Bear On Business - Tracking the Telecom Industry

Posted by Dan Caruso
May 21, 2009

Efficient Market Theory

Two day’s ago, the question was posed: Which of the following beliefs do you consider to be true?

Belief #1: Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

Belief #2: Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value. Wild swings in stock price reflect the market’s difficulty in calculating Intrinsic Value.

Yesterday’s post provided support for Belief #1. As discussed in 3.6X to 23.3X. Urk, modest changes in the growth rate and/or discount rate produce wild swings in Intrinsic Value. The Intrinsic Value of TWT, which was used as the illustration, really did experience a roller coaster ride in the past 12 months. The ride was fueled by an extreme change in the macro-economic environment. A year ago, the economy seemed A-OK. Six months ago was the Great Depression Redux. Today, the macro-economic environment is somewhere in between. Any reasonable expectation of cash flows would have changed materially, as would the discount rate. Therefore, it is natural to conclude that Intrinsic Value was being affected by the macro-economic environment.

This all supports Belief #1. Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. It would therefore follow that Intrinsic Value itself has wild swings. Nonetheless, I believe there is more to the story. But before I explain why, it is important to fully appreciate the stock market.

I went to University of Chicago and received an MBA. U of C is renowned in a lot of ways, but perhaps its most famous axiom is the Efficient Market Theory, it asserts that financial markets are “informationally efficient”, or that stock prices reflect all known information. It further asserts that the stock price reflects the consensus of highly skilled valuation professionals. It would naturally follow that the best estimate of Intrinsic Value of a public company is reflected in its stock price. Using the TWT example, today’s stock price of $11.28/share means that all of us should conclude that the best estimate possible of TWT’s Intrinsic Value is $2.4B.

I believe the Efficient Market Theory is an extremely important starting point. Anyone who seeks to trade stocks should understand and fully appreciate the EMT. Likewise, anyone who seeks to Measure Value Creation should pay homage to the EMT as well. This starts with the presumption that stock prices are usually set by the most savvy and most informed investors, not naive or poorly informed investors. The former are constantly looking to take advantage of the latter–and this dynamic results in the stock price finding its way to the price that the most skilled believe is appropriate. And these skilled investors, for the most part, understand the concept of Intrinsic Value. That is, the most skilled are opining on future cash flows and discount rates.

Keep in mind that I am focusing on the “most skilled” and I am distinguishing them from the “naive”. There are plenty of institutional investors with nice educational pedigrees that fall in the naive bucket. They pay little attention to future cash flows, and instead look at other factors such as historical trend, trading ranges, and multiples of similar companies. I put these folks in the naive bucket–and am skeptical of anyone who claims success with such investment strategies.

My point is this: Stock prices gravitate toward a consensus expert estimate of Intrinsic Value. This certainly supports Belief #1: Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

But as I said before, there is more to this story. To understand it requires a deeper look into the Efficient Market Theory.

So Now What?

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Stock Price provides Insight into Intrinsic Value

Yesterday’s post ended with a question: Which of the following beliefs do you consider to be true?

Belief #1: Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. Wild swings in stock prices reflect that Intrinsic Value itself can change dramatically over short periods of time.

Belief #2:: Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value. Wild swings in stock price reflect the market’s difficulty in calculating Intrinsic Value.

My answer is a bit of a cop out–I think the truth lies somewhere between the two extremes. Today’s post will discuss why Belief #1 cannot be easily dismissed.

As discussed in 3.6X to 23.3X. Urk, modest changes in the growth rate and/or discount rate produce wild swings in Intrinsic Value and EBITDA multiples. So perhaps the wild changes in TWT’s Enterprise Value were driven by very real changes in these two variables. A year ago, the financial crises had not quite hit stride. Six months ago, it looked like Great Depression Redux. Today, the macro-economic environment seems okay. In the absence of a financial crises, growth prospects for TWT were better and the discount rate would have been lower. In a depression scenario, growth prospects would be much worse and cost of capital far higher. Today’s outlook is somewhere in between.

