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Chapter 1: Why Value Value?

Tuesday, September 24, 2019


2:28 PM

 Earning a return on capital that exceeds the cost of capital, means that the company is creating value

 Creating value is not a short-term process, rather a constant long-term focus strategy in decision
making

 The definition of creating value for both current and future shareholders is more correct, since it
implies that management is acting with a long-term strategy

 Evidence shows that companies with a long-term strategic horizon create more value for their
shareholders

 A company cannot create shareholder value without having other satisfied stakeholders too(suppliers,
customers). CSR is good for business

 While there is constant criticism on some companies for not considering many stakeholders at the
same time, the real criticism is against short-termism. Companies gain more long term if their
workforce is satisfied for example.

 That being said, shareholder capitalism cannot be the solution to all social issues

 When the principle of value creation is forgotten crises happen. Think about the dot-com bubble and
the financial crisis of 2008

 Even when the value creation principle is supposedly understood, there might be a focus on short term
EPS by board members and executives

Chapter 2: Fundamental Principles of Value Creation


Wednesday, September 25, 2019
8:56 AM

Future cash flows worth less than those of today because of:
 The time value of money
 Riskiness of the future
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 Accounting earnings and cash flows are not the same

 Growth, ROIC and cash flows are interconnected

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Practically the above means that if a company invests less it has higher cash flows, making it a potentially
more attractive investment

If high growth occurs when ROIC is lower than the cost of capital, value is being destroyed rather than
created

For example a company with high ROIC and low growth might have a higher valuation than a company with
high growth and low ROIC. The figure below demonstrates that
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Higher growth that in turn will lead to higher ROIC can be true for start-ups, not for mature businesses. Low
ROIC might indicate an unattractive sector or a flawed business model

Higher ROIC leads to higher valuations and subsequently higher P/E ratios. For example US packaged
goods companies had higher trailing P/E ratios compared to their Asian counter pants, due to their higher
ROIC.

Lessons for Managers

General lesson here, high-ROIC companies should focus on growth, while low-ROIC companies should
focus on increasing ROIC before growing.

Different growth generates different value. Generally speaking, new products generate more value while
acquisitions create the least.
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Different growth generates different value. Generally speaking, new products generate more value while
acquisitions create the least. That is because usually the introduction of a new product requires less new
capital, while not all of this capital is needed right away. A not promising product can be cancelled and
therefore save capital that would have otherwise gone into its development. Acquisitions are the exact
opposite of that.

Management can improve ROIC by either increasing profit margins or improving capital productivity.

Example

Revenues $1,000.00
Profit 100.00
Inv. Capital 500.00

Profit Margin 10.0%


Invested Capital Ratio 50.0%
ROIC 20.0%

If Profit increases by $5 then value goes up

Revenues $1,000.00
Profit 105.00
Inv. Capital 500.00

Profit Margin 10.5%


Invested Capital Ratio 50.0%
ROIC 21.0%

If Working Capital goes down then Value goes up

Revenues $1,000.00
Profit 100.00
Inv. Capital 476.00

Profit Margin 10.0%


Invested Capital Ratio 47.6%
ROIC 21.0%

Economic Profit

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Economic profit measures the value created by a company in a single period.


The Math of Value Creation
Or just a summary of terms and formulas

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Chapter Summary
This chapter has shown that value is driven by expected cash flows discounted
at a cost of capital. Cash flow, in turn, is driven by expected returns
on invested capital and revenue growth. Companies create value only when
ROIC exceeds their cost of capital. Further, higher-ROIC companies should
typically prioritize growth over further improving ROIC, as growth is a more
powerful value driver for them. In contrast, lower-ROIC companies should
prioritize improving ROIC, as it is a stronger value driver.

Chapter 3: Conservation of Value and the Role of Risk


Sunday, October 06, 2019
4:47 PM

Moral of this chapter: If it doesn’t increase cash flows then it doesn’t increase value.

Actions that don’t increase cash flows over the long term will not create value, regardless of whether they
improve earnings or otherwise make their financial statements look stronger. One exception could be actions
that reduce a company’s risk and, therefore, its cost of capital.

Practically speaking, if cash flows are not increased then value doesn’t increase. No matter the capital
structure or the accounting treatment, if cash flows are not growing then valuation remains stagnant.

Here the authors cite the Modigliani-Miller theorem that in absence of taxes the capital structure of the firm
does not affect its valuation.

Three examples for understanding the value principle:

Share repurchases: In a simplified example where the company borrows money and repurchases stock,
EPS will go up. The higher leverage will make equity more volatile, meaning that P/E will go down. Some
argue that if a buyback occurs then managers will not be able to invest in at low returns, meaning that the
buyback actually created value.

Acquisitions: Acquisitions only create value due to synergy effects like cost reductions, accelerated rev.
growth, or better use of fixed and working capital.
Here the authors also talk about "multiple expansion" where an acquisition happens and the company with
the lower P/E attains the (higher) P/E of the other company. According to the authors there is no data that
can support this.

Financial Engineering: The authors defines this as the use of financial instruments to affect the capital
structure and the risk profile of the firm. While some of those instruments might actually create value, most
of the time that doesn’t happen.

Risk and Value Creation


The cost of capital is the price charged by investors for bearing the risk and uncertainty of future cash flows.
It is the opportunity cost of what the investors earn from something with a similar risk profile.

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A notion of academic finance is that as long as investors can diversify away from risk, and it is not costly to
diversify then the investors will not ask a return on risks that they can diversify. They will though, for risks
that they cannot diversify away. Aka Systematic risk.

Companies and managers should identify and management their cash flow risk.

After several comprehensive examples where scenarios of companies that have to decide on projects are
examined, we get the bottom line. If a project puts a company in danger as a whole (i.e. danger of
bankruptcy) , then the company should forgo the project entirely.

According to the authors, hedging commodity risks should be avoided, while currency risk should be hedged.
Here the authors give the example of Heineken, who produces everything in the Netherlands and then
exports it. Revenue is subject to FX fluctuations but not the costs. Heineken is also not able to pass on costs
since it is competing with local brewers, therefore FX hedging might be more important for Heineken.

