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Valuation Multiples: Carnival plc

How to Value Companies: Valuation Multiples

The Valuation Multiples method is one of the most common approaches to valuation because it is quick and does not require detailed analysis of a company’s annual accounts

It is also an excellent approach when a company is private and the share price is not available.

Which Valuation Multiple to Use?

The best multiple for a particular company will depend on its industry and growth opportunities.  Common multiples include:

Enterprise Value/Sales Price/Earnings Sales/Assets
Enterprise Value/EBITDA Price/Book Value of Equity Sales/EBIT
Enterprise Value/EBIT Price/Sales Price/Sales

Note: Enterprise Value = Market value of equity + Debt – Cash and Cash Equivalents

Four Key Steps

  1. Identify peers/benchmarks for the company.
  2. Find valuation multiples for the comparator firms.
  3. Calculate the median or mean multiples of the peer group.
  4. Calculate the expected multiple for your chosen firm and use to value equity.

Given we are in December and the weather is dreadful outside, let’s use the Cruise firm, Carnival plc as a case study for the Valuation Multiple approach.

Step 1: Identify peers/benchmarks

Carnival plc is an international leisure and cruise firm with operations throughout the world.  You can find out more about the company on their corporate website.

Our first step is to find Carnival’s peers.  For a listed firm it’s as easy as searching for “company name peers” in Google. I did this and got the following set of results:

Carnival plc Benchmark Companies

I went with the first entry in the list above and found that Carnival had two main competitors:

Carnival peers screenshot from csimarket.com

We have two peers: Norwegian Cruise Line Holdings Ltd, and Royal Carribean Cruises Ltd – both private firms.

Step 2: Find valuation multiples for the comparator firms.

Given we have private firms, there will be no share price available so we will use Enterprise Value ratios

*** For clarity, I don’t know anything about the Hotels and Leisure industry sector.  To check, I did another search on google with the following request, “what are the best valuation multiples for hotels and leisure?”.  The first result that came up was Enterprise Value/EBITDA, which is one of our ratios so we are on the right track ****

Step 3: Calculate the median or mean multiples of the peers

Simply calculate the average of the peer ratios and compare it to your target firm.

For our case study, let’s focus only on Enterprise Value/EBITDA.  If you are doing a full analysis, you should use other ratios as well to triangulate your values.

The internet is a wonderful resource. I did another search on google for “Carnival plc Enterprise Value/EBITDA“.  Our old friend, gurufocus.com, came to the rescue:

Doing the same thing for Norwegian Cruise Line Holdings, we get:

For Royal Caribbean Cruises Ltd we get:

Let’s bring the data together.


Enterprise Value/EBITDA
Carnival plc 10.94
Norwegian Cruise Line Holdings Ltd 12.25
Royal Caribbean Cruises Ltd 11.63
Average of Norwegian and Royal 11.94


Step 4: Calculate the expected multiple for your chosen firm and use to value firm

From Gurufocus.com, Carnival has an Enterprise Value of $48.451 billion and an EBITDA of $4.430 billion.

On the basis of the comparator EV/EBITDA figure, you would expect the Enterprise Value for Carnival to be 11.94 x $4.430 billion = $52.894 billion, which is higher than the actual Enterprise Value of $48.451 billion.

It would look as if Carnival is underpriced compared to its two peers.

Strengths and Weaknesses of the Valuation Multiple Approach


  1. There is a massive number of different multiples you could look at and so you have different ways to carry out firm valuations.
  2. Ratios are simple to calculate and easy to interpret.
  3. You are valuing a firm based on other companies in the same sector. Differences between the actual share price and estimated values can provide much insight into where the company could improve its operations.
  4. This method is used for private firms and each industry will have standard valuation multiples to arrive at an expected value for a company. This is important when you are looking to sell your firm.


  1. It can be difficult to identify appropriate peers for the company. Choose the wrong ones and your value estimates will be wrong.
  2. It is easy to focus on the wrong multiples given that there are so many to choose from.
  3. The method does not actually look at the company’s figures but uses other company data to arrive at a value.


In this series of articles, I have shown a number of different ways to value companies. The exposition was necessarily simple to ensure the central concepts are presented in a clear and concise way.

There are many factors I didn’t consider as my objective was to show you the general approach to value firms, rather than to look at the specific valuation of any one firm.

If you want to know more about valuation multiples, you should check out Chapters 12 and 13 of my book, Financial Markets and Corporate Strategy, where I explore the method in much more depth.

I’m now going to take a break for a couple of weeks and when I return in January, I will continue with my valuation videos on YouTube.

