I listened to an inderesPod where different valuation methods were presented. There are many of these different methods, but their selection criteria sounded quite peculiar. P/E is chosen because it is easy to calculate. If the company’s profit is very low, another method is used instead of P/E. EV/EBITDA is used because capital depreciation could distort the “true” profit. If the company is not profitable at all, but is making a loss, EV/Sales or P/S ratios are discussed. This choice is justified by the assumption that every company, once its profit has normalized, would be as profitable as another company that has operated in the industry for a long time. Let me add that this is about future valuation (your guess is as good as mine) instead of looking at past performance (for which we have plenty of data).
What on earth? The method used cannot depend on company-specific factors, can it? Either cash flows matter in business or they don’t. I have noticed that the best-performing companies state their cash flows and profits in the first sentence. The weaker the business in question, the more one sees these “relative development in currency-adjusted comparable EBITDA” with three asterisks. What is measured, is what is aimed for.
However, all companies have periods when things go worse and periods when things go better. Therefore, it is not good to use the same key figure to describe a company’s success in every situation. If a company is making strong investments, the P/E ratio may be too low compared to its actual performance, so it is not a suitable key figure for that situation. EV/Sales, for example, might be better, as it better reflects how the company is actually performing at that moment. The choice of key figure aims to eliminate temporary deviations from what the company is truly capable of.
The cash flow of a single year is not essential. What is essential is the present value of future cash flows. For this reason, one cannot directly deduce a company’s true ability to make money from this year’s cash flow, if there are clear reasons that burden the cash flow.
No key figure is, of course, the path to happiness, but a certain key figure is better suited to a certain situation than another. However, nothing guarantees that the situation will normalize in the future, but depending on the company, it is likely.
Business cash flow is the essential one, isn’t it? Other cash flow items are investments and financing items, the latter of which measures the change in the balance sheet’s debt amount. How are these future cash flows reasonably calculated? Stock appreciation and dividends are the only two ways to earn, and it seems to me that volatility is much more significant. Let’s take a concrete example.
Comrade evolove paid 3.54 euros for his Hoivatilat in another thread, and these are sold on the stock exchange for 8.05 euros. So, evolove has earned 8.05 - 3.54 = 4.51€ per share. Hoivatilat has 25.439 million shares, so according to the new price, it should pay 4.51 * 25.439 = 114.73 million euros more in dividends. Reasonable companies pay their dividends with operating cash flows, which were 5.59 million euros during the trailing 12 months. Thus, with the stock price having grown, it would take 20½ years at this rate to cover the price increase. This calculation treats the cash flows of all years as equally valuable, while in a proper discount calculation, future cash flows are less valuable.
What about investments? They increase operating cash flows. Investments are paid for with money obtained from a combination of retained earnings, debt, and funds from share issues. If a company wants to maintain an equity ratio of 45%, a million-euro real estate investment must have 450,000 euros of its own money. In share issues, money flows from investors to the company, and without share issues, growth will be slow. Weakening the equity ratio, in turn, increases risks and makes financing more difficult. The decrease in yield requirements for care properties also means that more must be paid for new properties. Too often, analysts’ calculations show that growth is somehow automatic, but these decisions seem difficult to me.
So, if we do a discount calculation for Hoivatilat at 3.54€ and Hoivatilat at 8.05€, what changes in the parameters would justify such a change in value?
I agree about Hoivatilat’s valuation, and it’s not as cheap right now as some might think. Shares should indeed be valued at the present value of future cash flows, but estimating long-term cash flows is a bit of a gamble. In reality, share valuation can’t be based on cash flow calculations, but theoretically it can.
In the real estate sector, operating profit and cash flow are the significant factors, not so much changes in property values, unless active trading of properties is being pursued. For this reason, Hoivatilat should be examined on a cash flow basis, and in that regard, it’s not very cheap. Hope rests on growth, and the properties currently under construction will certainly significantly increase cash flow. What’s crucial is growth from this point forward.
Mostly agree, but companies tend to want to show good results. Investments end up being maintenance investments, which are essentially like any other expenses. That’s why it’s good to deduct them from the operating cash flow when calculating cash flow. Usually, it’s close enough if you deduct the line “investments in tangible and intangible assets.”
If a discount calculation is made for Hoivatilat at €3.54 and Hoivatilat at €8.05, what parameter changes would justify such a change in value?
