As a forensic accountant, we are frequently required to consider share valuations that start with an earnings figure, such as Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), and a multiplier. In many cases, this approach is the only proportionate and sensible option available.
However, it is important to recognise what these methods are actually valuing. In reality, they value something that has no intrinsic value on its own. Profit is merely a proxy for the thing that does have value, which is positive net cash flow.
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Where Does Value Really Lie?
Assets such as shares have value only if the present value of their future cash inflows exceeds the present value of their future cash outflows.
That relationship depends on three core factors:
- The amounts involved
- The timing of the cash flows
- The risk attaching to those cash flows
The Amount of Cash Flows
The principle is straightforward. Higher future cash inflows increase value, while higher outflows reduce it.
The Timing of Cash Flows
Timing matters because money received today can be deployed to generate further value over time. Inflation reduces the purchasing power of money in the future, and there is also an inherent risk in delayed receipt. Receiving cash earlier removes that uncertainty.
The Risk Attached to Cash Flows
Cash flows that are more certain and less risky are more valuable than those subject to higher levels of risk.
Value therefore increases when net cash inflows are higher, received earlier, or subject to less risk. Value decreases when the opposite is true.
Why Discounted Cash Flow Reflects True Value
In an ideal world, asset valuations would be carried out by discounting forecast future cash flows at a rate that reflects both the time value of money and the risks attaching to those cash flows. This approach is known as discounted cash flow, or DCF.
DCF captures subtleties that a single accounting profit metric multiplied by a multiple cannot.
When properly implemented, it forces the valuer to engage with fundamental drivers of value, including:
- Growth drivers
- Cost structure
- Capital expenditure requirements
- Strengths and weaknesses of the business
It also allows for the modelling of different scenarios and their impact on value, based on the likely future pattern of cash flows.
Why Earnings Measures and Multiples Are Used
Despite its conceptual strength, DCF requires reasonably reliable forecasts of future cash flows and a defensible estimate of the appropriate discount rate. In many real-world situations, this is simply not possible.
Practical Constraints in Valuation Exercises
Smaller entities are often less financially sophisticated and less able to produce the information required for a robust DCF valuation.
In addition, the budget for a valuation exercise may not justify the time, effort, and cost involved in building, explaining, and defending a full DCF model. Given that all valuations involve subjectivity, the perceived additional precision may not be considered worth the cost.
As a result, the theoretically sound gold standard must sometimes give way to practical realities.
The Appeal of Earnings Multiples
While crude, earnings measures and multiples are widely used because they offer several perceived benefits:
- They are relatively simple to understand, at least at a surface level
- Although research is still required to establish an appropriate multiple, the process is often quicker and less costly overall
Another commonly cited advantage is that this approach avoids the sensitivity issues inherent in DCF valuations. Small changes in growth assumptions or discount rates can have a significant impact on DCF outputs.
While this criticism is valid, it should be noted that earnings multiples simply obscure these same assumptions. They are embedded in the market data from which the multiples are derived rather than eliminated.
A further claimed benefit is that earnings multiples avoid the need to forecast future cash flows, which can be difficult even for stable businesses and nearly impossible for volatile or high-growth ones. However, the value being estimated exists only in those future cash flows, and a single-period earnings figure may be a very poor proxy. Many businesses that ultimately fail report healthy profits shortly before collapse.
Where Does This Leave Share Valuation?
Discounted cash flow remains the most powerful tool for understanding the true, intrinsic drivers of a company’s value. It enforces discipline and a fundamental approach to valuation.
Ideally, budget permitting, a DCF valuation would be used to establish value and then cross-checked against market sentiment and peer comparisons using earnings multiples.
In practice, however, this is often not feasible. Earnings multiples are therefore commonly used. Provided their limitations and inherent compromises are properly understood, there is nothing inherently wrong with this approach.
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Frequently Asked Questions
1. Why do profits have no intrinsic value in a share valuation?
Profits are an accounting construct and do not represent cash available to investors. Value lies in future net cash flows, not in reported earnings.
2. What is the main limitation of EBITDA-based valuations?
EBITDA ignores capital expenditure, working capital movements, tax, and financing costs, all of which affect cash flow and therefore value. Where the budget allows, combining EBITDA-based valuations with free cash flow analysis (taking account of expected capital expenditure and working capital movements) will give a better understanding of likely value.
3. Why is discounted cash flow considered the gold standard?
DCF directly values future cash flows while accounting for timing and risk, which are the true drivers of value.
4. Why are earnings multiples still widely used?
They are quicker, cheaper, and often the only practical option when reliable cash flow forecasts or sufficient budget are not available.
5. Can a profitable company still be worth very little?
Yes. Companies can report strong profits while generating weak or negative cash flows, particularly where they are overtrading or require significant ongoing investment. Companies that are not going to survive to convert the reported profits into cash, can have surprisingly little value.
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