See you in a few weeks!



How to Value Companies: Focussing on the Operations

You can value companies in a number of ways. For example, use balance sheet/stock market data for the market valuation method, or you can use Cash Flow/Income Statement for FCFF valuation. In this article, we focus on the actual operations of a firm to get a valuation estimate.

Consider the basic accounting equation:

Assets = Liabilities + Equity

The method used in Part 1 of this series separately estimated the liabilities and equity of a company to arrive at an overall firm value.

Our focus shifts to the left-hand side of the accounting equation – the assets of the firm.  Theoretically, asset value should be equal to the sum of the liabilities and equity values.

Valuation Steps

The best approach to valuing a firm’s assets is to work with the company’s management to identify all future cash flows likely to come from the assets (including human capital, brands and other intangibles). If you don’t have access to the management, you will need to use websites and the financial pages.

To value your firm, follow steps 1 and 2 below.

  1. Split the company into different divisions/activities and analyse each of these separately.
  2. Carry out a discounted cash flow analysis on each of the firm’s operational lines and then sum the individual present values to arrive at a total value of the assets (and the firm).

Valuation in Practice

Consider the construction firm, Carillion plc.  From its website, the company is involved in 4 distinct operations: Support Services, Public Private Partnerships, Middle East Construction Services and Construction Services (Excluding Middle East).

Cash Flows

The Carillion Annual Report provides the following information on the firm’s operations:

How to Value Companies

It is clear  that whereas Support Services is the largest market by far for Carillion, it is fairly stagnant compared to their Construction business.

Pipeline orders for Construction (The Middle East and elsewhere) are massive compared to existing revenue streams.  In addition, the efficiency of these business lines is much better than for Support Services.

The Discount Rate

Page 93 of the Annual Report states:

Discount rates have been estimated based on pre-tax rates that reflect current market assessments of the time value of money and the risks specific to the Cash-Generating Units (CGUs). Whilst the Group has four CGUs, the risks and rewards associated with Construction services (excluding the Middle East) are consistent, and therefore one discount rate has been applied to each CGU. Similarly the risks and rewards encountered in the Support services CGUs are consistent and therefore one discount rate has been applied to each CGU. Management has derived a Weighted Average Cost of Capital (WACC) using the capital asset pricing model to determine the cost of equity and then weighting the overall cost of capital for the Group by equity and debt. The WACC was then used to determine the pre-tax discount rates for each CGU. The rate used to discount the forecast cash flows for the CGUs in the Construction services (excluding the Middle East) was 10.0 per cent (2012: 11.7 per cent) and for the CGUs in the Support services segment was 8.8 per cent (2012: 9.9 per cent).

So, from this text, we have a discount rate of 10.0% for Middle East Construction and Construction (Exc. the Middle East) and 8.8% for Support Services and Public Private Partnerships.


From this point on, it is up to the analyst to decide on the assumptions with respect to cash flow growth and future cash flows.  This is covered in much more detail in my textbooks, so, for now, I am just going to state a number of very broad (and probably unrealistic!) assumptions.


  1. For the next five years, cash flows will grow at a rate in proportion to the Pipeline/Order Book ratios for each business line.
  2. From the 5th year onwards, cash flows will remain constant.
  3. The maximum year on year growth in cash flows in any unit will be 20%.

I admit these can be criticized as being “finger in the air” assumptions.  However, without further in-depth analysis, we cannot forecast any further than five years from now. Also, from year five onwards assuming no growth is as good an estimate as any.

With the exception of Support Services, the pipeline of orders in all units are significantly higher than the existing order book.  Consequently, I am assuming 20% growth year on year for all units, excluding Support Services .

Support Services looks as if future performance will be flat.  Given that the pipeline of orders in this division is 23.5% less than the existing order book, I have chosen a negative growth rate of 23.5/10 = -2.35% for the next five years. This reflects a potential thttp://www.david-hillier.com/wp-admin/post-new.phpightening of this market over the coming period.

With these assumptions, we have the following cash flow streams for each business unit: 

We now need to estimate the terminal value for each of the Business Lines.  To do this, I simply treat the cash flows from Year 6 onwards as perpetuities and discount them at the respective discount rate for each unit (=Cash Flow@Yr 6/Discount Rate).

Company Valuation: Assets

We now have cash flows and a Terminal Value for each business unit.  These will be discounted to present values using the respective business unit discount rates.  The present values for each cash flow are given below:

Company Valuation

Summing these present values gives us an estimate of the value of Carillion plc.  The value from the Asset Valuation method is £4.089 billion.

