based on this description, it is clear that estimating the company's value by adding up discounted cash flows is a difficult task. That is why many investors use heuristics that reduce complex cash flow calculations to simple formulas.
A formula for company valuation
An example of this approach is the following formula: Company value = C × (ROC-G) / (R-G).
C stands for the capital invested, ROC for the return on this capital, R is the cost of capital, and G is growth. This formula is extremely useful in that it illustrates various important things to an investor.
If the return on investment is the same as the cost of capital (ROC = R), then the expression (ROC-G) / (R-G) is size 1. This is the case when there is strong competition in a market. In this case, growth has no economic value, so the investor can save the growth estimate. The enterprise value then corresponds to the capital invested, more precisely the amount it would cost a competitor to reproduce this capital. Cash flow estimates and discountings are then also unnecessary.
Competition spoils the business
A brief explanation on this point: Suppose a company invests CHF 100 million to build a factory for a new product. The cost of capital in this industry is 10%. However, the company achieves a profit of 20% with its product, well above the cost of capital. However, these high returns will soon attract the attention of the competition.
Other companies will enter this market and sell similar products if there is no entry barrier (e.g. patent protection). New providers will appear until all excess returns are "rivaled". In such a competitive market, corporate profits just cover the cost of capital. The company above earns CHF 10 million per year, its value corresponds to the capital invested, i.e. CHF 100 million.
The formula also shows that company value also depends on the capital invested in companies that are not exposed to strong competition. However, this must be multiplied by a factor that expresses the market power of the company (the higher the ROC is above the cost of capital R, the less affected by competition the company can act). Only in the case of market power does the formula show that growth has economic value at all.
Many companies are only exposed to weak competition
For many listed companies, competition is not so strong that it pushes profits down to the cost of capital. In other words, companies often earn more than their cost of capital, so the goodwill cannot be read directly from the assets.
This is the case with the food company Nestlé, which is to serve as an example. The 2019 annual report shows that the balance sheet total at the end of the year was CHF 128 billion and the profit was CHF 12.9 billion. The balance sheet has grown by an average of 1% per year since 2009.
How to get the numbers for the formula
The question, of course, is how investors determine the other numbers required for the formula. For the ROC, investors typically focus on the operating profit from which they deduct taxes. This avoids distortions due to different types of financing.
The invested capital can be calculated from the assets side of the balance sheet as well as from the liabilities side. Some well-known financial experts like Michael Mauboussin recommend that investors calculate the capital invested from the assets side.
However, it is easier to use the liability side. A possible procedure to determine the invested capital: The non-interest-bearing short-term liabilities are deducted from the balance sheet total.
For the borrowing costs, many investors adhere to the company's interest payments and set them in relation to the adjusted borrowing (for Nestlé this results in borrowing costs of around 2%). The result is increased by 4 percentage points to get the cost of equity. These 4 percentage points roughly correspond to the long-term yield premium on equities versus bonds. For Nestlé, the cost of capital is around 4% (with a ratio of debt to equity of 50:50).
In addition, professional investors do not normally derive the figures for their value calculations from just one year, but from the annual reports of the past five or ten years. In this way, individual outliers distort the result less.
The value of Nestlé
An investor who estimates the value of Nestlé using the above formula comes to an amount of a good CHF 280 billion (the calculation: 105 × (9% –1%) / (4% - 1%)). Nestlé's actual market capitalization is CHF 305 billion. At first glance, the Nestlé stock exchanges seem fairly fair.
The problem, however, is that an investor must also determine the R and G values for the far future. And because he cannot know these values with certainty, he relies on estimates and guesswork.
If he deviates from the above calculation by only one percentage point for both factors, the possible ratings for Nestlé range from CHF 190 billion to CHF 735 billion. The results can be a factor of 4 apart.
What does that mean for investors?
An estimation method that has such a range of possible results is far from optimal. Low interest rates, as they now prevail, also increase the problems of methods based on discounted cash flows. However, the fact that almost everything can be proven with this method is advantageous for some actors. Companies that demand media attention, for example, have an excellent tool for generating sensational media releases and studies.
Professional investors, meanwhile, are using a makeshift tool to deal with the problem that the choice of input data has such a decisive influence on the results: They carry out a large number of sensitivity analyzes. To do this, they vary the variables included in the calculation and see how the result changes. Sensitivity analyzes raise awareness among investors of how sensitive valuations react to the input data using discounting processes. But they do not help to determine which variable values are the right ones.
Private investors can draw two conclusions from what has been said. First, the valuation of companies or markets is more an art than a science. Second: Value calculations using discounted cash flows are heavily dependent on the assumptions made. A slight variation in the input data can produce almost any desired result. Therefore, considerable skepticism is called for when using this method.