There are many businesses out there that have excellent fundamentals and economics – strong return ratios, low capex requirements, pricing power, good cash generation, strong brands, no debt, negative working capital, strong and stable margins, among others.
These are facets that one would find in high quality companies. However, advocates of fundamental and value investing would agree that one cannot pay a price for a business, no matter how strong its fundamentals are.
And there's a reason for it. After all, one has to think about the payback period while investing in a company. And thus paying any price for a good business would not be the way to go as a good company may not always be a good investment.
Not to mention when one buys into a business, he is not only paying for growth that is expected to come in a two- to three-year perspective, but is rather paying for the expectation of the business being around for many years to come.
DCF discounts the future free cash flow projections to arrive at a present value estimate. The latter value helps evaluate the potential upside of an investment. If the present value of a business is below the derived value, then the opportunity may be a good one (same holds true in the reverse situation).
There are two broader components of a DCF model – the value of the projection period and the terminal value. The projection period (the period for which the cash flows are forecasted) is usually done from a medium to long term period such as five or ten years.
The terminal value is calculated by taking the present value of the last year of the projection period and adding a perpetual growth rate (common assumption is taking the long term real GDP growth figure).
But what is quite interesting to gauge is the amount of influence these two components have on the overall value of a business.
Let us take up an example to understand this well.
Company 'XYZ' is a high growth business. It reported a steady state free cash flow of Rs 100 million in the previous year. It has now come up with a new product which is at a nascent stage and is expected to see good acceptance and thus would grow at a strong pace going forward.
Let's say the growth rate is expected to be a good rate of 18% per annum over the next decade. All else being equal, its cash flow would grow at the same pace over the projection period after which the market will get saturated and grow along with the GDP (3 per cent assumption).
The discount rate assumed here is 15 per cent.
When this calculation is done, the overall value comes to a little over Rs 2.2 billion. But what is interesting is that just a little over half of the overall value is influenced by the value of the projection period (a decade) and the rest is contributed by the terminal value. In other words, the terminal value and the projection period both have almost equal weightage when it comes to the value of this business.
While this is purely a theoretical example, it does drive home the point that the terminal value of a company has a strong role to play in the overall valuation; and thus, the 'staying power' of a company is very important when it comes to making long-term investments as it is essentially a big chunk of what one would be paying up for.
As such, simply assigning high multiples to businesses by gauging the short term outlook would not be the way to go as the staying power of the company plays a considerable role in driving overall value.
Sure, the weightage of the terminal value would vary as we play around with the key inputs – lower discount rates would push the overall weightage in favour of the terminal value while higher discount rates would tilt the same more in favour of the projection period.
I would like to conclude by quoting Benjamin Graham, where he has rightly said: "Investing is more intelligent when it is most businesslike." What this essentially means is that rather than looking at a stock as a ticker, one should look at it as a business that one is buying into.
When one thinks of investing from this perspective, his approach is bound to change. This kind of thinking would lead an investor to think about many factors (including survival and health of the business many years down the line), and in the process be not so concerned about what is expected to happen in the short term.
Warren Buffett's quote sums it up rather well: "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."
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