 Strengths and Weaknesses:

The strengths of the Asset Valuation approach are:

  1. If full sight is given of the firm’s operations, it is possible to come to a completely independent estimate of firm value that does not rely on financial reports.
  2. The method (when valuing the future cash flows of operations) avoids accounting assumptions like intangibles valuation, which can be difficult to understand.

The weaknesses of the Asset Valuation approach are:

  1. It is often exceptionally difficult to get information on the firm’s operations and sales pipeline, making this method almost impossible to use.
  2. The method suffers from the need to make assumptions about future cash flows just like all other methods.

In the next installment of this Primer on Corporate Valuation, I will look at the final valuation technique, Valuation Multiples and Peer Comparisons.

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FCFF Valuation

How to Value Companies: The Free Cash Flow to a Firm (FCFF) Method

I apologise upfront as this is quite a long post that takes you step by step through the process of valuing a firm using the Free Cash Flow to the Firm (FCFF) approach.

Like all valuation methods, you need good estimates for your model and in this case, you need to forecast:

  • Future free cash flows;
  • Free cash flow growth rates; and
  • the Weighted average cost of capital, WACC.

The FCFF method requires the total cash available to all investors (equity and debt holders).  Unfortunately, there are a number of ways to calculate Free Cash Flow to a Firm (FCFF) and people often get confused regarding which one is the best.

In addition, the accounting standards a firm follows affects the formulae used to estimate free cash flows.  I am assuming your company uses International Financial Reporting Standards (IFRS), which applies to most companies outside of the US.

In keeping with the theme of my blog, I am not going to deep dive into any single approach but instead, simplify the models enough so that FCFF can easily be used by anyone. In addition, my philosophy is that more noise comes from forecasting the future than from any variation in the different approaches you meet in practice.

Step 1: Free Cash Flow

The best way to estimate free cash flows is to work with a company’s management and derive estimates of future cash flows (up to about five years). However, this isn’t practical in many cases and most times only the financial accounts are available

Free cash flow is the money left over after all operating and investment costs have been paid.  This is the amount that can be distributed to debtholders and equityholders of the firm.

Simple Estimation

Free Cash Flow to the Firm = Cash Flow from Operations + Cash Flow from Investing Activities

Important Points

  1. Normally, dividends and interest payments must be stripped out of the figures given above.  I say ‘normally’ because if a company is a bank, it may make interest payments as part of its business operations rather than through financing needs.  In addition, many companies receive interest payments or dividends from their own investments in other firms. Given that these are operating cash flows, they should be included in the Free Cash Flow estimates.
  2. When looking at the Cash Flow from Operations and Cash Flow from Investing Activities, you may consider stripping out extraordinary items or one-off special payments.  This is because you want to get an expected future free cash flow that can grow at a specific rate constantly into the future.  If your initial cash flow is unusual, your future cash flow estimates will also be out.  You can separately discount any extraordinary items as a single cash flow and add it later if required.

FCFF Case Study: BP plc

We will look at the global energy firm, BP plc. The most recent annual results (31st December 2015) can be found from BP’s Investor Relations page.

The BP plc Cash Flow Forecast is presented below:

FCFF BPHow to Value Companies FCFF

A quick scan of the figures shows BP reported a major loss of $9.5 billion that was caused by an accounting provision to pay fines linked to Gulf of Mexico oil spill in 2010. There was also a general downturn in its business because of low oil prices (read this Reuters news report for more information on BP’s results).

To keep things simple, we will go with the overall figures without correcting them for any items.

Free Cash Flow to the Firm (FCFF) = Cash Flow from Operations + Cash Flow from Investing Activities

FCFF = $19.133 billion + (-$17.300 billion) = $1.833 billion

You will see that the operating cash flows (the cash flows that arise from everyday business) are positive, whereas the investment cash flows are negative. You would expect this because the underlying operations should make money and the company should also be investing to grow.

We now have an FCFF estimate. Time to estimate growth rates.

Step 2: Free Cash Flow Growth Rate

A simplifying assumption that I am going to make here is that the FCFF grows at a steady rate forever.  Clearly, this is unrealistic.  However, it is good as a starting point and a launchpad for more complex analyses.

If you want to look at different approaches to modelling future growth rates, check out YouTube video on Equity Valuation or any of my books.

Growth rates are notoriously difficult to estimate as they are based completely on subjective forecasts.  My favoured approach is to simply use analyst forecasts as an initial estimate, and iterate further once initial firm values have been calculated.

