“Definition of Statistics: The science of producing unreliable facts from reliable figures.”
- Evan Esar
“The art of valuation seems like it should be relatively simple. But nothing could be further from the truth. Investors have hundreds of ways to get to a value of a company – relative versus absolute, economic value add (EVA) versus discounted cash flow (DCF), dividend discount model (DDM) – the list goes on and on. Is one better than the other? Likely not. It’s more what facts are more important to the investor and their ultimate investment goal or strategy.”
- Lester String
“I wondered why Nintai has chosen to use a discounted cash flow model for valuation purposes versus other methods, particularly one that compares investments against each other versus just focusing on one company. Also, why do you use cash versus earnings? Thank you very much.”
- A.M.
I have received several questions from readers (an example is quoted above) and fellow investors about why Nintai utilizes a discounted free cash flow model versus what is known as relative valuation methods. I thought I’d take a moment to answer this question as part of a series of articles on investment valuation methodology. Let me say up front that whatever I can fit into a few-page article will be woefully short of the complexity and detailed discussion the topic deserves. To any trained professional analyst, I apologize. For the rest of you, get out your green tinted shades and prepare to jump into the some of the technical aspects of investing. It will be worth it, I assure you.
Absolute versus Relative
When one talks of valuation at a high level, two distinctive models are absolute versus relative. The absolute model is the estimated valuation of a specific company’s share utilizing data specific to the potential investment. This process allows the investor to measure the price versus the value of that company’s shares and that company alone. The relative model estimates how the company’s valuation compares to other industry players. This process gives the investor a very broad look at how a potential investment’s value compares to possible alternatives. Generally, comparisons are made using commonly accepted metrics like price-to-earnings or price-to-sale-ratios.
In most cases, the absolute approach requires a good deal of research and considerable knowledge of the company’s business strategy, operations, competitors, market size, financial strength, etc. A great example of this is a discounted cash flow model. At the end of the exercise, an investor should be able to estimate the intrinsic value of the company and its per-share price. This is specific to the company and nothing else. The relative model will compare certain accounting ratios of the company versus other players or competitors. It’s less about the specific company’s valuation and more about whether it's cheap or expensive against similar companies. The data needed for a relative model can usually be quickly found on publicly available websites.
I thought I would use Abiomed (ABMD) - a current Nintai Investments holding - as an example to demonstrate both models. The company describes itself as “providing temporary mechanical circulatory support devices primarily used by interventional cardiologists and heart surgeons. The firm's products are used for patients in need of hemodynamic support before, during, or after angioplasty and heart surgery procedures. In plain English, they provide devices that keep blood flowing for patients after surgery or due to unique illnesses. For comparison, I have chosen Masimo (MASI), a maker of oximeters vital to calculating how well the patient is absorbing oxygen and getting it to their vital organs. The stock is also a holding in the Nintai Investment’s portfolio. A third company is Zimmer Biomet (ZBH), a leader in the design and manufacturing of joint replacements, including hip and knee components. All three companies are players in the medical device industry.
The Absolute Model: Discounted Cash Flow (DCF)
Without getting into too much detail, the absolute model can tell the investor what the estimated intrinsic value of the company is at this moment, irrespective of the value of its competitors. It can give you the estimated value of the whole company or just a share. As an example of an absolute model, I will run Abiomed through Nintai’s discounted cash flow (DCF) model. I will also demonstrate a relative model to see if/how the finding varies.
I won’t go into too much detail about DCF models at this point, other than to say the model is an interactive way to demonstrate that a bird in the hand today might (but not always!) be worth more in the bush of the future. The major components necessary for calculating intrinsic value are the current share price, current free cash flow amount, the estimated free cash flow growth rates over the next decade, the number of shares outstanding, the estimated discount rate, and the terminal growth rate. In this case, the major data puts look like this:
Abiomed Share Price (as of May 27, 2022): $266.34
Abiomed Free Cash Flow (FCF): $250,000,000
FCF Estimated Growth: 2023-2026 (14.5%), 2027-2030 (14.0%), 2031 (13%)
Abiomed Shares Outstanding: 45,900,000
Discount Rate: 8.65%
Terminal Growth Rate: 3%
Using Nintai’s DCF model[1], we calculate that Abiomed is worth roughly $206/share versus the current trading price of $266/share. This tells us that a share of Abiomed is trading at a 29.5% premium to Nintai’s estimated intrinsic value. Utilizing the same process, we estimated Masimo trades at a 13% discount and Zimmer Biomet trades at a 29% discount to our estimated intrinsic value. The DCF model clearly tells us that (all else being equal) Abiomed is the company we would be least likely to invest in based on valuation.
