“A great deal more fiction is written in Microsoft Excel than in Microsoft Word” – Anonymous
Previously, I have written about what, according to me, is one of the biggest mistakes that people make in a DCF valuation. Two years of experience post that article has only reinforced my belief in this as I have come across numerous valuations from reputed organisations/ analysts make the same mistake over and over again.
Setting the context
In its essence, every DCF valuation is a projection of the following four aspects of a company:
- Existing cash flows: What are it’s existing revenues, margins and cash flows;
- Growth: What is going to be the growth in those cash flows;
- Reinvestment: How much would the company be required to reinvest back into the business to generate that growth; and
- Competitive advantage period: How long the competitive advantage period of the company last.
While it is futile to try and accurately predict the future, investing is all about making bets about the future. The role of the DCF then is not to give you a point estimate of the intrinsic value of a company, but to guide you as to the reasonableness of your assumptions – reasonableness with regard to the history of the company, its industry and the historical experience of business in general.
A real life example of valuation fiction
In this post, I am going to detail one such example of a valuation of an Indian consumer company done by the research arm of a top global investment bank (I am going to heed Warren Buffett and not name names!)
Here are some of the main assumptions that the analyst is making in his DCF:
| Particulars |
FY19(A) |
FY45(E) |
Increase |
|
| Revenue (INR cr.) |
A |
8,533 |
71,243 |
62,710 |
| EBIT (INR cr.) |
B |
1,563 |
16,338 |
14,775 |
| EBIT margin (%) |
C = B/A |
18.3% |
22.9% |
23.6% |
| Invested capital (INR cr.) |
D |
3,252 |
3,680 |
428* |
| Sales to capital (x) |
E = A/D |
2.6x |
19.3x |
146x |
* The increase in invested capital calculated is based on the total net capex plus change in working capital that the analyst has assumed over the projection period.
The analyst assumes a high growth period of 26 years (I am already rolling my eyes!!) with a revenue and earnings growth rate of 8.5% and 9.5% respectively. Although these are pretty optimistic assumptions, I can still live with them as you can make an argument that the growth runway for this company is long and that its competitive advantages will allow it not only to maintain but also slightly improve its margins over time.
But what really bothers me is that the company will be able to increase its revenues by INR 62,710 cr. in 26 years’ time by only reinvesting INR 428 cr. over that period, i.e. an incremental sales to capital ratio of 146x. Let’s see how robust this assumption is by looking at this company’s history. Over the last 15 years (a time when India has had a huge tailwind for consumer companies), the company has increased its sales by INR 7000cr. by reinvesting INR 2,800cr. in the business, i.e. an incremental sales to capital of 2.5x. Just let that sink in – the analyst is making an assumption that a company with a history of generating INR 2.5 in sales for every INR 1 in capital will suddenly start generating INR 146 in sales over the next 26 years. There are only two ways this can happen, both of which are near impossible:
- The company improves its production processes to such an extent that it is able to achieve a 8.5x increase in sales and volume without expanding capacity either through setting up new factories or upgrading old ones; or
- The demand for the company’s products is so inelastic that it is able to achieve a 8.5x increase in sales all through increased pricing with no dip in demand.
As if this assumption was not enough, the terminal year has a 4% growth in perpetuity with NO reinvestment – meaning that the company will earn an “infinite” return on capital on new investments forever!
But here is the bit that is most hilarious – the value of the company in spite of these assumptions is still short of the current market price of the company!!!
Conclusion
With so many implicit assumptions embedded in a DCF, it is easy to see why many analysts, who start of writing non-fiction, end up writing fiction. It is, therefore, important to flesh out the underlying assumptions of any DCF to distinguish between the two.