Looking at the BP page on FT.Com (search for the name in the FT.Com website and click on forecasts tab):

FCFF Valuation Model BP plc

Source: FT.Com, December 2016.

Two forecasts are provided for the growth rate: 1.27% and -3.50%. These aren’t particularly valuable because there is no consistency between the two short-term estimates.  We need to look elsewhere!

A good site for current company data is www.gurufocus.com, which calculates these figures automatically from data.  According to Gurufocus:

During the past 13 years, BP PLC’s highest 3-Year average Free Cash Flow per Share Growth Rate was 52.60% per year. The lowest was -35.90% per year. And the median was 5.80% per year.

Let’s go for the Gurufocus growth rate of 5.80% since it is based on 13 years of data and is an average.  Clearly, you should investigate these figures more using different growth rate models, but for our purposes, 5.80% will do.

Step 3: Weighted Average Cost of Capital (WACC)

The fastest way to find out BP’s Weighted Average Cost of Capital is to search Google to see if an analyst has estimated the figure already (sometimes, the company itself will provide the WACC.   I’ve found two estimates:

www.finbox.io: range 7.8% – 8.8%; Midpoint: 8.3%

www.Gurufocus.com: 7.17%

Given we went with Gurufocus for growth rate, we will stick with them for the WACC estimate.

Step 4: Estimate Value of Firm.

There are many ways to work with cash flows in discounted cash flow analysis and much of what is calculated comes down to simplifying assumptions.  In my analysis here, I am assuming that cash flows will grow at a constant rate forever.

The formula I am using is then:

Value of Firm = FCFF(1+g)/(WACC-g) = $1.833(1+.058)/(.0717-.058) = $101.16 billion

According to the FCFF model and our estimates, BP is worth over $100 billion.


Our estimate is quite a bit lower than the current market value of BP based on share price and book debt value ($150 billion), so clearly we have either underestimated the cash flow and/or growth rate or overestimated the WACC.  More research is needed into these estimates.

Does this mean FCFF is a poor method? Definitely not!

For example, Finbox.io used a number of different estimates to arrive at a range of WACCs, as did Gurufocus.

Our Cash Flow estimates were also quite simplistic and we could have looked at the components of the Cash Flow Statement to identify any one-off items that should be stripped out.

Strengths and Weaknesses of FCFF


  1. The method is applicable for all firms (public and private firms) and useful when the company to be valued has no stock price data.
  2. The method is based on a company’s financial accounts and thus based on audited financial figures.
  3. It is a good model for companies with stable cash flows and constant capital structures.



  1. It doesn’t use stock price information, which is the most timely information.
  2. It is very sensitive to inputs such as Free Cash Flow Estimates, Growth Rates, and Discount Rate.

Admittedly, the method hasn’t been particularly effective in valuing BP plc. I would definitely attempt to come up with a more refined set of cash flow forecasts.  I would also look again at the growth rates we used in this example and identify the most appropriate measure.

Interested readers can find out much more about valuation in my YouTube videos and any of my textbooks.

If you have got this far, you’re clearly a finance enthusiast! Please leave a comment with your thoughts or even requests for future posts.

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How to Value Companies: The Market Valuation Approach

In this four-part series on valuation, I will describe different approaches to valuing a firm.

My advice is to start off with the methods given in this post, adapt them to the specific industry and corporate conditions, and then come to a consensus view based on all four approaches.

The Four Valuation Methods:

  1. Market Valuation, where actual market information is gathered on the debt and equity of a firm.
  2. Free Cash Flow to the Firm, where the present value of future cash flows to the firm are calculated.
  3. Asset Approach, where the company’s assets are valued.
  4. Valuation Multiples, where information is used on peer firms in the same industry to arrive at a valuation of the firm.

To show valuation in action, I will use the global pharmaceutical firm, AstraZeneca plc, as an example.

The Market Valuation Approach   

The Market Valuation method takes data from the stock market to value a firm.


  1. Find Equity Value: Visit any financial webpage (such as FT.Com, Yahoo! Finance, etc.) and find the market capitalization of equity. I went to FT.Com’s webpage for AstraZeneca plc and got the information below: AstraZeneca Market Capitalisation Figure 1: Summary data on AstraZeneca, 26 November 2016 (source: FT.Com)

The Market Capitalisation of equity is £54.30 billion.

  1. Find Debt Value: In most countries, corporate debt is traded irregularly. This means that the prices you get from financial pages can be out of date by a long way. The fastest way to find the value of a company’s debt is to get the total value of its liabilities from the most recent set of accounts. Don’t worry about any bond issues or loans issued since the most recent report because the cash raised will be reflected in the equity market capitalization.