Summary
Acorollary of the principle that discounted cash flow drives value is the conservation
of value: anything that doesn’t increase cash flows doesn’t create value.
So value is conserved, or unchanged, when a company changes the ownership
of claims to its cash flows but doesn’t change the total available cash flows.
Similarly, changing the appearance of the cash flows without actually changing
the cash flows—say, by changing accounting techniques—doesn’t change
the company’s value.
Risk enters into valuation both through the company’s cost of capital,
which is the price investors charge for bearing risk, and in the uncertainty
surrounding future cash flows. Because investors can diversify their portfolios,
the only risk that is captured in the cost of capital is the risk that cannot
be diversified. Although finance theory has little to say on how to approach
cash flow risk, in practice managers’ and investors’ valuations also need to take
account of any risks attached to cash flows that shareholders cannot manage for
themselves.

Chapter 4: The Alchemy of Stock Market Performance(pg 49-53)


Sunday, October 06, 2019
6:07 PM

Total Returns to Shareholders(TRS) is the measure where the combination in gains in share price with the
sum of dividends received of a specific time period.

TRS measured over a period of 10-15 years actually reflects the performance of a company. Measured over a
shorter period, TRS does not measure true performance for two reasons:
 When managers have to work hard to improve the company, investors take notice and buy stock. This
in turn makes the managers work even harder in order to keep up with the high expectations. Looking
at TRS in isolation therefore is not a good performance index
 When TRS is analyzed in the traditional way then there is no way of knowing how much do the
improvements in operating performance contributing to TRS. However, operational improvements are
the only measure that reflects sustainable and long-term value creation that is under management
control

Managers that are going after TRS maximization might pursue short-term goals that might hurt the long-term
potential of the business.

Companies with low expectations have an easier time increasing TRS over the short term. Once a company
has demonstrated good performance it is trapped in the performance treadmill where it has to live up to its
own reputation of delivering good returns.

Companies that have shareholders with high expectations, in an attempt to achieve high TRS, might be led to
misguided actions such as risky acquisitions.

The performance treadmill might make it hard to perform peer-comparisons since companies have different
expectations from their shareholders.

Chapter 6: Return on Invested Capital


Sunday, October 06, 2019
6:47 PM
The longer a company can raise its return on invested capital and the longer it can sustain a ROIC higher than
the discount rate, the more value it will create.

A company with a competitive advantage can usually produce really high ROIC. Additionally, the sector
structure and the competitive behavior define the ROIC.

What drives ROIC?

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This formula simply translates NOPLAT into per unit calculations.

A company with a competitive advantage, can either charge a premium for its products or it can produce in a
more efficient manner.

According to the Structure-Conduct-Performance(SCP) framework, the structure of an industry influences


the behavior of competitors which in turn drives the performance of the companies in the industry.

The competitive structure of an industry, as explained by Porter's 5 forces, defines ROIC. An example of that
would Consumer Staples companies like Procter and Gamble have very strong brand names with intense
customer loyalty; this in turn produces high ROIC. In the extraction sector(mining), the product is virtually
the same with capital intensive processes involved. This in turn leads the extraction sector to having a lower
ROIC.

The industry structure is not the only determinant of ROIC. Certain automotive brands were able to
outperform the sector based on cost efficiencies and the brand being perceived as more trustworthy, allowing
the company to charge a premium.

Industry structure and competitive behavior are not set in stone. They might be shocked by innovation,
government regulation, and competitive entry.

Competitive Advantage
There are two categories that define competitive advantage. Price premium and Cost and Capital efficiency
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Price premiums offer better chances of achieving a higher ROIC. The businesses and products with more
than one of those characteristics are usually the industry leaders.

 Innovative Products: Products that are either protected by a patent or are difficult to copy.
 Quality: The real or perceived difference between a product/service and another for which the
customers are willing to pay a higher price.
 Brand: Brand and quality are highly correlated. While quality matters, a long standing brand sometimes
matters more.
 Customer lock-in: When replacing a company's product/service with another's is relatively costly for
customers.
 Rational price discipline: In commodity industries with many players, supply and demand will drive
down prices and ROIC. Once an industry is deregulated we usually see prices collapse.
 Cost and capital efficiency advantages: Cost efficiency is the ability to sell products and services at
lower cost than competitors. Capital efficiency is selling more products per dollar of invested capital
than competitors.
 Innovative business methods: The combination of production, logistics, and pattern of interaction
with customers.
 Unique resources: A company's access to a unique resource that is very hard to replicate. An example
of that, American gold ore producers get gold that is closer to the surface compared to the ones in
South America. Geography can also be a resource, due to costs of shipping
 Economies of Scale: Scale is important to value but usually only to regional or local level. A company
sees benefits in economies of scale, if investment s are large enough to deter competitors.
 Scalable products or process: Having very low cost of supplying or serving additional customers.

Sustainability of ROIC
The longer the high ROIC, the more value the company creates.
 Length of product life cycle: the longer the life cycle the better the chances of sustaining a high
ROIC.
 Persistence of Competitive Advantage: If a company cannot prevent competitors form duplicating
its business, then high ROIC will be short-lived.
 Potential for product renewal: The ability to use brand to launch new products(e.g. iPhone)
Empirical Findings on ROIC:
 Median ROIC in big cap US companies went up in 2013 because of high performing sectors like
pharma and IT
 Industries that rely on patents and brands have higher ROIC
 There are great deviations of ROIC within sectors
 ROIC rates tend to be stable. Only a few industries trend upwards in the ROIC rates

ROIC by Industry

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Persistence of Industry ROICs


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Summary
There are many lessons to learn about returns on invested capital. First, these
returns are driven by competitive advantages that enable companies to realize
price premiums, cost and capital efficiencies, or some combination of these.
Second, industry structure is an important but not an exclusive determinant
of ROIC. Certain industries are more likely to earn either high, medium, or
low returns, but there is still significant variation in the rates of return for individual
companies within each industry. Third, and most important, if a company
finds a formula or strategy that earns an attractive ROIC, there is a good
chance it can sustain that attractive return over time and through changing
economic, industry, and company conditions—especially in the case of industries
that enjoy relatively long product life cycles. Unfortunately, the converse
is also true: if a company earns a low ROIC, that is likely to persist as well.
There are many lessons to learn about returns on invested capital. First, these
returns are driven by competitive advantages that enable companies to realize
price premiums, cost and capital efficiencies, or some combination of these.
Second, industry structure is an important but not an exclusive determinant
of ROIC. Certain industries are more likely to earn either high, medium, or
low returns, but there is still significant variation in the rates of return for individual
companies within each industry. Third, and most important, if a company
finds a formula or strategy that earns an attractive ROIC, there is a good
chance it can sustain that attractive return over time and through changing
economic, industry, and company conditions—especially in the case of industries
that enjoy relatively long product life cycles. Unfortunately, the converse
is also true: if a company earns a low ROIC, that is likely to persist as well.
Chapter 7: Growth
Tuesday, October 08, 2019
8:23 PM
Missing some graphs from this chapter

