Corporate valuation often involves forecasting future company performance. While this is sensible because a company’s worth should reflect the economic value it will create in the future, the ability to make forecasts about what the future will be like is extremely limited. This often results in significant valuation errors that have a negative impact on capital providers as well as recipients. By incorporating resilience measures into cash flow forecasting, corporation valuation can be significantly strengthened. This will strengthen the corporate sector as well as capital markets.
Forecasting and Valuation
While there are many ways to value companies, one of the most common approaches is by calculating the present value of a company’s expected future cash flows. This requires projecting different components of a company’s expected future performance, forecasting the company’s free cash flows and then calculating the present value of those cash flows based on how risky they are. The riskier the future cash flows are, the lower the value of the firm is assumed to be. A more detailed description of the discounted free cash flow method of valuation is found here.
The Discounted Cash Flow method of valuation determines the present value of a company by discounting its projected free cash flows.
While sounds logical on paper, since the future cannot be predicted with certainty, a large amount of valuation analysis will very likely turn out to be wrong. One person has conjectured that 99% of discounted cash flow valuations are inaccurate.
The fact that such a significant probability of error is inherent in valuation has a very large impact on the corporate sector, capital markets and economies as a whole. Overvaluing companies causes investor returns not to be met, results in systematic capital misallocation and ultimately negatively affects financial liquidity.
Undervaluing companies, on the other hand, puts too little funds in the hands of companies or provides companies with funding at an excessive cost. While this impedes corporate development and acts as a drag on the reinvestment of corporate resources, it also counterintuitively has a negative impact on investors because, if companies had access to capital on better risk-adjusted terms, they could use that capital to improve financial performance, which of course would have a positive impact on investors.
Resilience Forecasting
The fact that the future cannot be predicted with certainty does not mean that we cannot make reasonable assumptions regarding how certain things will behave beyond the present. Let’s take an example of two people who are planning to hike through the jungle: one is an experienced guide, and one has never been on a hike through a jungle before.
While we cannot forecast what will happen in the jungle, we can reasonably say that the guide will have a better chance of surviving than the inexperienced hiker regardless of what will happen in the future. Thinking about this in a different way, we could say that the guide has a good chance of surviving many types of negative future scenarios while the inexperienced hiker has a good chance of surviving only a narrow range of negative future scenarios.
Resilience measures allow us to make reasonable guesses about how people will be impacted by future events.
The reason we can make this forecast is because we can analyze the resilience of a person today and it is likely that their level of resilience will remain more constant than changing external circumstances. In other words, they will continue to be resilient regardless of what external conditions are faced.
In addition to experience in the jungle, many other factors, such as the physical fitness of a person, the amount of water and food they have and their ability to communicate with other parties in the event that problems arise can give us a reasonably good sense of how likely an expedition is to be successful even if we cannot forecast what challenges the expedition will face.
Resilience and Companies
This analysis can also be applied to companies. While we cannot predict what conditions a company will face in the future, we can make reasonable assumptions regarding how companies will perform regardless of what the future holds. We can make this prediction based on numerous factors, including:
- team factors
- business model factors
- resources factors
- community factors
Team Factors. The first factor in determining the degree of a company’s resilience is the quality of its team. Key elements of team resilience are the experience of the team, the experience of the team working together through challenging times and the commitment of the team to continue working together regardless of market changes.
Business Model Factors. The second factor in determining the degree of a company’s resilience is how diversified the firm’s business model is. The more diversified a firm’s business model, the greater the likelihood it will be able to hold up under different types of market circumstances. Key elements of resilience in a firm’s business model are the degree of diversification of its clients, products and product pricing. The lower the level of diversification, the greater the likelihood that the firm will not be able to resist a range of future market scenarios.
Resource Factors. The third factor in determining the degree of a company’s resilience is the physical and financial resources it has. While not surprisingly as a general rule the more resources a firm has the more resilient it is, a key component of a firm’s resources is how accessible they are. A firm may have a great deal of physical resources, but if it cannot convert those resources into cash (because they may be difficult to sell given market conditions or they may be restricted from selling them due to agreements with third parties) the resources may not contribute to increased resilience when needed.
Community Factors. The fourth factor in determining the degree of a company’s resilience is the likelihood of community support in difficult times. The community does not only mean the physical community where a company is based but the larger community that supports the firm through purchasing its products or otherwise supporting the company’s mission.
The next step is to quantify a firm’s resilience. While the exact weighting of resilience factors depends on the sector the company is in, just for purposes of analysis let’s assume that each of these factors are weighted equally and have a maximum score of 25 points for a total possible score of 100. This means that a firm with a score of 100 could be expected to withstand virtually any future event and a firm with a score of 0 could be expected to likely not withstand any future event.
With this in mind we can compare the resilience of three hypothetical firms.
| Firm 1 | Firm 2 | Firm 3 | |
| Team | 14 | 10 | 17 |
| Business Model | 20 | 18 | 22 |
| Resources | 24 | 10 | 11 |
| Community | 10 | 22 | 17 |
| Resilience Score | 68 | 60 | 67 |
Resilience Forecasting and Valuation
Once a firm’s level of resilience has been analyzed, the next step is to incorporate its level of resilience into valuation. The simplest way to do this is to adjust its valuation based on a hypothetical resilience score.
To create a few parameters just for the purpose of illustration, let’s say that the cost of equity capital for a firm in a particular industry is 10%. We might assume that as general assumption a baseline resilience score for an average firm in the industry is 50. In other words, we assume that this is the implied level of resilience for a firm in this industry.
Let us further assume that the cost of equity capital should be adjusted by a maximum of 30% based on the company’s resilience (a 30% increase if the company’s resilience score is 100 and a 30% decrease if the company’s resilience score is 0). This means that if a company’s resilience score is 75, its cost of equity should be upwardly adjusted by 15% to reflect its additional resilience compared to the market. Conversely, if the company’s score is only 25, its cost of equity should be downwardly adjusted by 15%.
While it is easy why the cost of capital for a company should be downwardly adjusted based on a low resilience score, it may not be immediately easy to see why the cost of capital should be upwardly adjusted, particularly even if a firm’s cash flows assume a strong case market scenario. The answer is because the assumption is that a resilient firm will not only be able to withstand changing market conditions but will also be able to convert those conditions into new opportunities. This is an important resilience upside.
Conclusion
Valuation is a key driver for how capital is apportioned in financial markets. Despite its importance, Discounted Cash Flow valuation is highly prone to error because of the inability to predict the future. However, it is possible to make reasonable predictions about how a firm will perform, regardless of future scenarios, by analyzing a firm’s resilience. By incorporating resilience measures into valuation analysis, it is possible to strengthen the valuation process, which will improve capital allocation and capital pricing. This will have a positive impact on the corporate sector as a whole.
Thanks to Matteo Vistocco for the great photo on Unsplash. Beautiful Free Images & Pictures | Unsplash