Figure 2: AstraZeneca Balance Sheet (Source: AstraZeneca 2016 Q3 Results)

From Figure 2, the value of the Debt is equal to total liabilities = $48.31 billion.

At an exchange rate of $1.2478/£ (source: XE.com, 26 November 2016), AstraZeneca’s debt is worth £38.72 billion.

The total value of AstraZeneca plc according to the market valuation method is £93.02 billion.

Value of Equity + Value of Debt = £54.30 billion + £38.72= £93.02 billion.

Strengths and Weaknesses

The strengths of the market valuation method are as follows:

  1. Share prices contain all available information in the stock market including future growth prospects, intangible assets and the quality of a firm’s management, among other factors.
  2. The information you are using is the most up to date out of all the valuation approaches. Other methods use figures that can be many months old.
  3. The method makes no theoretical assumptions and is based entirely on observed market valuations.


  1. Market prices may not reflect value fundamentals. This can occur if a firm is the target of a takeover and the price has responded to the potential bid.
  2. If the company is not publicly traded there will be no market prices. Most valuations are carried out for private companies with no share price, which makes it impossible to use this method.
  3. The company may be small and traded infrequently leading to stale market prices. Out of date information can cause as many issues as poorly estimated information.

If a company is large and traded on the stock market, the market valuation method can be used quickly and easily to arrive at a firm value.

In my next post, I will explain the Free Cash Flow to the Firm method, which is also known as the income approach to corporate valuation.

Strathclyde Business School 2016

Strathclyde Wins Business School of the Year!

I am absolutely delighted that Strathclyde Business School has won the Times Higher Education Business School of the Year.  This is a great reflection on all the staff and students, past and present, of my great institution.

The Times Higher Education Awarding Panel announced:

An innovative programme that boosted the external business engagement of Strathclyde Business School was a substantial reason for its being named as winner of this award.

Under the Growth Advantage Programme (GAP) – launched in June 2015 in conjunction with Santander bank and the first of its kind in Scotland – leaders of businesses turning over at least £500,000 attend four workshops tackling areas critical to business growth, such as resource, market, operations and leadership advantage. GAP helps business owners to improve growth as well as providing them with relationship-building opportunities.

Along with this and Strathclyde Business School’s growing number of company-specific MBAs – including the Weir MBA, Babcock MBA and Iberdrola MBA – the judges were “particularly impressed” with the school’s level of external engagement, a central feature of Strathclyde’s agenda.

Strathclyde also garnered praise for its academic success. It was rated first in Scotland and in the top 10 business schools in the UK for its research in the 2014 research excellence framework. The results showed that, in particular, its research was strong in terms of impact. Additionally, the REF rated the research environment, for both academic and doctoral student communities, as joint first in the UK. A report that reinforced the business case for employers to adopt the living wage had particular impact.

“Strathclyde Business School has been innovative since its inception 50 years ago, responding to business and technological developments,” the judges said.

“We were particularly impressed with its level of external engagement… and the research project of the case for the living wage also impressed.”

7 Key Equity Characteristics for 2017

It may seem as if the world has never been stranger nor more uncertain.  We’ve had Trump and Brexit in the second half of 2016. Who knows what will happen in Italy’s referendum or the elections in France and Germany in 2017?  Sterling has collapsed and the UK stock market has surged (although it has been relatively flat since August 2017).

The global economy appears just as risky.  Will Russia run out of money in 2017? Will the Middle East flare up further or will it calm down? How will China respond to the fracturing of Western political structures? What part will emerging markets play in global economic growth? Will the Gulf Region adapt to the low oil price regime?

Although it appears as if the risk facing financial markets in 2017 rivals that of the 2008 global financial crisis, the data doesn’t show this to be the case.  Consider the CBOE VIX Volatility Index (source: Google), which is a good proxy for uncertainty in the financial markets:

VIX Volatility

The risk at the tail end of 2008 was four times greater than today.

Saying that, we’re looking into a new period of protectionism and slowing economies.  In the UK, Brexit is contributing to a major suspected slump in growth and I wouldn’t be surprised if this is replicated over the next year in Europe as well.

With all this uncertainty, you may be thinking it’s not worthwhile to invest in the stock market in 2017.  However, if you take a long-term investment strategy (I never recommend short-term investments of fewer than 5 years in equities), there may be some good opportunities available.

