Value In Vision

The discounted cash flow (‘DCF’) methodology is generally seen as the prime instrument to assess a company’s intrinsic value. There are many pitfalls associated with this methodology, though. A frequent rookie mistake is to assume capital expenditure at the similar level as depreciation over the forecast period. This implies that a company growing at 5% over a ten-year period would generate 50% more sales over a constant net asset base. That represents a more than generous increase in return on capital, which is unjustifiable and leads to overvaluation.

A more pernicious assumption is embedded in the terminal value. Beyond a detailed forecast period of five to ten years, a DCF requires that a high level view be taken on a normative growth rate and cash flow generation to assess the value of an asset at the end of such forecast period. When discounted back to the present, that terminal value typically ends up accounting for comfortably more than 50% of the net present value of the company today. No practitioner has ever felt fully comfortable with that shortcut, but the approach is seen as pragmatic and acceptable by convention.

Today, it requires some further consideration. Indeed, the rate of innovation has been accelerating in the Diversified Industrials world. Twenty years ago, a research analyst or an M&A professional could value a car manufacturer through a DCF. For the terminal value, one just had to take a long term view on the growth rate for cars in the targeted segments and on a related cash flow generation profile, et voilà! Today, a first question will have to be about the very existence of motor cars as we know them beyond the forecast period. The same would apply to programmable logical controllers, distributed control systems, electricity switches, hydraulics, turbine blades manufacturing, etc.

How can a terminal value be rationalized in a world where the likelihood of a company producing even remotely identical products and services by the end of a forecasting period is rapidly declining? Accounting for such value requires a more fundamental assessment of what a company is intrinsically about, of its ability to cope with innovation and of its capacity to reinvent itself. Any doubt about the perennity of a company by the time the end of the forecast period is reached can have a substantial impact on valuation multiples through the terminal value. Take Apple for example: 5%+ growth rate, 27% operating margin and trading at a forward P/E of… less than 14x, below the Diversified Industrials sector (15x and above), and below UBS (15x). Why? Part of the explanation is driven by the notion that Apple may fail to reinvent itself before it reaches its terminal value. Those who followed Nokia, SONY or RIM/Blackberry would find good arguments supporting that cautious approach.

This creates a need for many industrial companies to market their core competencies and strategy with renewed care so that investors be prepared to expect value in the long term, beyond what is seen as the foreseeable future. Defining ‘who you are’ may require a few trips to corporate psychologists, a role which strategic consultants and bankers will relish. The often derided mission or even ‘vision’ statements may be back with a vengeance.

A number of further changes will most likely be observed as Diversified Industrials companies move into a faster-changing world:

  • An increase in R&D spend, with a ratio to revenues expected to go beyond the usual 3–5% of revenues in capital goods, with an accompanying increase in the related level of disclosure of such activities

  • A more conservative balance sheet, more closely aligned with those of high tech companies (including in software or pharma) which tend to have a net cash position as they need to secure the ability to invest in R&D at all times

  • A more diversified Board and Management team set up, ready to challenge traditional trends

  • A change of attitude towards risk with potentially deep implications for corporate culture

  • An active portfolio management which goes beyond historical patterns as most Diversified Industrials player will need to position themselves alongside an increasingly dichotomic world: the high tech industrials and the rapidly maturing, if not declining activities

To cap all of that, a healthy dose of tech paranoia will be required. The best way to maximize the terminal value is to worry about it every day.

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