Let’s map this to the definition of Intrinsic Value: “An enterprise is worth what its cash flows, appropriately discounted, are really going to be”. Any reasonable expectation of cash flows would have changed materially, as would the discount rate. Therefore, it is natural to conclude that Intrinsic Value was being affected by the macro-economic environment.

This all supports Belief #1. Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. It would therefore follow that Intrinsic Value itself has wild swings. Nonetheless, I believe there is more to the story.

So Now What?

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Does Stock Price reflect Intrinsic Value?

Last Friday’s post 3.6X to 23.3X. Urk was the most recent in a series on Measuring Value Creation. Friday’s post showed how modest variations in discount rate and growth rate can have a dramatic affect on the EBITDA multiple of a business. It ended with a statement of frustration: How could anyone possibly know–even approximately–what their business is worth? Before fully addressing this question, I draw your attention to an extremely important take-away.

Used casually, EBITDA multiples are dangerous proxies for estimating Intrinsic Value.

Let’s use TW Telecom to illustrate. Today, the stock price is about $11/share and their market cap (which is the value of their equity based on the current stock price) is $1.1B. They have about $1.3B of debt. Their Enterprise Value (based on today’s stock price) = ~$1.1B market cap + $1.3B debt = ~2.4B. $104M was their 1Q09 EBITDA; multiple this by 4 and the annualized is $416M. Divide $2.4B by 416M reveals that their EBITDA multiple is 5.76X.

Is 5.76X reflective of their Intrinsic Value? That is, does the current stock price translate into a good estimate of Intrinsic Value? Before you are quick to answer yes, consider TWT’s EBITDA multiple in their recent past. Six months ago, TWT’s stock price was ~$6/share. A year ago, it was $18/share. At $6/share, the Enterprise Value was $1.9B and the EBITDA multiple was 4.5x. At $18/share, EV = $3.1B and 7.3x was the multiple. These are sizable ranges.

So, is today’s $2.4B a good approximation of Intrinsic Value? Prior to answering, consider the following two beliefs:

Belief #1: Enterprise Value, as calculated using the current stock price, IS a good estimate of Intrinsic Value. It would therefore follow that Intrinsic Value itself has wild swings. That is, Intrinsic Value 6 months ago was $1.9B and 12 months ago, it was $3.1B. All three estimates were good approximations of the wildly changing Intrinsic Value.

Belief #2:: Enterprise Value, as calculated using the current stock price, IS NOT a particularly reliable estimate of Intrinsic Value. That is, Intrinsic Value today is not wildly different than it was 6 months ago or 12 months ago. The fact that Enterprise Value changed dramatically reflects the market’s difficulty in calculating Intrinsic Value.

So, readers, what do you think–#1 or #2? (MattyG–given your comment, I would be interested in your opinion.)

So Now What?

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“I am Dr. Realist” Newsweek Article

A recent issue of Newsweek Magazine contained an interview with Nouriel Roubini . In a September 2006 speech to the International Monetary Fund, Roubini warned that the global bubble was going to burst, earning him the nicknamed him “Dr. Doom”. Then the hard times hit, and Dr. Doom became the financial crises’ E.F. Hutton-the economic professor that experts began to listen more closely to.

Roubini, a The New York University professor, told NEWSWEEK’s Lally Weymouth that he sees more trouble ahead.

Excerpts:

How about the deficit the banks are building up?
In the short term I am supportive of it, because if we didn’t have these fiscal deficits, the recession would become a depression. On the other side, I do agree that this is not a free lunch. We are going to add trillions of dollars to our public debt, which is going to go from 40 to 80 percent of the GDP. There are only a few ways in which you can finance that extra public debt. If you rule out default and a capital levy on wealth, you either have the “inflation tax” or you have to painfully cut spending or raise taxes, and either one is not going to be politically palatable.

Do you worry about China getting tired of holding our bonds?
In the short run, China has no option but to accumulate more reserves and dollar reserves. Why? Because if they stop doing that, their currency would appreciate sharply while their exports are plunging. So in the short run, they are going to keep on accumulating. But I have seen a huge number of new initiatives in the last month that suggest [the Chinese] are pushing for the yuan to become an international currency and a reserve currency. They are doing bilateral deals with countries like Argentina and half a dozen others in yuan, not in dollars.

