Dirty secrets of modelling: What happens behind the scenes
In this section, we lay bare the callous relationship between returns, fade, and value.
High or low returns earned by companies tend to fade over time to the average cost of capital. The returns for some companies are more persistent than others. This could be due to barriers to entry/exit, strong brands, or something company or industry-specific.
Those returns may also be high or low during business cycles. Instead of overvaluing or undervaluing during peaks and troughs, we need to take a longer-term view.
Finally, companies go through the business lifecycle stages, from a start-up to a mature firm.
When modelling a company, your narrative, based on the three arguments above feeds into our valuation engine. We will explore how they interact with returns and fade.
Your model derived value needs to be backtested and compared with the historic share price, and it can be used to project forward.
Strength of Business
Breaking with convention, let’s explore the second option
first, “Strength of Business”.
The graph above represents the fade of ROCGA-x, one of our
return measures, from 14% to the weighted average cost of capital of 5.5%. Fade
begins immediately and is a result of selecting low business strength.
If the company you are modelling is able to slightly delay
the mean reversion of returns, you may want to click medium for business
strength. This simply delays the fade by 5 years.
Similarly, for companies that you classify as having strong
business strengths, returns will persist for longer and fade is delayed by 10
years.
It goes without saying that companies that can sustain higher returns for longer will have a higher valuation.
The same is true if the returns are negative or below WACC. Low strength will allow the returns to fade to the cost of capital quicker whereas medium of strong will delay the fade and keep the returns low for longer. This will have a negative effect on valuation.
Company Life Cycle Stage
This again is to do with company returns and mean reversion
to the cost of capital. But this time the life cycle stage determines the rate
of fade of returns as opposed to a delay.
The above diagram shows the returns gently fading to the
cost of capital.
Life cycle stage 5, or mature companies will have a higher
rate of fade than the early-stage companies.
The combination of business strengths and life cycle stages gives us significant flexibility in modelling companies with different profiles. For early-stage companies, you might want to use a low life cycle stage, combined with strong business strength. The stronger business strength indicates the companies returns will be sustained for longer as it is going through the life cycle stages.
The obvious blind spot for our model is when returns increase in the near term before stabilising and fading.
Is the Company Cyclical
For cyclical business, it may be useful to use the average
of Returns on Cash Generating Assets, ROCGA-x & Growth. This will ensure
that we do not overvalue or undervaluing during different stages of business
cycles.
This companies returns (above) is showing peaks and troughs
and using average returns may give a better indication of value.
On the other hand, the company above shows improving
returns. A non-cyclical flag for this company will be better suited.
Some companies will show changing returns profiles, along
with some cyclicality. We have split the cyclical flag into three options,
ROCGA, ROCGA-x & Growth. This allows us to work with companies with different profiles, as well as semi-cyclical
companies.
Conclusion
Well done for getting this far. Now disregard everything you have read. The tools above help us reach the end goal of finding a correlation between the share price and your narrative derived valuation.
Once the valuation falls within the historic share price high-low river, we can assume we have captured most of the market assumptions.
We can use this model to project forward.
