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The general perception of a Valuation model is a sophisticated tool with large formulas that spins out numbers. The paradox is that , these complicated valuation models are of very little help , because no one completely understands the logic behind scores of factors that are used in coming up with a valuation. In reality a tool can only be helpful to an extent one knows what it does. Just assume a software that predicts your monthly expenditure on groceries. It uses some arcane formulas to come up with a dollar amount. If you don’t know the logic behind those formulas , then in reality by using the software you are simply speculating your monthly grocery bill, which you can do well even without that fancy software.
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So the most fundamental feature of a Valuation model is that , one should be able to provide a logical explanation for every factor or formula used in the model. It’s very common to see Greek letters like alpha and Beta in valuation models. They are perceived as a symbol of sophistication in the investment world. But in reality they translate to “I DON’T KNOW ABOUT THIS FACTOR, SO HAD TO PUT SOME VALUE”. So if you see any valuation models with Greek letters and fancy algorithms then don’t spend time going thru it. You might as well pick a number out of your hat and substitute it as your valuation. What is a valuation model??? It’s a set of formulas that one can use to determine the value of a business. As we are using Discounted Cash flow valuation technique the formula basically gives us the total cash the business would be generating in its lifetime. One should note that the purpose of a valuation model is not to just come up with a number, instead its main goal is to estimate how much the final output changes based on the changes in the input values. The first step : One should first identify all the important factors that impact the final outcome. If you miss any factor, then your valuation will be based on in-complete facts and would not portray the true picture of the business. Following is a simple example that explains the basic concepts of developing a valuation model. EXAMPLE: Bob’s convenience store is located near a Highway exit. It caters to folks passing by the Highway. Following are some important points affecting Bob’s business: 1. Total number of Cars and Trucks passing by the Highway. The more, the better because it increases the number of customers coming in the store. 2. Probability of another convenience store coming up in 5 miles radius. As of now his convenience store is the only one in the 5 miles radius. If another store comes up then there is a potential reduction of 50% of his business. 3. Weather: On any given day, this can play a big part of the business for that given day. For instance in a nice sunny day, the traffic in the Highway shoots up and thus the number of customers visiting his store can increase on that day. On a winter storm the store probably will have very little traffic. 4. Access to the Highway exit: Access to the Highway exit is very crucial for the business. Just imagine that for a brief amount of time the highway exit is blocked because of a construction activity. The Highway traffic instead is forced to take a detour. Because of this the business will get less traffic to its store and hence will affect its sales. 5. Consumer’s choice of products: The above factors impacted the total number of customers that show up in the store. Now let us analyze a factor that impacts the conversion ratio, in other words the average money each customer spends in the store. As of now the leading products sold by the store are chips and candy. The customers love them and its good for the store also, because the margins are high. What if , the consumer’s tastes changes and they start drifting away from chips and instead look for Greek yogurt. This in turn might reduce the gross margin. PROBABILITY ANALYSIS 1. Number of cars and trucks: Last 5 years on an average 10,000 cars and 200 trucks passed by the exit each day and 5% of those vehicles stopped by at Bob’s convenience store. It’s safe to assume that this traffic trend will continue in the future. The Weather factor and Access to highway exit also impact the number of vehicles passing by the exit. These factors might impact the business on any particular day, but on an yearly basis one can assume that the weather pattern and Highway construction activity will follow the past trend. 2. Probability of another convenience store coming up: Bob’s convenience store has been in the business for 8 years. It has zero competition. Probability of this continuing in future is very remote, because other small business owners have noticed Bob’s thriving business. Bob had access to cheap capital and hence was able to setup the store. Once other small businesses get access to cheap capital then there is a good possibility of a couple of a store opening up across Bob’s convenience store. This in theory would reduce Bob’s customers by 50%, because half of them might just want to go the store across the street. Even if we assume that the probability of this to happen is 25% . The total impact to the sales would be 50% x 25% = 12.5%. Hence this factor will reduce Bob’s future revenues by 12.5%. 3. Consumer’s choice of products : Based on the current product line , the gross margin is 40%, but if consumer’s tastes moves towards other products like Greek yogurt , then the store has to source it from other vendors that in turn would reduce the gross margin to 30%. Let us assume that the probability of this to happen is 25%. The net effect of reduction in gross margin is 25% x 10% = 2.5%.
How would the Free cash flow be impacted if we take into account the changes in probability as highlighted above : 1. If the Revenue fell by 12.5% then the revenues would drop from $1 million to $875,000. 2. The Gross margins can fall by 2.5% because of change in product line. Thus the gross profit can come down to $328,125. 3. Operating expenses are made up of the following , each line item also lists if the cost is Fixed or variable.
If the operating costs remain the same , the operating profit will fall to $128,125 ($328,125 - $200,000) . Let us assume that the business is able to bring in efficiency and reduce total number of employees to 8, thus save expenses of 2 employees which is 2 x $12,000 = $24,000 , increasing the operating profit to $128,125 + $24,000 = $152,125. As the interest expense is fixed at $25,000 per year , thus the pretax income comes to $152,000 - $25,000 = $127,125. The income tax rate is 28.5% . Therefore the Income tax expense comes to 28.5% of $127,125 = $36,230 . Therefore the operating cash flow = $127,125 - $36,230 = $90,895 4. Capital Expenditures are $25,000. It was mostly used to upgrade the equipments like coffee making machine and ice cream maker. If we assume 12.5% less traffic, therefore the wear and tear of equipments could be less . Thus we can estimate a reduction of $5,000 in Capital expenditures , making it $25,000 - $5,000 = $20,000. 5. Thus the updated FREE Cash flow is Operating cash flow - Capital Expenditures = $90,895 - $20,000 = $70,895. CONCLUSION : The above exercise portrays the main concept of use of the Valuation model. We can see how the Valuation model helped us calculate the updated FREE Cash flow if the business has increased competition and changes in consumer behavior, because of which the revenues go down by 12.5% , gross margin reduces from 40% to 37.5% and FREE cash flow reduces from $100,000 to $70,895. |