This process tells us which company has the greatest variance in price to value and to focus on for additional research. The model Nintai uses allows us to focus on the most important piece that drives value - increasing free cash flow. This number is derived through the input of many variables including estimated market size, market share, company product development, competition, and technology trends (to name a few). The process also considers other measures such as the company’s competitive moat, financial strength, and management which are all part of the discount rate calculation. We believe the DCF model used allows Nintai the most comprehensive view of where value will be generated over the next decade. We don’t believe a relative valuation process is as accurate or detailed as this method.
The Relative Model
In a relative model, an investor uses specific metrics to help estimate whether a company is trading fairly, above, or at a discount to other companies in the same industry. The most common of these metrics are price-to-earnings, price-to-sales, and price-to-book. Utilizing these, Abiomed compares to two competitors in the medical device space in the following manner.
- Evan Esar
“The art of valuation seems like it should be relatively simple. But nothing could be further from the truth. Investors have hundreds of ways to get to a value of a company – relative versus absolute, economic value add (EVA) versus discounted cash flow (DCF), dividend discount model (DDM) – the list goes on and on. Is one better than the other? Likely not. It’s more what facts are more important to the investor and their ultimate investment goal or strategy.”
- Lester String
“I wondered why Nintai has chosen to use a discounted cash flow model for valuation purposes versus other methods, particularly one that compares investments against each other versus just focusing on one company. Also, why do you use cash versus earnings? Thank you very much.”
- A.M.
I have received several questions from readers (an example is quoted above) and fellow investors about why Nintai utilizes a discounted free cash flow model versus what is known as relative valuation methods. I thought I’d take a moment to answer this question as part of a series of articles on investment valuation methodology. Let me say up front that whatever I can fit into a few-page article will be woefully short of the complexity and detailed discussion the topic deserves. To any trained professional analyst, I apologize. For the rest of you, get out your green tinted shades and prepare to jump into the some of the technical aspects of investing. It will be worth it, I assure you.
Absolute versus Relative
When one talks of valuation at a high level, two distinctive models are absolute versus relative. The absolute model is the estimated valuation of a specific company’s share utilizing data specific to the potential investment. This process allows the investor to measure the price versus the value of that company’s shares and that company alone. The relative model estimates how the company’s valuation compares to other industry players. This process gives the investor a very broad look at how a potential investment’s value compares to possible alternatives. Generally, comparisons are made using commonly accepted metrics like price-to-earnings or price-to-sale-ratios.
In most cases, the absolute approach requires a good deal of research and considerable knowledge of the company’s business strategy, operations, competitors, market size, financial strength, etc. A great example of this is a discounted cash flow model. At the end of the exercise, an investor should be able to estimate the intrinsic value of the company and its per-share price. This is specific to the company and nothing else. The relative model will compare certain accounting ratios of the company versus other players or competitors. It’s less about the specific company’s valuation and more about whether it's cheap or expensive against similar companies. The data needed for a relative model can usually be quickly found on publicly available websites.
I thought I would use Abiomed (ABMD) - a current Nintai Investments holding - as an example to demonstrate both models. The company describes itself as “providing temporary mechanical circulatory support devices primarily used by interventional cardiologists and heart surgeons. The firm's products are used for patients in need of hemodynamic support before, during, or after angioplasty and heart surgery procedures. In plain English, they provide devices that keep blood flowing for patients after surgery or due to unique illnesses. For comparison, I have chosen Masimo (MASI), a maker of oximeters vital to calculating how well the patient is absorbing oxygen and getting it to their vital organs. The stock is also a holding in the Nintai Investment’s portfolio. A third company is Zimmer Biomet (ZBH), a leader in the design and manufacturing of joint replacements, including hip and knee components. All three companies are players in the medical device industry.
