When valuing businesses, go with the flow

Cash flows matter more than forward multiples

During a recent webinar, I was asked whether we have enough real data to see what forward price/earnings (P/E) multiples look like, or whether the market is just “guessing.” This is an interesting question that highlights a very important point when it comes to valuing businesses. It highlights the danger of using forward multiples to evaluate long term intrinsic value¹.

Significant business disruption, either as a result of the current pandemic or an abrupt downturn leading to a recession (think Global Financial Crisis) can significantly impact forward P/Es. However, these events do not have the same impact on the intrinsic value of a high-quality business. The key distinction is that forward P/Es rely on one year of earnings, while a company’s intrinsic value is a function of all of its future cash flows.

Consider a hypothetical company that consistently grows its earnings (and free cash flow) by 5% per year. The earnings generated from this type of high-quality compounder is outlined in Table 1.

For those of you who enjoy discounted cash flow models, we will use an assumed 8.5% discount rate³ and an assumed terminal growth rate⁴ of 2.5%. If you would prefer to avoid using spreadsheets, you will have to take my word that the intrinsic value for this company is $20.00. The forward P/E is 19.

Now consider what would happen if immediately after reporting their annual earnings (year 0 above), the economy (and society) was hit with a pandemic. What would happen to their intrinsic value if their year-one earning was reduced by 30%. If the remaining years from 2 onward rebound to their pre-pandemic level, the only change to the cash flows in Table 1 would be year one being changed to $0.70. While the forward P/E would increase to 28.5 (20/0.7), the underlying change in their intrinsic value would only decrease by 1.6%, to $19.74. In fact, when it comes to valuing the long-term cash flows of a business, the first-year cash flows in this example represent only 5% of the company’s intrinsic value.

Using the above example, but assuming the first-year cash flows drop by 50%, would lead to a forward P/E of 39 but a reduction in their intrinsic value of only -2.5%. If the current economic backdrop continues to worsen and earnings are revised downward, the forward P/Es will increase. This does not necessarily mean that the long-term values of the companies are worth significantly less.

Let’s pose a more realistic scenario that would result in the companies’ first-year cash flows to decrease by 30%; rebound 20% in year 2 (i.e., halfway back to the starting point) and get back to our baseline year cash flow of $1.00 in year three. Once the economy has recovered, the business continues to grow by 5% over the next eight years – back to normal. The cash flows for the first four years are outlined in Table 2.

Similar to Table 1, the forward P/E would become 28.5. However, in this long recovery scenario, the intrinsic value of the company would decrease by 11% to $17.9.

The critically important thing to get right is the quality of the business and its ability to remain competitive after the short-term noise. Questions like “is the business strengthening or weakening” as a result of the new normal. If you are invested in a business that will come out of the current situation with an equally strong (or even better, stronger) business model, the impact of 2020 and 2021 is not significantly meaningful to their underlying intrinsic value.

Conclusion

The key to valuing a business is being able to develop a high level of conviction in the cash flows the business can generate over the next 10-20 years. Every business will go through challenges, either internally generated (poor product launch) or due to external factors (current pandemic). If these issues only have an impact on their immediate, short-term cash flows without impacting their mid- to long-term ability to generate cash, the impact on their valuation is generally not significant.

1. Intrinsic value is the calculation of an asset's worth based on a financial model.

2. CAGR – Compound annual growth rate

3. A discount rate is the rate of return used to discount future cash flows back to their present value.

4. A terminal growth rate is a constant rate at which a firm’s expected free cash flows are assumed to grow, indefinitely.

Michael Hatcher is Senior Portfolio Manager, Invesco Canada Equity team.

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