Harry is a magical pig. He gets rid of gold coins. You want to estimate the value of Harry, what are your thoughts?
Here are the answers you shared with me as well as my interpretation. The various points that will follow will in particular allow me to introduce the most widely used evaluation models in the world. I took the liberty of grouping together several of your answers when they had common characteristics. Before reading on, try the exercise on your own.
The concept of future flows
- How many gold coins does Harry offload daily? What is the value of these gold coins?
This question seems obvious, and yet, when we want to value a company, the reflection is not direct for everyone. Some of my colleagues who practice in private equity have even told me that it is common to meet CEOs willing to sell their baby for the amount of equity on the balance sheet. However, in finance, we value according to what the investment will bring us in the future, this is also the main idea behind the most widely used valuation model in the world: the DCF ( Discounted Cash Flows) by which the operational value of a business is calculated by adding the future flows that creditors and shareholders will receive, taking care to discount these flows according to the moment when they will be perceived (the more distant a cash flow, the less weight it will have in the final value). A potential is valued, the risk of which is modeled by a discount coefficient. It is therefore essential to model the value of Harry, to collect information on his future production. Obviously, to make coherent assumptions, we will base ourselves on historical production as well as on the evolution of the prices of the type of product that Harry transforms, but the flows generated in the past will not be taken into account in the calculation of the value. from Harry.
- What is Harry’s life expectancy and how old is he? How has his production evolved lately?
To value Harry, we quickly realize that making assumptions is something essential. Harry is a magical pig yes, but does that mean he will live forever? We will have to consider several scenarios and carefully monitor Harry’s behavior to understand if his health is deteriorating. On the markets, it’s the same, we can’t be certain, analysts are constantly studying different scenarios, which they weigh according to their probability of occurrence and which they update when new information is available.
Reasoning in value and not in price
- What environment will Harry live in? Is its owner a fine gold negotiator? A pig farmer?
These different questions are very interesting. They lead us to consider the notion of value, which is quite different from price. It must be understood that the value of an investment depends on its profitability just as the value of capital depends on the rate at which it is invested, but depending on who gets their hands on an asset, the profitability of this asset can be brought to change. Is Tiffany&Co worth more when the company is consolidated in the LVMH group? Does Ecore gain in value when the company is acquired by Derichebourg? And what about Porsche if it leaves the scope of Volkswagen? It is obvious that M&A analysts ask themselves these different questions to determine the amount they are ready to invest.
If Harry’s owner is a good trader who knows the Gold market well, this will undoubtedly be a real advantage. Same thought if it is a seasoned pig breeder who knows these animals well.
- Does Harry need a pen? Should we buy a van to transport Harry? Can we improve Harry’s living environment in the hope of increasing his production?
We return to fairly obvious questions that several people have raised. Thinking in flow also means taking into account the investments necessary for the sustainability of production. Since we apply a discount factor to future cash flows, we understand that depending on when these investments will be made, they will have a more or less significant weight. It can be interesting to install Harry near a foundry as soon as possible to optimize the transformation process. Each new outflow of money must be studied carefully based on the profitability gain created. Similarly, Harry’s profitability must be compared to financing costs to be certain that the leverage effect created creates value.
- What does Harry eat? How much does it cost ? How long will our customers take to pay us?
Still in this notion of investment, the question here concerns the need for working capital. Even though Harry is magical, he definitely needs to eat! Nothing is lost, everything is transformed, isn’t it? If feeding Harry increases his production, the future owner will not ask himself thousands of questions before taking action. However, will he be able to financially advance the increase in Harry’s rations? What about the price of his food? Is it volatile? Seasonal? Will the owner have to build up strategic stocks and therefore freeze part of his finances for this purpose? Again, if the owner of the pig is a fine negotiator, he could possibly ask his customers to pay earlier, as soon as the Gold is delivered for example or even upstream. This strategy would enable it to optimize its cash management.
- Is Harry’s talent hereditary? Can Harry reproduce?
My interpretation of these various questions is not direct, you will agree. I make here the link with the style of management of a company. Will Harry’s owner be able to raise him in good conditions, will he be able to make the right decisions? Let’s say Harry can reproduce, maybe it will put him in danger, maybe Harry will stop producing gold coins. We don’t have the answers to these questions at the time of investment, so we rely on executive judgment. Care should be taken to study the results of his past experiences in order to understand his management style.
- Is Harry the only magical animal?
This is a rather astonishing reflection when we stick to Harry’s framework, but it is ultimately the first instinct that investors have when it comes to putting a price on something: are there comparable? Maybe a golden egg hen was sold a few days earlier? How much did the buyer pay to get their hands on it? Does the hen produce less than Harry? Are the eggs harder to sell than the coins Harry is dumping? This question obviously leads us to consider the comparative valuation by multiples, another model widely used when a representative sample is found or when there is a lack of data on the past performance of a company.
This reflection can also let us think that Harry is not in an oligopolistic situation. If the owner discovers the day after his acquisition that his neighbor is hiding a magic hen in his garage, then he will be very annoyed to negotiate his selling price with the local gold miner, the same for his grain suppliers who have been dealing for years with his neighbor.
Harry’s Residual Value
- If Harry dies tomorrow, is there anything left to sell?
Here is an original question! What about Harry’s Net Asset Value? When a business reaches the end of its life, its value approaches that of its net assets (what remains when one separates from all the assets and then repays the debts). Even though Harry’s future looks bright, the possibility of a tragic event occurring must be considered. So even if Harry should be valued on the basis of the flows he will generate, it is essential to calculate his residual value. Basically, is Harry edible and how much does he weigh?
The concept of responsibility
- Is exploiting a pig badly perceived by the market, are my values in line with such a business? What will happen if the owner takes a liking to Harry?
We now come to extra-financial issues that can have a significant impact on Harry’s value. Obviously if you consider that humans have no empathy and animal abuse is just fantasy, you would expect to see investors flocking to the town square when Harry is put on sale. To what extent will the ethical values of the crowd influence potential buyers? It is obvious that Harry will always find a buyer, and this one will potentially make a good deal if its price falls without the demonstrations against the operator calling into question the production capacity of the pig or even the Gold prices. But it is clear that if, in the long term, this can have an impact on the sale price of Harry and therefore the added value of the future owner, he must take it into account. This is also why, from my point of view, speculators play a key role in the evolution of stock prices.
We went through the different lines of thought addressed not only by the students in class when the teacher asked us, but also by you, when you reacted to the twitter post I made a few weeks ago. Together, we have put our finger on several key points of the financial assessment, but you will agree, this is a non-exhaustive list. This fun experience will allow me to introduce the evaluation models that will be the subject of future articles. In the same way, if one day someone around you is reluctant to value DCF, ask them to value Harry and they will realize for themselves that the logics behind this model are far from being aberrant.