Net Present Value Analysis and When to Use It

Valuing a loss making company is pretty difficult. The ‘gold standard’ of the stock market, the price/earnings ratio, can’t be applied. You could look at price to sales, but if the company can’t make a profit out of those sales, it’s not the most interesting measure. You could look at price to book, but for tech stocks, say, that would be missing the point – the book value is likely to be very low, and not really relevant to an investment decision.

If a company is just making a loss this year, then you might look at next year’s PER. But with a company that’s expected to make a loss for several years as it boosts its revenues and finally gains profitability, that’s not an option either.

You could look at a PER some years ahead, but then you’re going to be extrapolating earnings growth to get comparable figures for the market or sector, and that’s likely to introduce significant error.

So one of the better ways of looking at this kind of loss maker – let’s say a datacentre that is going to take some time to fill up its capacity, and which will be operating below the breakeven level for the first couple of years – is creating a discounted cash flow valuation to arrive at an NPV – net present value.

The whole concept of discounted cash flow is that the same amount of money is worth more to me today than it is in ten years’ time. So if I’m looking at the company’s earnings in ten years’ time, I need to discount them back to today’s value. If I’d put the money in the bank instead I would have earned, say, 3% on my money, and by tying it up in the company I’ve given up that interest – so I’ll only see 97% of the value of next years’ earnings, and so on.

To do a discounted cash flow you need to build a ten year cash flow account – the company’s revenues, profits, capital expenditure and working capital needs over that time. Then you’re going to take each year’s cash flow and discount it to today’s value. You can then compare that to the current share price and see whether there is some value in the stock, or not.

You’ll also give a ‘terminal value’ to the stock, because at the end of ten years, it doesn’t self-destruct but it will still be worth something. So that gets added in, as well. Usually, you’d say if stocks in the sector trade at 10x earnings, then this company in 2020 will be worth 10 times 2020 earnings. And then of course you discount that back to today’s value.

It’s a relatively simple concept. However, getting it right is tricky. First of all, how accurate are your forecasts? Have you got a good feel for how fast the industry is growing? Have you done a reality check? Some internet stocks assumed you could just keep growing your customers – one business plan I saw had a 2015 figure for broadband subscribers in the UK that was slightly larger than the entire population!

NPVs also have their pitfalls. For instance if you have made an error in your year one forecast, that error will be compounded in future years. So if, say, you thought sales in year one would be £10m, rising at 20% in year two, and they’re £8m, rising at only 10% in year two, the effect on the final year in the series will be massive. That’s one reason growth stocks often react extremely badly to what look like relatively small shortfalls in revenues.

The good thing about NPVs is that once you’ve prepared one, you can tinker with it and create various scenarios. You can see what happens if revenue is only half what’s expected. You can see what happens if costs rise faster. You can play around with different profit margins or levels of capital spend. You can try to ‘break the model’ by finding out how far each variable has to be adjusted to make the stock worth zero.

I sometimes find NPVs tell me when the rest of the market is overegging a company’s prospects. On occasion, the NPV comes out lower than the share price. Sometimes, too, 80% or more of the value is represented by the terminal value. I really don’t like that – it means all the money is ‘jam tomorrow’ with very little bread and butter today, and it makes the stock much riskier than one where the stream of income represents a higher percentage of the value.

If you bear in mind the problems and pitfalls, using NPVs can be a useful way to look at growth stocks, as well as at long term investments such as refineries, chemical plants and power stations – the areas the technique was originally developed for.

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