Artistry and Interpretation in Finance1
Valuation modeling is as much of an art as it is a science. While the equations used in motivating model outcomes are all very specific, the construction of the inputs to these models may be less so. Similarly, the outcome of one model given a set of firm inputs may result in an altogether different value than that of another model using inputs for the same firm. If these two models are intended to provide a value relatable to the firm’s Enterprise Value, how is it the outcomes are often so different?
The answer may rest on what the model’s outcome is intended to represent. Consider the Adjusted Present Value (APV) and Key Value Driver (KVD) models. Both rely on the present value of the firm’s future cash flows, which have been adjusted (discounted) to reflect time and some notion of the opportunity cost of capital. The APV model considers a firm’s value as a function of its Free Cash Flow (FCF) plus its Tax Shield (TS), suggesting a firm’s value may be influenced by the firm’s capital structure. The KVD model informs us of the firm’s value as a function of its Net Operating Profit Less Adjusted Taxes (NOPLAT) and its Return on Invested Capital. Supposing both models share all other inputs with equal measures, we might expect the two outcomes to be similar, but they often are not…. that is, unless some very intuitive adjustments are made to reconcile them2.
It’s possible the outcome differences are simply a function of the algebra underlying the models. Four of the five valuation models under examination in this study employ similar denominators in their continuation forms in which the expected long-run growth rate of the firm’s cash flow (g) is subtracted from the firm’s Weighted Average Cost of Capital (WACC). In the event WACC < g, the value of this term will be expressly negative and may result in a negative overall valuation for the firm, even if the firm has a substantial Enterprise Value and consistently posts significant annual profits. While we may be left to consider whether or not the expected value of g is appropriate, it’s altogether likely we can’t consider these model forms as offering credible outcomes for firms with this problematic relationship between WACC and g3.
There’s also the issue of what John Maynard Keynes refers to as Animal Spirits4 reflected in the market values of both a firm’s equity and debt components at any particular point in time. Based on the notion that a firm’s value to its debt and equity stakeholders is the present value of their claims on the firm’s future cash flows, which is the value most models seek to present, we would expect the value represented by any particular valuation model outcome would equal the firm’s Enterprise Value, or the sum of the market value of its capital components. However, we observe that Enterprise Value and the firm’s calculated values may differ substantially due to short-term economic conditions and their influence on investor demands (Animal Spirits).
Similarly, differences in these measures may also be a function of the effects of asymmetric information held by buyers, sellers, industry analysts, and firm managers with respect to a firm’s capital components in these same markets. For example, when the discount rate applied to the firm by would be investors is not aligned with the discount rate applied by the firm’s current stakeholders, including firm management, valuation model outcomes may differ widely. Not only may these effects result in observed Enterprise Values that differs from the calculated outcome of a valuation model, but we may also see differing outcomes using the same valuation model applied to a particular firm.
The artistry lies in the ability to both interpret model outcomes and divine model inputs from a dizzying array of values and variables relative to any particular firm. It’s often suggested to students of Finance that a well-trained monkey and an iPad may currently perform relevant finance functions for a firm. While this high tech/low intellect combination may warrant minimal recompense in the capital and labor markets, talented and capable financiers often receive annual incomes measured in the hundreds of thousands or millions of dollars. Why the difference between the low cost monkey/iPad combination and the highly compensated financier labor form? Artistry and intuition.
1Prepared by Richard Haskell, PhD (2017), Associate Professor of Finance, Bill & Vieve Gore School of Business, Westminster College, Salt Lake City, Utah, firstname.lastname@example.org, www.richardhaskell.net
2Shrieves, R., and J Wachowicz (2001), Free Cash Flow, Economic Value Added, and Net Present Value: A reconciliation of variations of discounted-cash-flow valuation, The Engineering Economist, Vol. 46, No. 1, pg 33-52, 2001
3Discounted cash flow models generally produce consistently positive outcomes based on the condition ROIC > WACC > g. When a firm presents with a different generalized condition certain models may not be credible instruments for estimating the firm’s value
4“Animal spirits” is a term emphasizing the importance of investor sentiment on the market value of a firm’s debt and equity components. J.M. Keynes, General Theory of Employment, Interest and Money, pp 161-162, McMillan, London, 1936