The Absolute Model: Discounted Cash Flow (DCF)
Without getting into too much detail, the absolute model can tell the investor what the estimated intrinsic value of the company is at this moment, irrespective of the value of its competitors. It can give you the estimated value of the whole company or just a share. As an example of an absolute model, I will run Abiomed through Nintai’s discounted cash flow (DCF) model. I will also demonstrate a relative model to see if/how the finding varies.
I won’t go into too much detail about DCF models at this point, other than to say the model is an interactive way to demonstrate that a bird in the hand today might (but not always!) be worth more in the bush of the future. The major components necessary for calculating intrinsic value are the current share price, current free cash flow amount, the estimated free cash flow growth rates over the next decade, the number of shares outstanding, the estimated discount rate, and the terminal growth rate. In this case, the major data puts look like this:
Abiomed Share Price (as of May 27, 2022): $266.34
Abiomed Free Cash Flow (FCF): $250,000,000
FCF Estimated Growth: 2023-2026 (14.5%), 2027-2030 (14.0%), 2031 (13%)
Abiomed Shares Outstanding: 45,900,000
Discount Rate: 8.65%
Terminal Growth Rate: 3%
Using Nintai’s DCF model[1], we calculate that Abiomed is worth roughly $206/share versus the current trading price of $266/share. This tells us that a share of Abiomed is trading at a 29.5% premium to Nintai’s estimated intrinsic value. Utilizing the same process, we estimated Masimo trades at a 13% discount and Zimmer Biomet trades at a 29% discount to our estimated intrinsic value. The DCF model clearly tells us that (all else being equal) Abiomed is the company we would be least likely to invest in based on valuation.
This process tells us which company has the greatest variance in price to value and to focus on for additional research. The model Nintai uses allows us to focus on the most important piece that drives value - increasing free cash flow. This number is derived through the input of many variables including estimated market size, market share, company product development, competition, and technology trends (to name a few). The process also considers other measures such as the company’s competitive moat, financial strength, and management which are all part of the discount rate calculation. We believe the DCF model used allows Nintai the most comprehensive view of where value will be generated over the next decade. We don’t believe a relative valuation process is as accurate or detailed as this method.
The Relative Model
In a relative model, an investor uses specific metrics to help estimate whether a company is trading fairly, above, or at a discount to other companies in the same industry. The most common of these metrics are price-to-earnings, price-to-sales, and price-to-book. Utilizing these, Abiomed compares to two competitors in the medical device space in the following manner.
As an investor, what strikes you right away - for all three candidates - is that they all appear equally expensive. None seem to be flashing a “buy” signal. Having said that, Masimo is the cheapest by earnings, with Zimmer Biomet cheapest by price/sales and price/book. It’s very difficult to pick a winner among the three with these results.
Utilizing this process has both positives and negatives versus the DCF model. On the positive side, an investor can quickly ascertain the ranges of value within a specific competitive space. For instance, from this case, it can be quickly seen that medical device companies generally trade at higher-than-normal multiples. Finding one trading at much lower levels could give the investor insight that the company’s value is more compelling than most. On the downside, the investor doesn’t know much detail about each company, such as its financial strengths, competitive moat, or management qualities. I would argue that the relative model could be best used to quickly ascertain what company might represent a better value than others, but the DCF model would be best to evaluate if the company represents a good value in itself.
Is one model better than the other for making an investment case for these three companies? At Nintai, we prefer to always base our valuations on in-depth company research combined with an intensive understanding of the markets, competition, product cycles, regulatory, and other ecosystem information. Having said that, it is the individual investor’s level of commitment, desire to learn, and focus on what’s important that will drive whether they use the absolute or relative valuation method.
Cash Flow versus Earnings
That brings us to one of the key questions an investor must answer before deciding on whatever valuation tool they choose to use. Anybody completing a valuation of a company has the choice between earnings and free cash flow as the choice of data to use in the valuation model. Most Wall Street analysts use earnings as the basis of their calculations.