Revenue growth can be divided into 3 components:


Portfolio momentum: Organic growth due to expansion in the market segments
Market share performance: Organic revenue grow that a company earns by gaining or losing market
share
M&A: Inorganic growth that is achieved when buying or selling revenue through M&A

While it is good to gain market share, exposure should be focused towards growing markets and not
shrinking ones

Each components creates different amounts of value and therefore growth can come to the expense of
shareholders

For example, creating new innovative products has the biggest value creation. As said before, the stronger the
competitive advantage the higher the ROIC.

Bolt on acquisitions can create value if the premium isn’t very high. Large acquisitions tend to create less
value.

Why sustaining growth is hard


In many cases the sales targets that companies set can be too optimistic. For example a 5 billion dollar
company setting a 20% increase in sales target.

Due to the limited product life, sustaining high growth is difficult. A company needs to keep finding
untapped markets and enter them in time. Ultimately, a company’s growth is dependent to its product
markets, market penetration, and the product market that it is competing in. The company has to keep
indtroducing new products to continue growing.

Empirical analysis of corporate growth

The median rate of revenue growth between 1965 and 2013 was 5,3%. Real revenue growth was
fluctuating between 0 and 9%
High growth rates decay very quickly. Companies growing

Growth Trends

Some of the sectors with the highest growth are software, IT, and healthcare equipment.

Summary
To maximize value for their shareholders, companies should understand what
drives growth and what makes it value-creating. Long-term revenue growth
for large companies is largely driven by the growth of the markets in which
they operate. Although gains in market share contribute to revenues in the
short term, these are far less important for long-term growth.
Revenue growth is not all that matters for creating value; the value created
per dollar of additional revenues is the crucial point. In general, this
depends on how easily competitors can respond to a company’s growth strategy.
The growth strategy with the highest potential in this respect is true product
innovation, because entirely new product categories by definition have no
established competition. Attracting new customers to an existing product or
persuading existing customers to buy more of it also can create substantial
value, because direct competitors in the same market tend to benefit as well.
Growth through bolt-on acquisitions can add value, because such acquisitions
can boost revenue growth at little additional cost and complexity. Typically,
much less attractive is revenue growth from market share gains, because it
comes at the expense of established, direct competitors, who are likely to retaliate,
especially in maturing markets.
Sustaining high growth is no less a challenge than initiating it. Because
most products have natural life cycles, the only way to achieve lasting high
growth is to continue introducing new products at an increasing rate—which
is nearly impossible. Not surprisingly, growth rates for large companies decay
much faster than do returns on invested capital; growth rates for even the
fastest-growing companies tend to fall back to below 5 percent within 10 years.

From <https://mail.google.com/mail/u/0/#inbox/QgrcJHshbMDtrQRsVtFwBrvPfwshsPStMVv>

Chapter 8: Frameworks for Valuation


Wednesday, October 09, 2019
4:15 PM

In a valuation we focus on two things:


 Enterprise discounted cash flow
 Discounted economic profit

When applied correctly they both give the same results.

DCF is a favorite because it focuses on cash flows

Economic profit is a close link to competitive strategy and economic theory

We use WACC in both cases to discount future cash flows

The WACC is good when the company maintains a stable debt to value ratio

In the case that the capital structure will change we can use the adjusted present value(APV)

The APV works the same but uses the unlevered cost of equity. Then it values separately the cost benefits of
tax to determine total enterprise value.

When done properly, the APV yields the same result with the DCF
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Enterprise DCF

The DCF discounts the cash available to all investors using the WACC. Then debt and nonequity claims are
subtracted to give the value of equity.

Equity valuation on the other hand gives equity value directly.

The DCF is very useful when used at multi-business companies where the EV is the sum of all individual
operating units less the value of corporate-center costs plus the value of nonoperating assets.

The DCF is a 4 step process:


1. Value the company's operations by discounting cash flow with WACC
2. Identify and value nonoperating assets and add them to the above to get EV
3. Identify the value of all debt and nonequity claims
4. Subtract the value of debt and nonequity claims from EV to determine value of common equity.
Divide by shares outstanding to get value per share

 Valuing Operations: The discounted cash flow generated by the company's operations less any
reinvestments into the business.
 Reorganizing the financial statements: The company's financials need to be reorganized in order to
calculate FCF and ROIC. The accounting statements are reorganized in new statements that separate
operating and nonoperating as well as capital structure. The new reorganization leads to new terms:
o NOPLAT: Total after tax operating income generated by invested capital, available to all
investors
o Invested Capital: IC represents the investor capital required to fund operations
o Dividing those two we get the ROIC
 Once we have reorganized the financial statements, we the calculate FCF
 Analyzing historical performance: Analyzing past performance we see if the company has created
value, how fast it has grown and how it compares with competitors. This will help in making future
estimates
 Projecting revenue growth, ROIC and free cash flows: Then we project revenue growth, ROIC
and FCF.
 Estimating continuing value: We use the perpetuity method to calculate continuing value.

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 The above result is discounted to today


 Discounting FCF with WACC: WACC formula

Identifying and valuing nonoperating assets

The cash generated by assets that are not part of operations have to be valued separately. Some of these
assets are:
 Equity investments
 Excess cash
 Tradable securities
 Customer-financing businesses

Identifying and Valuing Debt and Other Nonequity claims

In order to arrive to equity value, we need to subtract debt and other nonequity claims from EV.

