AFG Basic Valuation Concepts

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AFG Basic Valuation Concepts: Economic Margin Forecasting - 12/11/2008

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Understanding Valuation: From 10-K to Intrinsic Value

As equity investors look to move forward from our latest global recession, we believe that a valuation-based strategy will provide significant outperformance for asset managers and their clients. The recent economic turmoil has left its mark across all sectors, styles, and sizes, and the massive unloading of quality stocks has created a large number of significant discounts between current prices and the value of the cash flows forecasted for these stocks.

To help our clients prepare to take advantage of these shifts in market-perceived valuation while markets regain stability as we move forward, we believe that this is a great time to ensure your understanding of the fundamental concepts of the Economic Margin framework.

Unlocking Value Creation - Economic Margin, Invested Capital:

The first set of questions we can answer about a company tends to be built around information we can generally find in an annual report:

Did the company generate a profit?
Is this profit on the rise, or is it declining?
Did the company meet analyst expectations?

Unfortunately, answering these questions will typically provide us very little insight into the question that we would really like to answer, which is What is a reasonable price to pay for this stock?

With that in mind, the Economic Margin (EM) serves two purposes - first, it creates an annual measure of a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use this EM as a function in our valuation model, which we will discuss in greater detail shortly.

Before we explore the valuation model, however, we would like to provide you with a better understanding of the Economic Margin calculation, and from there we can further explore how this leads to an intrinsic value.

Building Blocks of EM - Sales Growth, EBITDA Margin, Asset Turnover

The financial statements of a company are our starting point towards calculating an Economic Margin. In practice, there are essentially two different forms of this data:

Historical Data - financials directly from 10-K
Forecast Data - financials created from analyst EPS forecasts, or defined by the user

To help simplify our discussion, we will focus simply on the AFG default model, which builds forecasted financial statements using analyst EPS forecasts as a starting point, but remember that when using the valuation software, a user can always create a custom model when personal expectations deviate from the default model.

When building these forecasts, a user can simply define three value drivers to help simplify the forecasting process: Sales Growth, EBITDA Margin, and Asset Turnover. By using these metrics, we can create an income statement, balance sheet, and cash flow statement relevant to our forecasting needs. Using this financial data, we would like to answer three important questions:

What is the cash flow generated by the company’s operations?
How much capital is required?
What are the opportunity costs of this capital?

Answering these questions gives us a fundamental understanding of the wealth creation or wealth destruction of a firm in a given fiscal year. Simply stated, the Economic Margin calculation is the following:

This formula will allow us to calculate the EMs for a company across time, as highlighted below by the Economic Margins for Microsoft Corp. By using historical data we are able to calculate Economic Margins through 2008. The forecast data then becomes available for years 2009 - 2013 using our default algorithms built around analyst EPS forecasts.

Along with calculating the Economic Margin in a given year, we can also calculate the percentage by which the firm could organically grow its business if it chose to reinvest all of its excess cash flows.

This information becomes critical in the next purpose of the Economic Margin - the calculation an intrinsic value for the stock.

Forecasting Beyond the +5: Intrinsic Value & Economic Margin Decay

Using the Economic Margin that we calculate in the +5 forecast year, we are able to expand our research towards calculating the intrinsic value of a stock due to Economic Margin decay. Our research has proven that companies generating positive EMs will, over time, have their EMs fall to 0 due to competing market forces which will attract competition and reduce high-margin growth opportunities. Within this research, we have identified four factors that determine how attractive a company’s line of business will be to competition, and these factors help us define a custom level of Economic Margin decay for each company. The following graph illustrates the decay concept over the past ten years:

We can see from this chart that the median EM for the top decile of companies was 17.46% in 1997. When we look at those same companies today, we can see that the median EM for this group has fallen to 5.54%. Applying this decay concept to our previous graph for Microsoft, we can see how the Economic Margins, along with the Steady-State Growth, are forecasted to decay over the 22 years (which is the current Competitive Advantage Period based on our decay analysis) following our +5 forecast year.

The Economic Margin in each year will tell us how profitable the company will be as a percentage of the Invested Capital in that year. To convert this into a relevant cash flow figure, or Economic Profit, we need to multiply the EM forecast by the Invested Capital for that year, and we can use the Steady State Growth to help us calculate the Invested Capital for each year in our modified discounted cash flow model.

Once we have calculated the Economic Profits for each year, we can view those graphically on the following chart:

This chart highlights the Economic Profits for each period in blue, but to identify the value added each year to our current target price, we have also charted the present value of these Economic Profits, using the company’s size- and leverage-adjusted discount rate, in red.

After adding the sum of these discounted future Economic Profits to the value of the existing asset base for the company, we can calculate an enterprise value for the firm. From there, we can arrive at an equity value by subtracting debt, and a per share value by dividing by the number of shares outstanding.

Final Thoughts

This methodology can be very useful to a research process - the quantitative model that can be administered to create default valuation models for over 4000 companies in AFG’s universe can be helpful for identifying which companies look attractive through this broad framework. From there, an analyst can conduct his or her own research on a stock by creating user-defined forecasts within the system to create a target price based on personal assumptions.

The Economic Margin decay concept allows for a short-term focus on forecasting - after the fifth year, the decay concept replaces a perpetuity assumption. Also, accurately stating the effects of competition into a cash flow model can be very difficult, but this is accounted for in the decay theory.

This discussion is intended to provide a very general and simple overview of the AFG valuation process. Some items not discussed in great detail, but critical to understanding the full valuation process, include the following topics:

Operating Cash Flow
Capital Charge
Invested Capital
Cost of Capital
Competitive Advantage Period
Market-Derived Discount Rate

Graphical Representation of our Value Expectations calculation 

Over the coming weeks, we will provide additional material on these topics to help solidify your knowledge of the AFG Valuation methodology. Please let us know if you have any comments or questions in the meantime.

Click here to read a related article: EPS Increased.....Company Underperformed?

Registered Users: If you would like to Read our Economic Margin white paper which was published in the book: Value-Based Metrics: Foundations and Practice Edited by: Frank J. Fabozzi and James L. Grant Pages 157 – 178: Click Here
 
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