Earnings represent a company's net income or the dollars they have after subtracting all their expenses, like taxes, cost of goods sold, and administrative costs, from their revenue. Earnings can be found on a company’s Income Statement. They are the most common way of reporting a company's performance on Wall Street today. Cash flow is the money, representing cash and cash equivalents, coming in and out of a business. If a company has more inflows than outflows, they have a positive cash flow. When there's more money leaving than coming in, the company experiences a negative cash flow. Cash flow (or operating cash flow) is the cash generated by business operations. Free cash flow is operating cash flow minus capital expenditures. Free cash flow can be found on the company’s Cash Flow statement.
Why the distinction between earnings and free cash? Because reported earnings and free cash flow can be quite different. For instance, a company might be earnings positive but free cash flow negative or vice versa. Let’s look at how two companies might utilize different accounting to reach very different financial results to see how that might happen. Please recognize that this has been simplified for demonstration purposes.
Company A had net income (earnings) of $1,000,000 and spent $500K on capital expenditures for the quarter. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding.
In this scenario, the company reports earnings of $100 per share ($1,000,000 net income/1000 shares). The company also reports free cash flow of $750,000 ($1.25M cash flow from operations – $500,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash).
Company B (identical to Company A) has taken a different approach to its accounting by (illegally) claiming $250,000 of costs as capital expenses[1]. Let’s look at how they report.
For the quarter, Company A had earnings of $1,250,000 and spent $750,000 on capital expenditures. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding.
In this scenario, the company reports earnings of $125 per share ($1,250,000 net income/1000 shares). The company also reports free cash flow of $500,000 ($1.25M cash flow from operations – $750,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash).
So, what’s the difference we can learn from these two scenarios? Company A – reporting numbers by generally accepted accounting standards – has lower earnings for the quarter versus its evil twin Company B. From this perspective, Company B might go to Wall Street and tout it has outperformed its “weaker” twin since most analysts focus on earnings. Of course, the question is, how long is it before Company B’s financials are audited and the illegal shift of operational costs to capitalized costs is identified? However it works out, it shows the ease with which earnings can be manipulated (I should say there are much more sophisticated and perfectly legal ways to play this game. My example is for illustrative purposes only). The important point is that earnings can be manipulated rather easily, while free cash flow is extremely difficult. In the words of Alfred Rappaport, “profit is an opinion, cash is a fact”. In such instances as WorldCom or Enron, Wall Street’s focus on earnings growth blinded it to the fact that these companies were increasingly hemorrhaging cash (and reporting wholly fraudulent earnings). A savvy investor would have seen earnings increasing, but free cash flow highly negative. We choose to use free cash flow at Nintai simply because we believe it is a safer number to use.
Conclusions
In this - the first in a multi-part series on investment valuation models - we’ve discussed a couple of issues an investor faces when choosing a valuation method. In Part 2 of this analysis, I will look at the distinction between possible valuation means – our old friend, the DCF model, and Economic Value Add (EVA). EVA is an approach developed a couple of decades ago that – in its simplest form – should end up with the same valuation as your DCF model. I will discuss the pros and cons of these and why I feel they are complementary but not the same. Until then, I look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments currently holds shares of Abiomed and Masimo in client portfolios.
[1] In explanation, there are two types of expenses - operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.
[2] In explanation, there are two types of expenses – operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.
Utilizing this process has both positives and negatives versus the DCF model. On the positive side, an investor can quickly ascertain the ranges of value within a specific competitive space. For instance, from this case, it can be quickly seen that medical device companies generally trade at higher-than-normal multiples. Finding one trading at much lower levels could give the investor insight that the company’s value is more compelling than most. On the downside, the investor doesn’t know much detail about each company, such as its financial strengths, competitive moat, or management qualities. I would argue that the relative model could be best used to quickly ascertain what company might represent a better value than others, but the DCF model would be best to evaluate if the company represents a good value in itself.
Is one model better than the other for making an investment case for these three companies? At Nintai, we prefer to always base our valuations on in-depth company research combined with an intensive understanding of the markets, competition, product cycles, regulatory, and other ecosystem information. Having said that, it is the individual investor’s level of commitment, desire to learn, and focus on what’s important that will drive whether they use the absolute or relative valuation method.