Some of those items are:


 Debt: If market value of debt is available, good. If not, book value can be a good proxy
 Operating Leases: In some cases companies do not capitalize leases, then we look in the footnotes
 Underfunded retirement liabilities: Such liabilities are treated as debt
 Preferred stock: Unlike what the name suggests, it is more closely related to unsecured debt
 Employee options: options can be a substancial number and should be factored in equity value
 Noncontrolling interest: The funding other investors provide is recognized as noncontrolling interest.
Minority interest holders have a claim in the assets of the subsidiary

To determine equity per share value, divide equity value by undiluted shares outstanding.
Chapter 9: Reorganizing the Financial Statements pg. 192-197 & pg. 525-528
Monday, October 14, 2019
8:53 PM

When we reconcile NOPLAT, we start with net income and add back the increase or decrease in deferred tax
liabilities. Then add expenses for any adjustments you make to operating income, such as severance charges,
interest expense and investment income. Finally, subtract the nonoperating tax shield computed when
determining operating taxes.

Free Cash Flow in Practice

In order to make further adjustments specific to FCF and its reconciliation, we need the statement of retained
earnings and statement of accumulated other comprehensive income.

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The components of FCF are gross cash flow and investments in invested capital. If possible, investment in in
invested capital are separated into organic investments and acquisitions.

Gross cash flow represents the cash flow generated by the company's operations. It is the cash available to
all investors and investments without the company having to sell non-operating assets(such as excess cash)

The components of gross FCF are NOPLAT and noncash operating expenses. In order to turn NOPLAT
into FCF add back depreciation and amortization(only the amortization deducted from revenues).
Amortization from acquired intangibles and impairments should not be added back.

Investment in invested capital is the portion of cash that companies have to invest back into the business
in order to grow their operations.

Investment in invested capital is broken down into five components:


1. Change in operating working capital: growing a business requires investments in operating cash,
inventory, and others
2. Net capital expenditures: Investments in PPE less any PPE sold. One way of calculating that is by
adding back depreciation to net PPE. DO NOT estimate capital expenditures by taking the change in
PPE, since PPE will drop when companies retire assets
3. Changes in capitalized operating leases: In order to keep the definition of NOPLAT consistent include
investments in capitalized leases in gross investments
4. Investments in goodwill and acquired intangibles: This can be calculated by computing the change in
net goodwill and acquired intangibles
5. Change in other long-term operating assents, net of long-term liabilities: Subtract investments in other
net operating assets. Do not confuse long-term assets with other long-term nonoperating assets such as
equity investments and excess pension assets. Changes in equity investments need to be calculated
separately

In order to remove the currency effects we subtract the increase in the equity item "foreign currency
translation" which is found in the statement of accumulated other comprehensive income.

Cash flow available to investors

In order to calculate the total value of the enterprise

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To reconcile FCF with total CF available to investors include the following nonoperating cash flows:
 Nonoperating income and expenses:
 Nonoperating taxes
 Cashflow related to excess cash and marketable securities: Subtract the increase in excess cash and
marketable securities to compute total cash flow available to investors. If the company reports gains
and losses in comprehensive income net the gain or loss against the change
 Cashflow from nonoperating assets: The same process as above should be followed for excess cash and
other nonoperating assets. When possible combine nonoperating income from a particular asset with
changes in that nonoperating item

Reconciling Cash flow Available to investors


Cash flow available to investors should be identical to a company's total financing flow. We do that in order
to catch mistakes

 Interest expense
 Debt issues and repayments
 Change in debt equivalents
 Dividends
 Share issues and repurchases

The pg. 525-528 is what has been mentioned above put in practice in the Heineken case.

Chapter 11: Forecasting Performance


Wednesday, October 09, 2019
5:08 PM

In this chapter the mechanics of the model are explained. In order to arrive to future cash flow we forecast
the income statement, balance sheet, and statement of retained earnings. The projected financial statement
allow to compute NOPLAT, ROIC, and FCF.

Determine the forecast length and detail

First we have to determine how many years to forecast and how detailed the forecast will be. There should be
a year to year forecast for a period and then use the perpetuity formula after that period. In order to use the
perpetuity formula a steady state has to be reached by the company.

The following characteristics define the steady state:


 The company grows at a constant rate by reinvesting a constant proportion of operating profits in the
business each year
 The company earns a steady rate of return on both existing capital and new capital invested

The forecast period should be long enough that the company's growth rate is less or equal to that of the
economy.

The book reccomends a forecast period of 10-15 years, sometimes longer for cyclical companies and those
experiencing very high growth.

To simplify the model we spit the forecast in two periods:


1. A five to seven year forecast with complete balance sheet and income statements. With links to as
many variables as possible(unit volumes, cost per unit)
2. A simplified forecast for the remaining years, focusing on few important variables, such as revenue
growth, margins, and capital turnover

Components of a good model


1. Raw Data: Collect all data from financial statements, footnotes, and external reports in one place. Raw
data should be reported in their original form
2. Integrated financial statements: Using figures from the raw data create a set of historical financials
that have a right level of detail. Operating and non operating items should not be in the same line item.
The income statement should be linked with the balance sheet through retained earnings. This
worksheet will contain both historical and forecast financial data.
3. Historical analysis and forecast ratios: For each line item in the statements, build historical ratios as
well as forecasts of future ratios. The forecasted ones will be used to forecast the statements used in the
previous sheet
4. Market data and WACC: Collect all financial market data in one worksheet. This worksheet will
include estimates of beta, cost of equity, cost of debt, wacc, as well as historical market values and
trading multiples for the company
5. Reorganized financial statements: Once you have completed building the financial
statements(historical and forecasted), reorganize the financial statements to calculate NOPLAT, its
reconciliation to net income, IC and its reconciliation to total funds invested
6. ROIC and FCF: Use the reorganized financial statements to build ROIC, economic profit, and FCF.
Future cash flows will be the basis of the valuation
7. Valuation summary: This sheet presents discounted cash flows, discounted economic profits, and
final results. The valuation summary includes the value of operations, value of nonoperating assets,
value of nonoperating assets, value of nonequity claims, and resulting equity value

Additional advice
Well built models have certain characteristics:
 Limit user input to only a few sheets:
o Worksheet 1: Raw data
o Worksheet 3: Forecasts
o Worksheet 4: Market data
 Raw data and user input should be in different color from calculations.
 Formulas should not bounce from sheet to sheet without direction
 Raw data should feed into integrated financials which in turn feed into ROIC and FCF
 No hard coded numbers in formulas
 Avoid using excel formulas like the NPV