I post on this topic because I want all readers-regardless of their political affiliations-to grapple with the dangerous waters we are swimming in. Run-away government spending, even if driven by altruistic intentions, could harm us and our children for years to come. As Roubini warns, this is no free lunch.

So Now What?

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3.6X to 23.3X. Urk

In yesterday’s $6.25 to $40 post, we learned that $1 of annual payments could be worth between $6.25 and $40 depending on (a) the annual of the growth rate of the dollar, as it varies from 0% to 7.5% and (b) the discount rate, as it varies from 10% to 16%.

How does this variability affect the EBITDA mutliple?

npvof1b

In 11.6X EBITDA we derived an EBITDA multiple for a Bandwidth Business and declared 11.6x was Maybe or Maybe Not the answer. The math that produced the 11.6X was:

Three quarters from now, a Bandwidth Business’ annualized revenue is forecasted to be $100M and its EBITDA is $40M
The annual growth rate during this three quarters was 15%. Annualized capital was $35M
Had the business only have grown by 5%, the capital would have been $10M. SG&A in a 5% growth scenario would have been $42M, as SG&A costs would be materially lower in the 5% growth scenario
The cash flow generated by a $42M EBITDA business with $10M of capital is $25M (after we estimated income taxes to be $7M)
At a 5% growth rate and a 10% discount rate, the $25M is worth $500M
11.6X is calculated by dividing $500M by $42M

Well, this is all fine and dandy except for the table above. Had we just tweaked with the discount rate a little or slightly mis-estimated the growth rate, the 11.6X would be grossly incorrect. The table below shows the answer could range from 3.6X to 23.3X–ouch!

ebitdamultbandwidthd

This second table is derived from the table above, using the same math that determine the 11.6X multiple. Namely, $25M is multiplied by the various amounts in the first table and then divided by $42M.

This presents us with a dilemna. How could anyone possibly know–even approximately–what their business is worth?

So Now What?

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$6.25 to $40

A comment on yesterday’s11.6X EBITDA post was the perfect lead-in to today’s post. The post calculated that an appropriate multiple for a Bandwidth Business might be 11.6x EBITDA–hence the title. The math that led up to this was:

Three quarters from now, a Bandwidth Business’ annualized revenue is forecasted to be $100M and its EBITDA is $40M
The annual growth rate during this three quarters was 15%. Annualized capital was $35M
Had the business grown only by 5%, the capital would have been $10M. SG&A in a 5% growth scenario would have been $42M, as SG&A costs would be materially lower in the 5% growth scenario. The reason we took this step will be made more clear in this post and will be further discussed in the next
The cash flow generated by a $42M EBITDA business with $10M of capital is $25M (after we estimated income taxes to be $7M)
At a 5% growth rate and a 10% discount rate, the $25M is worth $500M
11.6X is calculated by dividing $500M by $42M

The very appropriate comment posted by Rob was:

“the growth assumptions and discount rates can cause wild swings in enterprise values, or really wild swings to leveraged equity”

As is nearly always the case, Rob is correct. In this post, I want to illustrate how wild the swings are. As you peruse, consider why I bifurcated the 5% growth scenario from the rest of the 10%. More on this in next post.

The table below calculates the Present Value of a $1 under various combinations of discount rate and growth rate. The top left shows the scenario of the $1 per year with 0% growth. It is worth $10. Two cells to its right shows the 5% growth scenario discussed above–the $1 growing at 5% a year is worth $20. However, that same $1 growing at 5% is worth only $9 if the discount rate is 16% instead of 10%. If the growth is 2.5% instead of 5%, and the discount rate is 16%, look out as the $1 is worth only $7 and some change.

npvof1b

The grid above considers only a small range of discount rates (10% to 16%) and a small range of growth rates (0% to 7.5%). Yet the outcomes range from $6.25 to $40.

So what happens to our 11.6 multiple? Tomorrow we will see…

So Now What?

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11.6X EBITDA

..continuation of discussions on multiples…

Yesterday’s post considered a Bandwidth Business that is growing rapidly–15% a year. Looking three quarters ahead, annualized revenue is $100M, EBITDA $40M, and Capital is $35M.