Cash Flow versus Earnings
That brings us to one of the key questions an investor must answer before deciding on whatever valuation tool they choose to use. Anybody completing a valuation of a company has the choice between earnings and free cash flow as the choice of data to use in the valuation model. Most Wall Street analysts use earnings as the basis of their calculations.
Earnings represent a company's net income or the dollars they have after subtracting all their expenses, like taxes, cost of goods sold, and administrative costs, from their revenue. Earnings can be found on a company’s Income Statement. They are the most common way of reporting a company's performance on Wall Street today. Cash flow is the money, representing cash and cash equivalents, coming in and out of a business. If a company has more inflows than outflows, they have a positive cash flow. When there's more money leaving than coming in, the company experiences a negative cash flow. Cash flow (or operating cash flow) is the cash generated by business operations. Free cash flow is operating cash flow minus capital expenditures. Free cash flow can be found on the company’s Cash Flow statement.
Why the distinction between earnings and free cash? Because reported earnings and free cash flow can be quite different. For instance, a company might be earnings positive but free cash flow negative or vice versa. Let’s look at how two companies might utilize different accounting to reach very different financial results to see how that might happen. Please recognize that this has been simplified for demonstration purposes.
Company A had net income (earnings) of $1,000,000 and spent $500K on capital expenditures for the quarter. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding.
In this scenario, the company reports earnings of $100 per share ($1,000,000 net income/1000 shares). The company also reports free cash flow of $750,000 ($1.25M cash flow from operations – $500,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash).
Company B (identical to Company A) has taken a different approach to its accounting by (illegally) claiming $250,000 of costs as capital expenses[1]. Let’s look at how they report.
For the quarter, Company A had earnings of $1,250,000 and spent $750,000 on capital expenditures. The company generated cash flow from operations of $1.25M. The company had no cash flow from investing or financing. The company began the quarter with $100,000 in cash on the balance sheet. There are currently 1,000 shares of company stock outstanding.
In this scenario, the company reports earnings of $125 per share ($1,250,000 net income/1000 shares). The company also reports free cash flow of $500,000 ($1.25M cash flow from operations – $750,000 capital expenditures). The company reports $100,000 cash on the balance sheet (there was no cash flow from investing or financing that utilized cash).
So, what’s the difference we can learn from these two scenarios? Company A – reporting numbers by generally accepted accounting standards – has lower earnings for the quarter versus its evil twin Company B. From this perspective, Company B might go to Wall Street and tout it has outperformed its “weaker” twin since most analysts focus on earnings. Of course, the question is, how long is it before Company B’s financials are audited and the illegal shift of operational costs to capitalized costs is identified? However it works out, it shows the ease with which earnings can be manipulated (I should say there are much more sophisticated and perfectly legal ways to play this game. My example is for illustrative purposes only). The important point is that earnings can be manipulated rather easily, while free cash flow is extremely difficult. In the words of Alfred Rappaport, “profit is an opinion, cash is a fact”. In such instances as WorldCom or Enron, Wall Street’s focus on earnings growth blinded it to the fact that these companies were increasingly hemorrhaging cash (and reporting wholly fraudulent earnings). A savvy investor would have seen earnings increasing, but free cash flow highly negative. We choose to use free cash flow at Nintai simply because we believe it is a safer number to use.
Conclusions
In this - the first in a multi-part series on investment valuation models - we’ve discussed a couple of issues an investor faces when choosing a valuation method. In Part 2 of this analysis, I will look at the distinction between possible valuation means – our old friend, the DCF model, and Economic Value Add (EVA). EVA is an approach developed a couple of decades ago that – in its simplest form – should end up with the same valuation as your DCF model. I will discuss the pros and cons of these and why I feel they are complementary but not the same. Until then, I look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments currently holds shares of Abiomed and Masimo in client portfolios.
[1] In explanation, there are two types of expenses - operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.
[2] In explanation, there are two types of expenses – operational and capital. Operational keep the company running and include such thing as salaries, office supplies, administration, etc. Capital expenditures are those that extend out over years and are long-term in nature. By generally accepting accounting standards, it is unacceptable to try to put operational costs under the capital expense category. Why? Because it inflates earnings and depresses the free cash flow number.
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