Many valuation methods are directly or indirectly based on projecting potential firm performance in the future. While it is sensible to consider a firm’s ability to create future economic value in the valuation process, forward-looking valuation approaches all share the analytical weakness that the future cannot be predicted with certainty. Due to the negative consequences of incorrectly forecasting future events for companies, investors and markets, traditional valuation approaches could benefit from expressly considering how adaptable firms would be in the face of different potential future business scenarios.
Valuation Approaches
There are three common families of approaches that are used to value firms and income-producing assets.
Balance Sheet Approaches. The first key type of valuation method is based on a company’s balance sheet. In this type of valuation approach, the company’s liabilities as stated on the balance sheet are simply subtracted from the company’s assets to determine shareholders’ equity. Another type of balance sheet valuation approach involves determining what the cost would be replicate the company’s assets, such as a real estate project.
Market Approaches. The second important type of valuation method is the market approach, which, as the name suggests, derives the value of a company based on the market a company is operating in. In this approach, one or more valuation multiples are derived from transactions in a market and then applied to a company to determine its value. For example, if the EBITDA multiple for a particular industry in a given market is 8x, the enterprise value (meaning the value of the company’s equity as well as its debt) can be determined simply by multiplying the multiple by the company’s EBITDA.
Income Approaches. The third major type of valuation approach is the income approach, which seeks to derive a company’s value from its expected ability to generate economic value in the future. In the most common of these approaches, the Discounted Cash Flow valuation method, the company’s future free cash flow is forecasted and then discounted back to the present by applying a discount factor. This discount factor represents the perceived riskiness of the company’s future cash flows and includes many types of risks, including macroeconomic risk, financial risk and operational risk.
Valuation and the Impact of Future Uncertainty
Each of these valuation approaches, directly or indirectly, are based on the future. This can most easily be seen in the Discounted Cash Flow approach, which expressly projects the company’s future economic performance. However, the market approach is also effectively based on the future because the multiples are determined based in part on investor perceptions of the future. Even the balance sheet, which is a snapshot of a company at a specific point in time, contains items, such as receivables and payables, which are of course based on assumptions regarding future events.
The fact that valuation approaches, to greater or lesser degree, are based on perceptions of the future creates a very significant valuation challenge. Given that the future cannot be known with certainty, any valuation analysis unavoidably rests on unstable ground. This ground, moreover, is theoretically infinite because the structure of the future is not limited by the structure of the past.
Consequences of Forecasting Errors. The uncertainty built into valuation analysis has significant consequences for companies, investors and society as a while. For companies, the misperception of risk by investors can cause them to pay a higher cost of capital than is warranted for their business model, which directly impacts their ability to create economic value.
For investors, a misperception of risk means that they may not reach their expected investment return, which of course will not only impact their financial performance but also the financial performance of third-party companies who have likely provided the investor with capital for reinvestment on their behalf.
Thirdly, of course society pays a price for errors in valuation because these errors are typically externalized through either a reduction in liquidity or an increase in capital costs. Both of these phenomena create a drag on potential value creation which in turn affects firm profitability and investment.
Real Options. While not widely used in the valuation of companies, real options is a valuation approach which considers the ability of a firm to change course in the future or simply not go forward with a proposed course of action at all. From the perspective of a real options valuation methodology, a company that purchases land that can be used for multiple uses is more valuable than a company that purchases land that can only be used for one type of use. This is because the former firm has a greater chance to take advantage of positive land use opportunities (and avoid negative land use consequences) than the latter.
While this optionality is without doubt a useful complement to valuation analysis, it does not address the important issue of whether a firm will be able to effectively take advantage of options that it has or, if those options are not useful given market conditions, come up with new ones. This requires not only optionality but also another very important corporate quality: resilience.
Measuring Resilience
The resilience of a firm can be viewed as the degree to which it is able to continue to build shareholder value regardless of adverse internal or external conditions that it may face. Internal conditions that can affect the ability of a firm to create value include a loss employees, loss of technology and having insufficient amounts of capital. External conditions that can affect the ability of a firm to create value include political conditions, macroeconomic conditions and financial market liquidity.
The resilience of a firm can be defined simply as: R = P x A
Where:
R refers to the likely resilience of a firm in the face of potential adverse events.
P refers to the persistence of a firm to not give up even when it is very challenging not to do so.
A refers to the agility of the firm to change courses of action if necessary to continue to create shareholder value or defend itself from threats.
For a firm to be truly resilient, it must possess strong elements of P as well as A. A firm may be extraordinarily persistent, but if it continues to head down the wrong path it will likely destroy shareholder value rather than create it. Similarly, a firm can be extraordinarily agile, but if it does not have the persistence to follow through with changes of direction the firm will also likely find itself in an increasingly unfavorable business situation.
Attempting to quantify firm resilience is useful in valuation because, even if we are unsure whether the future will turn out to be scenario A, B or C, we can be reasonably confident that a firm with a higher resilience score will perform better than a firm with a lower resilience score.
Conclusion
While valuation plays an extremely important role in finance and economics, a key weak point in many valuation methodologies is trying to forecast the future. While it is not possible to predict the future with a high degree of confidence, developing a framework for analyzing the ability of a firm to continue to create shareholder value regardless of future conditions is a useful way to strengthen the valuation process. This should have many positive consequences for companies, investors and markets.