Key Equity Characteristics to Look For

I’ve been thinking about the different equity characteristics one should consider in 2017 and have come up with seven key pointers.  These will help with the investment decision to buy, sell or hold over the next 12-24 months in any country or region.

Clearly, it will be difficult to identify companies that satisfy all 7 of my criteria, but I recommend that all good investments should have, at the very minimum, four of the below:

  1. Low Price-Earnings (P/E) stocks compared to industry norms. Research has shown that P/E ratios revert to the mean industry P/E ratio over time.  If a company has a low P/E ratio, it may be that the stock is underpriced. You can find Industry and company P/E ratios from Reuters (for example, check out current Oil & Gas P/E Ratios).
  2. Large Market Capitalisation. When the market is going up, smaller companies do very well and when it is going down, smaller companies tend to be hit worse. Stick to larger companies if you think the market is going to be bearish. Using the UK as an example, assuming that the FTSE 100 has fully anticipated the effect of a depreciated sterling on corporate profits, then I wouldn’t anticipate it growing by too much in 2017.
  3. Stick to Industries that have stable continuous demand or do well in downturns. This is a low-risk strategy because sectors such as retailers (especially discount companies like Aldi and Lidl) will perform consistently well during the bad times.  Strangely enough, firms that sell tobacco and gambling firms do better in downturns and these may be good areas to consider. Finally, Pharmaceuticals and Healthcare companies are solid players irrespective of the state of the economy.
  4. Low leverage firms Companies that have a lot of debt struggle to pay off interest when earnings drop. A permanent drop in cash flows leads to increased risk when interest payments need to be met.  Stick to companies that have low debt ratios if you think the economy is going to slow down in 2017.
  5. High operating efficiency During uncertain periods, only the most efficient companies can respond well to challenging external conditions. Look for high ROCE (Return on Capital Employed) compared to other firms in the same industry. Return on Investment (ROI) is another good ratio to consider (see Reuters for Oil & Gas ROIs)
  6. Stable recent performance This is a bit controversial, but I like the look of companies that have stable Net Income over the previous 24-36 months. When the future is uncertain, the drivers of very strong past performance may change dramatically and this could tip the earnings figures down.  Stable performance (irrespective of market conditions) is linked to my point (3) because it suggests that the company has a low-risk business model.
  7. Good cash balances More and more companies are hoarding cash (much more than twenty years ago) and, as a result, there is liquidity in the market. Ensure that your investment has good cash levels as credit may dry up in poor market conditions.


Taken together, The 7 characteristics will lead you to invest in undervalued companies with stable operating performance and lots of liquidity. They won’t provide you with stellar returns but would hopefully keep you financially safe if things don’t go well on the geopolitical arena. At a portfolio level, diversification is important, so invest in several companies rather than only one or two stocks.  Even better, think about Exchange Traded Funds or other investment funds.

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How to Estimate Equity Growth Rates

Equity Valuation: Why do Firms Grow?

In this second video of my Equity Valuation series, I ask two questions:

  1. Why do firms grow?
  2. What determines the return investors earn from equity investments?

This video is still in the theoretical space and I use the Dividend Growth Model to derive a simple expression that captures why firms grow. I then decompose investor returns into two components: Dividend Yield and Capital Gains Yield.  I am not working with real data at the moment as I need to ensure the basics are understood first.

Two Practical Insights:

  • Companies can change their dividend payout policy to ensure share price growth. This has no impact on the overall returns to investors (because they receive dividends and share price profits) but it can look like the company is performing well to unsophisticated or inattentive investors.
  • The key factor to ensure your company grows is to reinvest your earnings in good projects.  Any time you remove money from your company (such as through unnecessary expenses, high salaries, dividends), you are eating into future cash flows and reducing today’s firm value.   Controlling your expenses early and introducing discipline into your investments can have a massive impact on future cash flows.

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You Should Use Payback Period

Three Important Reasons Firms should use Payback Period

Over the past two years, I have grown more and more in favour of using Payback Period for making investment decisions.  This is based on engagements with a number of large and small firms who have raised their challenges with investment appraisal.

As you can see below (from Chapter 6 of my book, Corporate Finance), Payback Period is used in many large companies across the world.  In fact, it is the most common investment appraisal technique used by large firms in the UK.

Survey of Capital Budgeting Methods

The troubling issue for academics is that, compared to other methods like Net Present Value and Internal Rate of Return, Payback Period has so many theoretical weaknesses.

I will now show you how to calculate Payback Period and discuss its weaknesses. I will then explain why (despite its failings), it is one of the best methods for investment decision-making.

