Question

What are important assumptions for value models to work? How to check them?

Answer 1

Equity valuation is about guessing what the value of an organization is expected to be a decade from now or an even bigger time horizon. Obviously, the financial future, just like future in general is difficult to predict.

However, in equity valuation, one cannot proceed further until some assumptions are made about the future. Every analyst report that we read is therefore making some assumptions about the future. Some of these assumptions will be explicitly stated whereas others will be implied in the report.

The important thing to realize is that any report or stock valuation is only as good as the assumptions that it is built upon. If we, as investors, do not agree with the assumptions on which the report is based, we do not agree with the report in general!

A good investor, therefore consciously scans equity valuation reports for assumptions that have been made, validates them and only then proceeds to critically evaluate the report. If any discrepancies are found, investors may adjust the assumptions to arrive at what they feel is the fair value of the investment.

Let’s look at some of the common assumptions that are made during the investment process:

Going Concern Assumption:

The first and the most basic assumption that is made by analysts is the going concern assumption. It does not matter which model is being used or whether it is the cash flows that are being discounted or the dividends are, the analyst and therefore the investor are assuming that the company will continue to be in business for the foreseeable future.

This assumption is usually valid as most companies do in fact stay in business over a period of time. However, if investors are taking a bearish stand on a stock and expect the company to shut down in the near future, they must ensure that they value the company based on the liquidation assumption and not on the going concern assumption which is usually the case.

Re-investment Assumptions:

To forecast, future cash flows which may be 5 or 10 years down the line, analysts have to make assumptions about how the proceeds that the company will generate over the same period will be used. Or if they believe that the company is growing at a rate which is faster than that which can be financed by internal accruals, they also have to make assumptions regarding from where and at what cost will that money be arranged by the company. These assumptions must be grounded in reality i.e. the assumption of more investment must be supported by a bigger market which the company is trying to enter and the availability of human and other resources to do so!

This is one of the most fundamental assumptions in equity valuation. Different analysts have different visions for how the company plans to conduct its business in the future. These different assumptions are the root cause behind different valuations.

Many times analysts connect with the senior management of the company, specifically to know their long term plans so that they can plan the cash flows accordingly. These assumptions will usually be stated in the report itself.

Dividend Payout Assumptions:

Based on the past dividend payout of the company, its expected growth rates and its free cash flow, investors can make an educated guess of what the dividend payout ratio for any given company will be. These dividend payments are cash flows which go out of the firm and therefore slow down the growth rate. It is important to understand the validity of the dividend payout assumption as the valuation of the company can be significantly changed even if minor adjustments are made in dividend payouts.

Macro-Economic Assumptions:

All the assumptions that are to be made are not company specific. The company is a part of the macro economy in general. Therefore, any changes in the macro economy are also expected to affect the company. Analysts therefore use forecasts by bodies like IMP, World Bank etc as their assumptions. Since these forecasts come from bodies which are experts in their field, they are the best estimate that an analyst can really make. However, even these bodies have a dismal record when it comes to predicting the future state of the economy. Hence, it is exceedingly difficult to get accurate data about the economy even though it forms one of the most fundamental assumptions.

Industry Assumptions:

Lastly, analysts also make assumptions about how the different competitors of the company will fare. This is done as a part of industry analysis. No company operates in vacuum and hence the performance of any given company can be seen as linked to that of its peers. Assumptions regarding change in market share or market leadership must be based on sound data and foreseeable competitive advantages. Analysts have a difficult time predicting changed in the industry as well. However, this is easier to do as compared to macro economic analysis.

Thus, every equity valuation report has explicit and implicit assumptions. The job of an investor is to carefully study the validity of these assumptions before they believe in the contents of the report and make decisions accordingly!