Mechanics of Forecasting
FCF should be computed the same way both in the historical and forecast data

The forecasting process is broken down into six steps:


1. Prepare and analyze historical financials
2. Build the revenue forecast: Almost every line item will rely directly or indirectly on revenues.
Revenues can be forecasted either top down(market based) or bottom up(customer based). Forecasts
should be consistent with economy-wide evidence on growth
3. Forecast the income statement: Use appropriate economic drivers to forecast operating expenses,
depreciation, interest income, interest expense and reported taxes
4. Forecast the balance sheet: invested capital and nonoperating assets. On the balance sheet
forecast oprating working capital, net PPE, goodwill and non-operating assets
5. Reconcile the balance sheet with investor funds: Complete the balance sheet by computing
retained earning and forecasting other equity accounts. Use excess cash and/or new debt to balance the
balance sheet
6. Calculate ROIC and FCF: Calculate ROIC to ensure that forecasts are in line with economic
principles, industry dynamics, and the ability of the company to compete. To complete the forecast,
calculate FCF as basis for valuation. Future FCF should be calculated the same way as historical FCF

It is important that revenue forecast is done with caution since almost all line items are directly or indirectly
driven by revenues.

Prepare and Analyze Historical Data

 The authors suggest collecting raw data on the spreadsheet.


 Statement of retained earnings is for checking during forecast since it links the income statement to the
balance sheet
 Accumulated other comprehensive income will be necessary to derive FCF
 Have to decide whether to aggregate immaterial items
 The model can be simplified by combining the relatively immaterial line items. When doing that, do not
mix operating items with non-operating ones

Build the revenue forecast


 You can either do it with top down approach, where revenue is determined through market size,
market share, and forecasting prices
 The bottom up approach can use the forecasts of the company. These are derived by forecasting
customer behaviour
 When possible do both to set limits
 Top down approach can be applied to any company. In mature industries market grows slowly and is
tied to economic growth.
 Multiple scenarios can be used to account for uncertainty

Forecast the income statement

Each item in the income statement is forecasted using a three step process.

1. Decide what economic relationships drive the line item: Some items are tied directly to revenue and
others to specific assets and liabilities.
2. Estimate the forecast ratio: For each line item compute historical values and then follow with
estimated. Initially set the forecast ratio equal to last year's ratio. Once the model is complete, come
back and enter your best estimate
3. Multiply the forecast ratio by an estimate of its driver

Operating expenses
Authors suggest that operating costs are forecasted based on revenues.

Depreciation
Depreciation can be forecasted using three ways
1. Percentage of revenues
2. Percentage of PPE
3. Based on schedules and machinery purchases(if you are a company insider)

If CapEx isn't smooth it is better to use the PPE approach.

When the PPE method is used, net PPE should be used for the calculation

Nonoperating income
This can be tricky.
For nonconsolidated subsidiaries you can either project nonoperating income by using historic growth on
nonoperating income, or by examining profit forecasts of publicly traded companies that are comparable to
equity investments.

Interest expense and interest income


Interest should be directly tied to the asset/liability that generates expense/income.

The driver for interest expense is total debt. But it should be calculated based on last year's interest expense
to avoid a negative feedback loop of rising debt and interest with lowering profits.

Interest income should be estimated based on the asset that generates it. It usually is the product of many
assets. If there is such a footnote, make a separate calculation for each asset.

Provision for income taxes


Estimate operating taxes on EBITA and adjust for non-operating taxes. This combined number will be used
on the income statement. When marginal taxes differ across nonoperating items, forecast nonoperating taxes
line by line(?)

Forecast the balance sheet: Invested Capital and Nonoperating Assets


When forecasting the balance sheet, first invested capital and nonoperating assets should be forecasted.

Operating working capital


We start off by forecasting operating working capital. They can be estimated as percentage of revenues or in
days sales. Inventories and accounts payable will be estimated using COGS.

PPE
There is a three step approach:
1. Forecast net PPE as percentage of revenue
2. Forecast depreciation as a percentage of Gross or net PPE
3. Calculate CapEx by summing increase in net PPE and depreciation

Goodwill and acquired intangibles


We set revenue growth from acquisitions to 0 and hold goodwill constant.

Nonoperating assets, pensions and deferred taxes


Use the footnote on pensions and set a reasonable timeframe that these pensions will be eliminated

To forecast equity investments, look to historical growth

Forecast operating deffered taxes by computing the proportion taxes likely to be deffered. If a operating taxes
are 34% of EBITA and the company has been able to defer 1/5 of those taxes we can assume that this will
continue.

Reconcile the Balance Sheet with Investors Funds

Screen clipping taken: 09-Oct-19 7:20 PM

At this point short term debt, long term debt, excess cash, newly issued debt and common stock should make
the balance sheet balance. In simple models we assume that equity remains the same. Also, excess cash or
newly issued debt have to be 0. Then find out how much the plug is(equity?). Use if in excel

Calculate ROIC and FCF


Once you have completed your income statement and balance sheet forecasts,
calculate ROIC and FCF for each forecast year. This process should be straightforward
if you have already computed ROIC and FCF historically. Since a full
set of forecast financials is available, merely copy the two calculations across
from historical financials to projected financials.
For companies that are creating value, future ROICs should fit one of three
general patterns: ROIC should either remain near current levels (when the
company has a distinguishable sustainable advantage), trend toward an industry
or economic median, or trend to the cost of capital. Think through the economics
of the business to decide what is appropriate. For more on long-term
trends of ROIC, refer to Chapter 6.

Chapter 12: Estimating continuing value


Monday, October 14, 2019
9:33 PM

In order to calculate the company's value we separate cash flow in two periods.

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The second term in that equation is the continuing value: the cash flow expected beyond the forecast period.
By estimating the performance of the business during that period, using a constant growth rate, we can
estimate CV by using formulas.

CV is very important because it accounts for a large portion of the final value of the business.

Authors have beef with EV/EBITDA exit multiple since it leads to overly optimistic valuations.

The continuing value formula is demonstrated below:

Screen clipping taken: 14-Oct-19 9:42 PM

Where :
 NOPLATt+1 = NOPLAT in the first year after the explicit forecast period
 G = perpetuity growth rate for NOPLAT
 RONIC = expected return on new invested capital
 WACC = well the WACC

When using the CV formula it is common to make mistakes such as assuming that the company will have a
lower growth than in the explicit period, making FCF too low.