How to calculate Payback Period

When you calculate payback period you ask how long it will take to get your money back.  It’s as simple as that.

A basic example:

You invest £1,000 and receive £400 every year for the next 6 years.  The Payback Period will be between 2 and 3 years depending on when the cash flows occur during the second and third year.

Companies will have target payback periods beyond which they will refuse to invest in a project.  So, if your company had a target payback period of 3 years or more in the previous example, you would go ahead with the investment decision.  This is because the project payback period of between 2 and 3 years is less than the maximum Payback Period (3 years) the company is willing to consider.

Theoretical Weaknesses in the Payback Period Method

There are a number of theoretical and conceptual issues with Payback Period, which make it unattractive to academics.

  1. It doesn’t differentiate between cash flows that occur early in the project life cycle from those that occur later on.
  2. Payback ignores all cash flows beyond the company target payback period. In the previous example, the project may have a very large negative (or positive) cash flow in year 6.  This would be deemed irrelevant by the Payback Period approach and ignored.
  3. Target Payback Periods are subjective targets thought up by corporate management.  There is no theory justifying any particular target.

Three Important Payback Period Strengths.

  1. The Payback Period’s main attraction is its simplicity. Academics may forget that many corporate managers are creative entrepreneurs with skills in other areas like Marketing or Technology. In my experience, many businesspeople feel uncomfortable with concepts like Net Present Value or Time Value of Money. Payback Period simply tells you when you are likely to get your money back – providing insights into future liquidity and project flexibility.
  2. Although Payback Period does not explicitly consider cash flow risk, by ignoring future cash flows beyond a certain threshold period it is effectively reducing the present value of those cash flows to zero. This is comparable to a very high discount rate. High discount rates may be appropriate when firms face considerable future cash flow uncertainty.
  3. Forecasting cash flows beyond two years can be difficult, especially when a new product is introduced.  To arrive at a net cash flow for a specific year, one must predict market size, market share, sales price, variable costs and fixed costs.  These will all be predicted with error, and the errors grow in magnitude the further away the prediction. The best way to visualize this is to think of the prediction error below:

Prediction Errors in future forecasts

When viewed this way, it’s clear the theoretical strengths of methods that incorporate all cash flows (NPV, IRR, etc) may actually be weaknesses. Forecasts of long-term future cash flows will contain so much noise that the output figure (NPV, IRR) may be nonsense.  By ignoring later cash flows, Payback Period removes this prediction issue.

The Best Way to Use Payback Period

Payback Period is best used in combination with another method (IRR and/or NPV).  Only if the project is increasing wealth (has a positive NPV) and returns the initial investment within an acceptable period, is it worthwhile.

Use a hybrid investment appraisal method that combines more than one decision rule (for example, IRR and Payback, NPV and Payback). This is the optimal approach and dominates the use of any single method.

In fact, this is what many companies use in practice.


Equity Valuation

Video: A Brief Introduction to Equity Valuation

This new video series is in response to a number of requests from viewers to discuss how to value equities. I’ve already written a fairly detailed post on how to value equities with real data, but I want to go back to the fundamental concepts so that anyone can understand the main ideas underlying valuation.

I’ll repeat what I said in my earlier post: valuation is almost 100% about predicting the future.  If your predictions are inaccurate, there is a good chance your valuation estimate will be in error.

Valuing Equities during Volatile Periods

Because the financial markets are so volatile at the moment (Brexit and Trump presidency in the space of 6 months!), equity analysts will find it incredibly difficult to make good predictions of future cash flows.

What can you do in this environment?

  1. You can carry out a sensitivity analysis of your main assumptions relating to future dividends, discount rate and growth rate.
  2. Undertake a scenario analysis of different outcomes re: Brexit and US trade policy.
  3. Run a monte carlo analysis on your valuation model.

To find out more about these methods, check out my Risk and Sensitivity Analysis videos on YouTube:

In future videos, I’ll dig deeper in where we get the estimates for growth and discount rate.  Enjoy!

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How to write Brilliant Essays in an Exam

How to Write Perfect Essays for an Exam

If you are at university or college it is almost 100 per cent certain you will be asked to write an essay in an exam.  Fortunately, it doesn’t matter what subject you study, as the principals of essay writing are the exact same.

How to write brilliant essays is one of the most common questions I am asked by students.  This is a particularly worrisome issue for those who speak English as a second language and can mean the difference between a good degree qualification and failure.

Before the exam you need to fully prepare for essay questions and there are a number of things you can do to ensure you are well placed to write a killer essay that will attract a very good mark.