I don’t know the case of Hoivatilat (Hoivatilat), but the result of the calculation is sensitive to changes in the discount rate. When calculating the discount rate, it is justified to consider the risk-free rate, the equity market risk premium, Hoivatilat’s (Hoivatilat) beta, and bond prices, so those are the requested parameter changes.
“What is crucial is the growth from this point forward”
This determines whether the stock is cheap based on cash flow or not. The 2019 P/E ratio calculated from Hoivatilat’s (Hoivatilat) cash flow-based EPRA operational result is currently 18.6x according to our forecasts. At the same time, our estimated average annual EPS growth in operating profit is 26% for the years 2019-2021. If growth continues at this level (as we predict), we believe that a higher valuation than the current one is fully justified.
In short: strong scalable growth. When Hoivatilat’s share price was €3.54 in 2016, its operational EPS for that year was €0.15. Now, that operational EPS is projected to be €0.43 in our forecast for next year, which is almost threefold. This operational EPS for 2019 is, in our opinion, practically almost certain, as the properties required to achieve it have already been rented out with binding lease agreements at 100% occupancy, and financing is also in place. Assuming a constant P/E, tripling the EPS also triples the share price.
Sounds reasonable. I must admit that the scalable growth of companies has remained unclear to me. Looking at Hoivatilat’s 2017 annual report, the income statement line “Disposals of investment properties and changes in fair value” catches the eye, which in both 2016 and 2017 has been almost equal to the profit for the financial year according to IFRS standards. Is this a coincidence?
Asset turnover (revenue / total assets) remained stable. Hoivatilat are likely independent units scattered around Finland, so how does the business scale? The scalable factor appears to be changes in property values: the larger the invested capital, the larger the absolute changes in valuation. Since revenue is tied to the cost of living index, profit must be sought from cost savings in administration, property maintenance costs, or employee benefits. Is this where the scaling mechanism comes from?
In the care property business, fixed costs scale, meaning that even if the number of properties increases, the company can be managed with almost the same number of staff and other operating expenses as before. In 2016, personnel expenses and other operating expenses accounted for approximately 31% of revenue, and this year, according to our forecast, they will only be 23% of revenue. We also predict that this scalability will continue.
Part of Hoivatilat’s business involves the company constructing properties, which results in calculated fair value changes. For example, according to our forecast, 95 MEUR will be invested in this area this year.
How should one value fast-growing companies like Hoivatilat, which have a lot of debt relative to their cash flow? EV/EBITDA? I tried using DCF and WACC but got -4.9€/share as a result, so this method was obviously wrong.
For companies where the value of their balance sheet’s own assets can be determined relatively accurately (like real estate companies), the balance sheet provides a good starting point for valuation. Roughly, if a company can generate returns above the return requirement set by the stock market, then P/B is over 1x. If its expected return is below the return requirement, then the valuation is below P/B 1x. For example, Hoivatilat’s net assets (equity adjusted for deferred tax liability) per share is 8.0 euros in our forecast at the end of 2019, and the share is currently 8.33 euros. This means that the market practically prices in that the company will not reach its previous high return on capital (2017 ROE-%: 25%). Or perhaps the assumptions behind our NAV forecast are wrong, or the market is pricing in a share issue DCF (Discounted Cash Flow) works well in principle if cash flows are easily predictable, such as Hoivatilat’s rental income. The challenge with DCF is how to model the company’s construction development margin and how to properly account for its investments. Currently, Hoivatilat is investing very heavily, and its cash flow is therefore strongly negative. DCF also faces challenges with terminal value assumptions, which significantly affect the value. As a general rule, I would not recommend using DCF myself unless one has received training in the field, as applying DCF and drawing correct conclusions from it practically requires a very good understanding of financial statement analysis and financial theory. Even a small error can lead to completely wrong conclusions. Often, DCF is unnecessary “sophistication” in stock investing. Its most important value, at least for me, is that it helps to understand what assumptions a certain stock price contains. A kind of “sanity check,” therefore.
Okay, these are good to know, thanks for the tips What valuation multiples would you personally recommend for less experienced investors to follow to better determine the value of companies? I’ve studied some finance theory in my free time, but if what you said about DCF is true, then I’ll have to rethink how companies should be valued
The intention was just to warn, not to criticize DCF Our comments on DCF can be found, for example, here DCF-malli (älä tee tätä kotona!) - Inderes Personally, I like to focus on the return on capital a company achieves and value the stock that way, as mentioned above. Of course, this doesn’t suit all companies and, like DCF, requires modeling the required rate of return and growth. An easy and functional method that I also consider is to estimate an acceptable valuation level through earnings growth and the PEG ratio.