We bifurcated gross sales into a portion that has rapid payback period, and a portion that has long paybacks. $100K of the gross sales consumed only $10M of the $35M of capital, while the remaining $100K consumed $25M. If we stripped away the second $100K/month of gross sales, here is what this Bandwidth Business would look like in 4Q09:

$42M EBITDA (Despite lower revenue, EBITDA would be higher due to lower sales and service activation costs)
Growing at 5% a year
$10M Capital

Generally speaking, we should assume that the entity will pay taxes. Since taxes are paid on net income, not EBITDA, the tax assumption might be $8M.

So cash flow would be $42M minus $7M minus $10M = $25M.

In But my Business is Growing! post, we discussed the present value of getting paid $1M/year at a growing rate of 5%. When using a 10% discount rate, the present value math indicated that the value is $20M. So, assuming 10% discount rate, the $25M growing at 5%/year is worth $500M ($25M x 20). To get the EBITDA multiple, I simply divided $500M by $42M to get 11.6X.

Wow, a Bandwidth Business is worth 11.6X EBITDA!

Maybe. And Maybe Not. We will pick up more on this tomorrow.

So Now What?

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Estimating your EBITDA Multiple

…continuation of discussions on multiples…

A business is worth what its cash flows, appropriately discounted, are really going to be–and so goes my definition of Intrinsic Value. But until crystal balls are invented, we will need to recognize that our ability to predict future cash flows is limited. In the nearer term, financials can be forecasted accurately–and these forecasts should be the foundation for valuing a business. Once you get past a certain time–three quarter’s in my opinion–the discussion can shift to multiples.

In an earlier post, I explained why EBITDA, not Cash Flow, should be used in a capital intensive business like telecom. EBITDA is a better indicator of a company’s propensity to produce free cash flow. But when choosing an EBITDA multiple, the thought process must turn to how EBITDA translates into cash flow. Let me start out with using Zayo Bandwidth’s business to illustrate the thought process.

The “Bandwidth Business” uses fiber networks to deliver wavelengths and SONET/OC-n services to carriers and other big bandwidth hogs. It is a capital intensive business. In slow revenue growth environments, capital is required to maintain the network and augment bandwidth. In a fast growth environment, capital is the fuel of growth as construction of laterals and major augmentation of electronics is required to meet the rapidly growing demand.

In the “Bandwidth Business,” EBITDA is actually higher in lower growth periods than higher growth because low growth means less sales and service activation expenses. During lower growth periods, free cash flow is materially higher, as the capital program is also lower. To think through multiples, it is important to think through the economics of the business in lower growth environments. To illustrate, I will define a generic “Bandwidth Business”, using Zayo Bandwidth and similar businesses as context.

Per my methodology, I will focus on 4Q09, which is three quarters from now. Annualized 4Q09 revenue is $100M (hypothetical assumption to make math simple). Further assume that annualized EBITDA is $40M which is 40% of revenue and annualized Capital is $35M; therefore Operating Cash Flow is $5M. Finally, assume this business has been averaging about $200K of sales each month resulting in about a 15% revenue growth rate. Digging deeper, note that $100K of this revenue has rapid payback characteristics as it is largely on-net. Only $10M of the $35M of capital is to support this lower-hanging-fruit of $100K whereas the remaining $100K of harder-to-reach sales requires $25M of capital.

What if we only took the low-hanging-fruit of $100K? 4Q09 revenue would be slightly lower–perhaps $96M. But EBITDA would be slightly higher, say $42M, as we would have less sales and service activation costs. Our growth rate would shrink quite a bit, perhaps from 15% to 5%.