The CV formula should be used only when the company has reached a mature stable stage with low revenue
growth and stable operating margins.

Keep in mind:
 NOPLAT should be based on the normalized level of revenues, not in peaks or all time lows
 RONIC: Economic theory suggests that competition will eventually eliminate abnormal returns so that
RONIC becomes equal to WACC. Companies with sustainable competitive advantage may use the
RONIC equal to the later years of the forecast period
 Growth rate: The best estimate for that usually is consumption growth in the industry plus inflation
 WACC: The WACC should incorporate a sustainable capital structure and risk consisted with industry

Economic Profit
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Misconceptions of CV

Does length of Forecast Affect a Company's Value?

The forecast period only affects the distribution of value between the forecasted value and CV.

The forecast period should be long enough for the company to be stable at the end of the period. The
business must operate in an equilibrium level for the CV approach to have meaning.

How long is the competitive-advantage period?

The competitive advantage period should not be linked to the forecast period.

Assuming a RONIC equal to the WACC does not mean that the competitive advantage period has ended,
since the ROIC invested in the past years will continue to generate income.
When is value created?
Something that I do not understand, its late

Common pitfalls
 Naïve base year extrapolation: When working capital increases as percentage of revenues. This
understates the value of the company. Same applies to CapEx. To avoid that use the value driver
formula, instead of the cash flow perpetuity formula.
 Naïve over conservatism: Some analysts assume a RONIC equal to WACC, where value is neither
created nor destroyed. This severely underestimates the value of the company. When RONIC is
assumed to be higher than WACC it should be done with an economically reasonable growth rate
 Purposeful Overconservatism: Conservatism overcompensates for uncertainty

Screen clipping taken: 14-Oct-19 10:19 PM

Chapter 15: Analyzing the results


Wednesday, October 09, 2019
7:28 PM

Once you are sure that the model works and has no mistakes, start changing assumptions one by one in order
to see what affects the valuation more. Then create a set of assumptions called a scenario, in order to be able
to test multiple changes at the same time.

In order to build those scenarios, use the company's uncertainties, negative and positive ones.

Checking if the model is working


 Does the balance sheet balance for all years?
 Are the results consistent with company economics?
 Does ROIC change with the intensity of competition?
 Compare the model's valuation with current share price and multiples
 Can the differences be explained, or is there a mistake?

Is the model technically robust?

The model should follow the following equilibrium relationships


 Balance sheet should balance every year, historic and forecasted
 Check that net income flows correctly into dividends and retained earnings
 Does IC plus non-operating assets equal the total funds invested?
 Is the NOPLAT reconciliation correct?
 Does net income link correctly to dividends and adjusted equity?
 Does the change in excess cash and debt line up with the cash flow statement?

Stress test:
 Change gross margin to 99% or 1%. Does that shit still balance bro?
 Fuck with dividends paid, if NOPLAT, IC, or FCFF change then there is a mistake

Is the model economically consistent?


 If projected ROIC is higher than the WACC the value of operations should be higher than the book
value of IC

Additionally:
 Are the patterns intended?
 Are the patterns reasonable?
 Are the patterns consistent with industry dynamics?
 Is the company is a stable state by the end of the explicit forecast period?

Are the results plausible(even)?

 If the company is listed, compare your results with the market value
 Assume that the market is right
 Perform a sound multiple analysis

Sensitivity Analysis
See how the model responds to changing key values.

Assesing the impact of individual drivers


Good for understanding, but limited usability

Analyzing Trade-Offs
Do not be limited by financial variables, see what changes in sector wide non financial value drivers do to the
valuation.

Creating scenarios
Scenarios should capture future macroeconomic, industry, or business developments.

When devising scenarios keep in mind:


 Broad economic conditions
 Competitive structure of the industry
 Internal capabilities of the company
 Financing capabilities of the company
Build a different DCF for every different scenario

Aim for a plus or minus of 15%(of the current stock price?)

Chapter 13: Estimating the Cost of Capital


Tuesday, October 15, 2019
5:19 PM

We use WACC to discount the FCF of the company and get the value.

WACC is the expected return that expect from a company, this is also called opportunity cost.

The components of the WACC are:


 Cost of equity
 After tax cost of equity
 The company's target capital structure

Screen clipping taken: 15-Oct-19 5:24 PM

In order to calculate the cost of equity of a company we use the CAPM, which adjusts for company-specific
risk through the use of beta

Since calculations of beta can be wildly innacurate, it is essential to look at the betas of similar companies and
adjust for leverage

To approximate the after-tax cost of debt of a company we use the company's after tax yield to maturity on
its long term debt.

For companies whose debt is not trading frequently use the company's debt rating to estimate the YTM. And
then use the after tax cost of debt in the WACC

Then use the target capital structure to calculate WACC.


The capital structure of mature companies is usually approximated by looking the debt to value ratio, using
market values for debt and equity.

Generally speaking the cost of capital must meet the following criteria:
 It must include the cost of capital for all investors-debt, preffered stock and so on - since cash flow is
available to all investors
 Any financial benefits or costs related to the cost of capital, such as debt tax shield, must be
incorporated in the cost of capital
 It must be computed after corporate income taxes
 It should be based on the same expectations of inflation as those embedded in forecasts of free cash
flow
 The duration of the securities used to estimate the cost of capital must match the duration of the cash
flows

Estimating the cost of equity

There are two ways for estimating the cost of equity, which is the most difficult part of the WACC to
calculate

Estimating the market return

Instead of trying to calculate the historical average market returns, add a risk premium to a long-term
government bond. This way we incorporate today's interest rates and inflation.

Estimating the historical risk premium can be tricky. Based on the academic work of some dudes the average
excess return between 1900 and 2014 is 5.5 to 5.8 %. By subtracting a 0.8% of survivorship premium we get
4.7 to 5.4 % rate that we then round to 5%. We then add this number to a 10-year treasury bond that
averaged a 4.5% yield to maturity between 2000-2008, which in turn gives us a 9.5%.

In order to overcome the inconsistencies of interest rates on government bonds we use a synthetic risk-free
rate. To do that, we add 2.5% to the long-run average real interest rate of 2% which leads to a synthetic 4.5%
rate.