  1. Study past exam papers for essay topics and question structure. There are only so many essay questions that can be asked in an exam, and there is usually a predictable structure to the questions.  Are the questions open-ended? Do you need to discuss a statement? Do you need to explain a concept?  Write down all variations of past exam questions.
  2. Create your own essay questions. You’ll be amazed at how difficult it is to write a truly original exam question.  For every topic or lecture, create 3 exam questions: a) open-ended; b) discuss a statement; c) explain a concept.  If you do this for every topic, you will have an excellent bank of potential questions to practice.
  3. Practice your Essays. An examiner will expect you to write about an A4 page every 10 minutes.  So if you have to answer a 40-minute question, expect to write four pages (normal handwriting!).  This will be extremely difficult at first but I assure you, with practice, you can do it.
  4. Research how to apply the theory/concept/method. One thing that distinguishes excellent essays from run-of-the-mill attempts is showing you know how to apply the theory/concept/method in a practical setting.  For each topic, devise a practical example or brief case study.
  5. Independent Reading. For each topic, find two or three articles that research or critique the theory/concept/method.  This is another distinguishing essay characteristic examiners look for.  If you can show you have done your own reading, you will really impress the examiner.
  6. Memorise your lecture notes. This is the bare requirement for a pass.  Use mindmaps, flashcards or other memory aiding methods. For each theory/concept/method, ensure you can: a) describe it in detail; b) compare it to other theories/concepts/methods; c) know its strengths and weaknesses.

The Exam

  1. Read. Read the exam question carefully and highlight the important words in each sentence.
  2. Brain Dump. Do a brain dump of all the things you know about the topic. This should be half a page. List everything possible, including real-life application and references.
  3. Structure your Essay – The Beginning. An essay should have a beginning, middle and end.  The beginning sets the scene and structure of your essay. State what you are going to talk about and list the different sections of the essay. This should be one paragraph at a minimum but could be longer if the exam question is a big one.
  4. Structure your Essay – The middle. This is the core part of your essay and where you will get the most marks.
    1. Show you fully understand the main theory/concept/method.  This is essentially you rewriting the lecture notes.
    2. Give a worked quantitative example if appropriate.  By going through a calculation, you show you understand how to use the method.
    3. Give an example of how the theory/concept/method is used in practice.  This is your case study and should be a minimum of one paragraph but more is better.
    4. Refer and discuss to academic articles or other literature.  This part of the question shows you have undertaken independent reading and have gained more knowledge than what was provided in class.
  5. Structure your Essay – The End. You need to close off your essay by restating your main points and providing succinct conclusions.

Tips for Different Question Types

  1. Open-Ended Questions. These are the easiest questions because there is frequently no single answer.  For these questions, follow the structure as given above. Finance Examples include:
    1. Explain what is meant by the Dividend Growth Model and show how this can be used in Emerging Markets. 
    2. Explain what is meant by the payback period of an investment and discuss how the use of payback is related to the objectives of the company.
    3. Discuss the advantages and disadvantages of the use of the internal rate of return as an investment criterion.
  2. Statement Discussion Questions. For this question, you will be given a statement and asked to critique it.  An examiner is looking for you to show your understanding of the issue and so you should always make sure you present both sides of the argument: For and against.  Then you should present your position and justify it. The same general essay-writing principles apply. Finance Examples include:
    1. “Dividend Policy is Irrelevant.” Discuss.
    2. “NPV is completely useless in emerging markets because nobody can estimate a discount rate with any accuracy.” Do you agree with this statement? Discuss.
    3. “The only objective a financial manager should consider is shareholder wealth maximisation.” Is this a valid statement? Discuss.
  3. Compare and Contrast Questions. These are very similar to Statement Discussion Questions.  Present each theory/concept/method in turn and then discuss their strengths and weakness.  Show how each can be applied in practice and provide evidence of independent reading. Finance examples include:
    1. Review the strengths and weaknesses of the NPV and IRR investment appraisal methods.  In what situations (if any), would IRR be preferred to NPV?  Explain your answer using practical examples.
    2. Review the international parity conditions. In the context of Brexit, which condition is most likely to be violated? Which one is least likely to be violated? Explain.
    3. Compare and contrast CAPM with APT.  Is CAPM simply a subset of APT? Explain.

Marking Guidelines

It’s difficult to explain exactly how essays are marked because each examiner looks for different things. However, if you follow the guidelines given above, include evidence of independent reading, and know how to apply your knowledge in practice, you are sure to massively increase the chances of a good mark.

Best of luck and I hope my advice helps you in your exam preparations.

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