Would value be higher or lower in this slower growth scenario? Well, unless we are making bad decisions on the longer-payback sales, the value of the business would be higher in the more rapid growth scenario. But by removing the distortion of the longer-payback sales, we end up with more clarity for understanding how to choose an appropriate multiple. So, what would be an appropriate EBITDA multiple for the following business:

$42M EBITDA
Growing at 5% a year
$10M Capital

Tomorrow will be the answer…

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Multiples…

…continuation of value creation series…

I must start this discussion of multiples with a re-emphasis of the concept of Intrinsic Value. A business is worth what its cash flows, appropriately discounted, are really going to be–and so goes my definition of Intrinsic Value. No where in the definition is EBITDA mentioned. And no where do we discuss “multiples” of EBITDA or, for that matter, multiples of anything else. And, importantly, no where do we refer to the New York Stock Exchange, the NASDAQ, or the “multiples of similar public companies”, also referred to as “comps” or “comparisons”. Nope, if you want to know what your business is worth, all you need to know is what cash flows will really be plus the discount rate that is appropriate for your company’s situation.

Unfortunately, crystal balls have not yet been invented.

In lieu of a crystal ball, I emphasize the importance of developing a strong competency around forecasting income statement, balance sheet, and cash flow statement. I view the horizon of “three quarters from now” as being the period of time where accurate forecasting can be made. Beyond three quarters, forecasting becomes increasingly guesswork. Therefore, I recommend shifting to the use of a multiple.

In the prior post, I explained why multiples of free cash flow are not reliable in a capital intensive recurring revenue business. EBITDA is much better to use in a multiple calculation. But what multiple is appropriate? I will answer this over the course of the next handful of posts. For now, I will leave you with a clue. The multiple should be estimated based on two factors:

The business’ ability to generate free cash flows in the future
The discount rate that best reflects the uncertainty of future cash flows

More to come….

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Why not Multiple of Free Cash Flow?

…Continuation of Measuring Value Creation Series…

Throughout this series, we discussed at length the reason for focusing on “three quarters from now”. This time-period is the best reflection how the goings-on in today’s business will translate into bottom line financial performance.

Most recently in the series, we discussed how the true value of an enterprise–also referred to as Intrinsic Value–is based on what the cash flows of the business, appropriately discounted, are really going to be. Yet, in my methodology, free cash flow is not explicitly considered in the valuation of the business “three quarter’s from now”. Instead, we use a multiple of EBITDA. Our estimate of the free cash flow “three quarters from now” is just as reliable as EBITDA. Why not do a multiple of cash flow instead of EBITDA?

As I address this question, please note that my methodology is geared toward a facilities-based telecommunications business. A characteristic of this sector is its capital intensity. When business is booming, capital program increases dramatically. It fuels the growth. Investments are being made in the current quarter that are intended to create shareholder value in years to come. Conversely, when business slows, the capital is scaled back. Free cash flow increases dramatically, but growth in coming years looks less exciting.

In boom years, capital can be materially higher than EBITDA even for a highly profitable business. Expansion opportunities are plentiful. Free cash flow “three quarters from now” will be negative. No “multiple of free cash flow” will calculate into a meaningful estimate of valuation.

Conversely, a less profitable business might show higher cash flow because they have few growth prospects. They go into “milk the base” mode. The fact that this business’ cash flow is higher than the rapidly growing one does not indicate a higher value. In fact, the reality is just the opposite.

When we talk more about the choice of “multiple”, we will incorporate growth expectations into the discussion. In this post, I want to cover only the point that free cash flow in any given quarter is prone to be an unreliable measure of the business’ future prospects of producing free cash flow.

So what is a reliable indicator of a business’ propensity to produce free cash flow? EBITDA! If growth prospects slow, a material portion of the EBITDA will translate into free cash flow. Consider two businesses in the same industry sector–say fiber-based telecom. The first has EBITDA that is double that of the second. A good starting point assumption is that the first is worth about double that of the second.

Does this help you understand why so much focus is put on EBITDA? At the same time, I hope it is also beginning to shed light why EBITDA-focus should not overshadow free cash flow. At the end of the day, a business is worth what its free cash flows, appropriately discounted, are really going to be. A multiple of EBITDA is simply a shorthand method for estimating Intrinsic Value. When the sun sets over the horizon, it is Intrinsic Value–not muliple of EBITDA–that will matter.

So Now What?

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Efficient Market Theory

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Stock Price provides Insight into Intrinsic Value

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Multiples…

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