In typical times, we use the 10-year STRIPS whereas when valuing a European company we use ten year
German Bunds. Always use the government bonds of the country in which the currency of the cash flow is
denominated in. Same applies to the inflation rate. Do NOT use a short term bond for the risk-free rate.

Market implied cost of equity


The other method for calculating the market implied cost of equity is to estimate it based on current share
prices and performance of large cap companies. In this case we use the equity value, rather than the enterprise
value:
Screen clipping taken: 16-Oct-19 7:34 PM

There are some methods that the authors are using in order to take out the effects of inflation among other
things. The bottom line is that this is the best method, since they cite some research by Fama & French.

Once the real expected rate of return has been calculated, we add an inflation projection that is consistent
with the cash flow projections.

Generally speaking, the authors believe that a 5% market risk premium is the best choice.

Adjusting for Industry/Company Risk


Once the market risk premium has been calculated we then need to adjust for company/sector specific risk.
There are three models that can be used for that:
 CAPM
 Fama-French Three Factor Model
 Arbitrage Pricing Theory

The authors believe that the CAPM is still the best model for this calculation.

CAPM
Screen clipping taken: 16-Oct-19 7:42 PM

The risk free rate and the market risk premium remain the same across companies, only the beta is the one
factor that changes according to the company.

Fama French Three-Factor Model

In short: This model uses a stock's excess market return regression to the small to big(SMB) excess returns ,
and the high book to market stocks to low book to value stocks. It s a good model but not better than
CAPM.

Arbitrage Pricing Theory


In short: Only to be used in the classroom

Applying the CAPM


When calculating beta, our objective is to calculate a company's future beta, not the historical one. Therefore
a pure mathematical approach is not enough. Since a company's beta can be influenced by one-time events,
we use the peer median.

Calculating Beta step by step:


 Estimate the beta of each company in the peer group and adjust for leverage
 Examine sample for an appropriate beta metric, such as the median
 Do not apply the beta as a point estimate, rather examine the trend overtime

Estimating Beta for each company in the peer group

The most common model for doing that is the market model

Screen clipping taken: 16-Oct-19 7:59 PM

Where the stock returns(Ri), not stock price, is regressed against the market return.

 The measurement period should have at least 60 data points(five years in monthly returns)
 Raw returns should be measured on a monthly basis since daily and weekly returns lead to biases
 Company stock returns should be weighted against a well-diversified market portfolio like the MSCI
world index. Keep in mind that the value of the portfolio might be distorted if measuring during a
market bubble

In the US they use the S&P 500 as the market portfolio, while in Europe analysts use the MSCI Europe or
the MSCI world indices.

Beta Smoothing
According to empirical evidence betas tend to the mean. A smoothing method is this:

Screen clipping taken: 16-Oct-19 8:15 PM

According to Modiglian and Miller the weighted average of a company's financial claims equals the weighted
average risk of a company's assets.

Screen clipping taken: 16-Oct-19 8:17 PM

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Simplifying the formula leads to this equation:


Screen clipping taken: 16-Oct-19 8:18 PM

Some assume that the debt beta is 0 while others assume a 0.3 for investment grade companies.
The formula above is used to convert equity betas to unlevered betas

To calculate an industry beta follow these steps:


 Calculate the beta for all companies and unlever the betas according to each company's debt to equity
ratio
 Remove outliers
 Calculate a median on the data set
 Then plot the median industry beta over a long period

Estimating the after-tax cost of debt


To calculate the cost of debt use the company's yield to maturity of the company's long term, option-free
bonds. Multiply that with 1-Marginal Tax Rate to determine the after-tax cost of debt.

For BBB companies and above the YTM is a good proxy for the cost of debt.

To calculate YTM reverse engineer this

Screen clipping taken: 16-Oct-19 8:39 PM

A liquid bond of over a million should be used. For smaller companies with no tradable debt use the credit
rating on unsecured debt to estimate the cost of debt. Once you have the rating convert it into YTM.

On another note

 Use the market value of debt and equity


 Use target capital structure, not current capital structure

CLOSING THOUGHTS
The cost of capital is one of the most hotly debated topics in the field of finance.
While robust statistical techniques have improved our understanding of the
issue, a practical measurement of the cost of capital remains elusive. Nonetheless,
we believe the steps outlined in this chapter, combined with a healthy
perspective of long-term trends, will lead to a cost of capital that is reliable
and reasonable. Even so, do not let a lack of precision overwhelm you. Acompany
creates value when ROIC exceeds the cost of capital, and formany of our
clients, the variation in ROIC across projects greatly exceeds any variation in
the cost of capital. Smart selection based on forward-looking ROIC often generates
most of the impact in day-to-day decision making.

Chapter 10: Analyzing Performance


Wednesday, October 16, 2019
10:42 AM

 We start by analyzing ROIC with and without Goodwill


 Then we examine the revenue drivers
 Finally we assess the company's financial health

Analyzing ROIC
We should be using AVERAGE Invested Capital in order to get ROIC, in order to compensate for changes
that have happened during the year

ROIC should also be calculated with and without Goodwill and acquired intangibles in order to analyze
different things. ROIC without Goodwill tells you if the underlying economics of the business are generating
value, plus it can also be used to compare performance with peers. ROIC without goodwill is also used to
forecast and set strategy.
Generally speaking companies with high ROIC will generate more value through growth, while companies
with low ROIC will generate more value by improving ROIC.

Decomposing ROIC to Develop an Integrated Perspective of Company Economics

In order to understand what is driving the performance of ROIC we use the formula below:

Screen clipping taken: 16-Oct-19 10:56 AM

Each item in this formula can be dissagregated line item by line item so that each item can be analyzed.
The tree below shows the example.
Screen clipping taken: 16-Oct-19 11:00 AM

Once the historical drivers of ROIC we then should compare them with those of peer firms, which can then
be used to supplement the qualitative analysis of the sector.

Line item analysis


Each item in the financial statement should be then expressed as a percentage of something, usually
revenues. Some items might have to be expressed in days(such as inventories and receivables) in order to
avoid the distortions that come from price fluctuations.
Screen clipping taken: 16-Oct-19 11:05 AM

Operating Analysis

Chapter 16: Using multiples


Thursday, October 17, 2019
9:10 PM

While the DCF is the best and most flexible way for valuing a company, the multiple valuation can offer
some great insight when not used in a superficial way.