Now that I’ve read more reports and delved deeper into the matter, I think I’ve started to understand how to value companies. That’s why it would be great, Jesse, if you could briefly comment on whether I’m on the right track or completely mistaken, because I’d like to weed out any wrong ideas right from the start
So, this is the understanding I’ve gained. Before you start determining a company’s value, you should look at its business model and where the cash flow comes from. For example, if a company’s cash flows are cyclical (largely based on sales or projects) like Siili, Vincit, etc., then EV/sales is a good metric. If, on the other hand, the company’s cash flows are stable and very predictable, then ROE is a good metric (and if you really know what you’re doing, then DCF)? Am I completely wrong here or how would you see it ?
If a company is cyclical, its earnings or cash flow should be averaged over a long period. The EV/Sales ratio is used to evaluate loss-making companies to estimate what the company might produce if it were profitable. Growth companies with a short stock market history are more difficult to evaluate.
ROE is a somewhat flawed metric in that a company’s earnings may include value increases, such as with real estate companies. A real estate company’s earnings may grow when market yield requirements decrease. In other words, there is more money in the market seeking returns than there are profitable assets. However, an increase in the value of real estate is not the same as cash flow that could be reinvested or distributed to owners as dividends. A real estate company’s ROE might be 20% in one year when the yield requirement decreases and 2% in another year when real estate only follows inflation. ROE also does not take into account the company’s indebtedness. It is always advisable to carefully research an investment target before investing. These key figures are helpful in finding potentially interesting targets.
Juippi answered your questions well. Different valuation methods have their own shortcomings, and one should never rely on just one valuation multiple but rather examine the whole picture. In my opinion, the most important thing is to understand the business of the company being analyzed (how revenues and cash flows are generated) and the risks associated with the business. This way, one can better apply different valuation multiples and valuation methods to the stock. It is also important to look forward, meaning not to apply only historical figures in valuation but to use forecasted figures. If you are doing a peer group valuation, it would also be good to at least somewhat understand the business model and risk profile of the comparables.
I would need help with the valuation of an unlisted software company. Is there anyone here who could provide an estimate?
Company:
Revenue 350M€
SaaS (Recurring contracts year after year) 265M€
Revenue growth last 10 years: 30%/year
Forecasted revenue growth: 25%/year
Churn (annual customer attrition): 5% (meaning 95% continue using)
Profit: -20M€ (Growth at the expense of profit)
Personnel: 2000
Market leader in its field or at least top 3.
Operates quite globally, with customers and offices around the world (USA, Europe, Asia, Middle East)
More information is certainly needed for an accurate estimate, but can these details provide a ballpark figure?
Incomplete information, of course, but one could guess that its valuation multiples would be somewhere in the EV/S 5-10 range. If one compares, for example, Qt and Admicom, whose EV/S hovers around 6, with slower growth, but both, in turn, are very profitable, then I would give a rapidly growing software company like that perhaps slightly higher multiples, even if profitability isn’t yet evident.
If one gives, for example, a multiple of EV/S=7, one gets a value of €2.45 billion, not accounting for cash, but equally well, in my opinion, with this information, one person could estimate the value at €1.5 billion and another at €3 billion.
DCF (Discounted Cash Flow) works well in principle if cash flows are easily predictable, such as Hoivatilat’s rental income. The challenge with DCF is how to model the company’s construction development margin and how to properly account for its investments. Currently, Hoivatilat is investing very heavily, and its cash flow is therefore strongly negative. DCF also faces challenges with terminal value assumptions, which significantly affect the value. As a general rule, I would not recommend using DCF myself unless one has received training in the field, as applying DCF and drawing correct conclusions from it practically requires a very good understanding of financial statement analysis and financial theory. Even a small error can lead to completely wrong conclusions. Often, DCF is unnecessary “sophistication” in stock investing. Its most important value, at least for me, is that it helps to understand what assumptions a certain stock price contains. A kind of “sanity check,” therefore.
What valuation multiples would you personally recommend for less experienced investors to follow to better determine the value of companies? I’ve studied some finance theory in my free time, but if what you said about DCF is true, then I’ll have to rethink how companies should be valued 
Our comments on DCF can be found, for example, here 
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