The Little Book of Valuation
If we accept the proposition that normalized earnings and cash flows have a subjective component to them, we can begin to lay out procedures for estimating them for individual companies. With cyclical companies, there are usually three standard techniques that are employed for normalizing earnings and cash flows:
1. Absolute average over time: The most common approach used to normalize numbers is to average them over time, though over what period remains in dispute. At least in theory, the averaging should occur over a period long enough to cover an entire cycle. In chapter 8, we noted that economic cycles, even in mature economies like the United States, can range from short periods (2-3 years) to very long ones (more than 10 years). The advantage of the approach is its simplicity. The disadvantage is that the use of absolute numbers over time can lead to normalized values being misestimated for any firm that changed its size over the normalization period. In other words, using the average earnings over the last 5 years as the normalized earnings for a firm that doubled its revenues over that period will understate the true earnings.
2. Relative average over time: A simple solution to the scaling problem is to compute averages for a scaled version of the variable over time. In effect, we can average profit margins over time, instead of net profits, and apply the average profit margin to revenues in the most recent period to estimate normalized earnings. We can employ the same tactics with capital expenditures and working capital, by looking at ratios of revenue or book capital over time, rather than the absolute values.
3. Sector averages: In the first two approaches to normalization, we are dependent upon the company having a long history. For cyclical firms with limited history or a history of operating changes, it may make more sense to look at sector averages to normalize. Thus, we will compute operating margins for all steel companies across the cycle and use the average margin to estimate operating income for an individual steel company. The biggest advantage of the approach is that sector margins tend to be less volatile than individual company margins, but this approach will also fail to incorporate the characteristics (operating efficiencies or inefficiencies) that may lead a firm to be different from the rest of the sector.
What is a normalized price for oil? Or gold? There are two ways of answering this question.
1. One is to look at history. Commodities have a long trading history and we can use the historical price data to come up with an average, which we can then adjust for inflation. Implicitly, we are assuming that the average inflation-adjusted price over a long period of history is the best estimate of the normalized price.
2. The other approach is more complicated. Since the price of a commodity is a function of demand and supply for that commodity, we can assess (or at least try to assess the determinants of that demand and supply) and try to come up with an intrinsic value for the commodity.
Once we have normalized the price of the commodity, we can then assess what the revenues, earnings and cashflows would have been for the company being valued at that normalized price. With revenues and earnings, this may just require multiplying the number of units sold at the normalized price and making reasonable assumptions about costs. With reinvestment and cost of financing, it will require some subjective judgments on how much (if any) the reinvestment and cost of funding numbers would have changed at the normalized price.
Using a normalized commodity price to value a commodity company does expose us to the critique that the valuations we obtain will reflect our commodity price views as much as they do our views on the company. For instance, assume that the current oil price is $45 and that we use a normalized oil price of $100 to value an oil company. We are likely to find the company to be undervalued, simply because of our view about the normalized oil price. If we want to remove our views of commodity prices from valuations of commodity companies, the safest way to do this is to use market-based prices for the commodity in our forecasts. Since most commodities have forward and futures markets, we can use the prices for these markets to estimate cash flows in the next few years. For an oil company, then, we will use today’s oil prices to estimate cash flows for the current year and the expected oil prices (from the forward and futures markets) to estimate expected cash flows in future periods. The advantage of this approach is that it comes with a built-in mechanism for hedging against commodity price risk. An investor who believes that a company is under valued but is shaky on what will happen to commodity prices in the future can buy stock in the company and sell oil price futures to protect herself against adverse price movements.