The principle behind multiples valuation is that similar assets should sell for a similar price. The P/E multiple
is often used even though it might be the best ratio.

In order to use multiples you need to dig into the financial statements to make sure that you are comparing
apples to apples:
 Value multibusiness companies as a sum of their parts:
 Use forward estimates of earnings
 Use the right multiple, usually Net EV/EBITA or Net EV/NOPLAT
 Adjust the multiple for nonoperating items
 Use the right peer group, not a broad industry average

Value multibusiness companies as a sum of their parts

Many companies may appear to compete in only one industry, but in fact they are competing in multiple
subindustries. Each subindustry has distinct characteristics with different ROIC. For those companies use a
sum of the parts approach where you value each business unit with a multiple appropriate to its peers and
performance.

Use forward earnings estimates

When building a valuation multiple the denominator should be a forecast of profits, rather than historic ones.

Forward looking multiples generally have much lower variation across companies.

To build a forward looking multiple choose a forecast for EBITA that represents best the long-term
prospects of the business. In periods of stable growth and profitability, next year's projection is sufficient. For
companies with too high or too low earnings, or for companies whose performance is expected to change,
project further out.

Use EV to EBITA/NOPLAT

EV to either of those items provide a better ability for comparison among companies, since the P/E is
distorted by capital structure.

One items and items that are not good indicators of future cashflow should not be included.

Why not price to earnings?


The P/E is a less reliable guide to a company's relative value compared to EV/EBITA or NOPLAT.

Why not EV to EBIT?

EBITA usually includes amortization of intangible assets, which makes it a better index of performance of
the firm. EBIT distorts the multiple by making it appear as if there is a premium paid.

Choosing between EBITA and EBITDA

Depreciation in many companies is the amount set aside for the replacement of the assets. Therefore
subtracting it represents better the future cash flow and subsequently the value of the business.

In some cases EBITDA is better for valuation than EBITA. This happens in cases where depreciation is not
an accurate predictor of future CapEx.

NOPLAT vs EBITDA

When a company is active in different tax jurisdictions it is better to use NOPLAT over EBITA to
compensate for the different tax rates.

Adjust for nonoperating items

Only one approach to EV/EBITA is consistent, and that is the one where EV includes all investor capital but
only the portion attributable to assets that generate EBITA. Otherwise the multiple is distorted.

Use the right peer group

Common practice is to select 8-15 peer firms and take their average of multiples. A common approach is to
get the SIC codes for the firms, although those codes are usually too broad and do not give the right peer
group. Therefore it is better to have a smaller set of peers that is more representative.

Once you have collected the peer firms, the real work begins. Answers on questions like why are the multiples
across peers different, who has superior products? Better access to customers? Economies of scale? Must be
answered.

Alternative Multiples

 EV/revenues: Usually not good for valuation but can be good for industries with negative or unstable
profits
 PEG Ratio: It is seriously deficient since it does not take into consideration ROIC
 Multiples of Invested Capital: Good for some industries, like banking from 2008-2014
 Multiples based on operating metric: Good when used against peers. e.g. value per barrel of oil
reserves, also remember the non-financial multiples of the dot com bubble

SUMMARY
Of the available valuation tools, discounted cash flow continues to deliver the
best results. However, a thoughtful comparison of selected multiples for the
company you are valuing with multiples from a carefully selected group of
peers merits a place in your tool kit as well. When that comparative analysis
is careful and well reasoned, it not only serves as a useful check of your DCF
forecasts, but also provides critical insights into what drives value in a given
industry. Just be sure that you analyze the underlying reasons that multiples
differ from company to company, and never view multiples as a shortcut to
valuation. Instead, approach your multiples analysis with as much care as you
bring to your DCF analysis.

Chapter 32: Valuing High-Growth Companies


Thursday, October 17, 2019
8:16 PM

Valuing high growth, high uncertainty companies is a difficult task but the authors suggest that the DCF
principles can be still applied. Instead of focusing on historic performance we should be instead on scenarios
on the long term performance of the business and then work backwards.

A valuation process for high-growth companies

In high growth companies we start by looking at the future, where we focus on the potential market size,
levels of sustainable profitability, and estimating he investments necessary to achieve success. Once you have
worked out those try and work backwards while building comprehensive scenarios for the market under
different competition structures, size etc.

Start from the future


When projecting the future think of how the company and the sector will evolve in the future. Think about
how the company will look like when it involves into a mature company. This future should be bounded by
factors of operating performance such as customer penetration rate, average revenue per customer, and
sustainable margins.
Then determine how long will the hypergrowth state last. Usually start-ups need 10-15 years in order to
become stable companies.

To estimate a market size think about how a company fulfills customer needs and how it generates revenues.
It is a common problem of start-ups that they do not know how to monetize. By using the revenue drivers as
a guide, estimate the market product by product.

When estimating a market share for the company, a 65% is a very aggressive target, since competition will
probably follow. But in some sectors, the biggest company is possible to capture the lion's share in that
market. Think Windows.

Forecasting those things for startups requires lots of inputs that are uncertain. A small mistake will
compound the effects in the model

Once we have a revenue projection we then should calculate long-term operating margins, required capital
investments, and ROIC. To calculate operating margins, triangulate between internal cost projections versus
market prices, and operating margins for established firms.

Once market size, market share, operating margin, capital intensity, reconnect the long-term performance to
current performance. Here we have to assess the speed of transition from current performance to long-term
performance. These estimates must be consistent with economic principles.
In order to determine the speed of transition from current to long-term performance, examine the historical
performance for similar companies. This can be tricky, since startup usually spend money in intangibles that
they have to expense. Therefore accounting performance can be misleading.

A simple and effective way for compensating for the uncertainty of such companies is to develop multiple
probability-weighted scenarios. This method is usually more transparent than real options and Monte Carl
simulation.

Estimate a set of future financials, both optimistic and pessimistic. Then weight each scenario with its
probability of occurrence and sum them. Scenarios can be super subjective which makes the valuation very
sensitive. All the assumptions made for market share, market performance, and operating margins should be
calibrated by using historical analysis of high-growth companies.

No matter what we do, uncertainty is part of the game and history has shown that few players win big while
most others descend into obscurity.