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Steven Chen
Steven Chen
Articles (206)  | Author's Website |

A Quick and Dirty Approach to Valuing a Business

No complicated spreadsheets required

March 13, 2020 | About:

The essence of business valuation is that the value of a business equals the present value of future cash flows. That Discounted Cash Flow Model can go far simpler when formulated with the assumption of constant growth, as shown below.

Value = Free cash flow / (Required rate of return – Expected growth rate)

If we tweak the above calculation a bit, we can reach the following formula, which helps us estimate the return of a stock.

Expected annual total return = Free cash flow / (Stock Price) + Expected growth rate = Free cash flow yield + Expected growth rate

As with any valuation method, such a calculation has its limitations. First, it is always a challenging prospect to predict future growth. Second, the growth rate can be volatile and often decays over time. These are exactly the reasons why we at Urbem favor predictable businesses.

In our opinion, multiple factors contribute to predictability, including sustainable competitive advantage (to mitigate competitive risks), a slowly-changing industry (to “bore” disruptors) and a recurring or repeatable revenue stream (to build a bond proxy). With such traits in place, we may be able to depend on the return on capital and reinvestment rate to project future growth. This is why high returns can be more significant for shareholders than high growth. Without the former, the latter would be short-lived. Meanwhile, the management can always opt to return the excess capital if no attractive reinvestment opportunity exists. Of course, shareholders would have to rely on the management’s judgment and skill in terms of capital allocation in this regard.

Nonetheless, even with a stable return on capital alongside a wide economic moat, the challenge remains to accurately quantify the long-term prospect of some truly great businesses that do not require any capital to grow (think about the See’s Candies type of businesses).

Take Rightmove (LSE:RMV), the UK’s number one real estate portal, as an example. The company has produced a triple-digit return on capital, double-digit annual growth and an almost 100% payout rate (including dividend and share repurchase) for nearly a decade now. Rightmove’s market-dominating position with a two-sided network effect leads to the virtuous cycle to increase both customers and consumers without any reinvestment in the business. In such cases, we think that investors can always factor in a more considerable margin of safety. With a 4% free cash flow yield at the moment, it seems that Rightmove shares can easily offer a 10% annual total return (with only 6% growth rate needed), but may find difficulties in stretching for 20%.

The above equation echoes a couple of valuable lessons. First of all, the growth component (i.e., the expected growth rate) may contribute to more shareholder returns than the value counterpart (i.e., the yield). Especially in a low-rate environment, it appears much easier to find a 10% growth story than a 10% yield one (that is, a price-to-free-cash-flow ratio of 10) – both with quality business fundamentals.

With this in mind, long-term investors should really try to add to the winner possessing a sustainable, profitable growth capability even in the face of a little high valuation. In other cases, for businesses that deliver super-normal returns on capital consistently but cannot grow, the price has to be deeply attractive for buyers to perform well in the long run.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Rightmove.

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About the author:

Steven Chen
Steven CHEN is a quality-focused, business-perspective investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected], LinkedIn, or WeChat (ID: LSCHEN2005).

Also, check out his column at Smartkarma on the Asian market - www.smartkarma.com/profiles/steven-chen

Visit Steven Chen's Website


Rating: 5.0/5 (5 votes)

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Comments

scomas
Scomas premium member - 7 months ago

Question: Isn't FCF Yield defined as FCF/ MarCap? If so, how does this impact the valuation? I ran your calculation both ways and it predictably yields completely different results.

Thanks!

Steven CHEN
Steven CHEN - 7 months ago    Report SPAM

Thanks for the question! The "free cash flow" in the equation referred to the per-share basis. Assuming the price is fair, the equation solves backward to estimate the expected total return.

scomas
Scomas premium member - 7 months ago

Hi Steven, that clears it up! Thanks for taking the time and for the great article! I enjoy your other pieces as well!

Steven CHEN
Steven CHEN - 7 months ago    Report SPAM

You are welcome! Glad they are helpful!

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