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13. Return on Investment
Valuing a company is all well and good but what we ultimately want to know is our return on investment. In this lesson, I calculate the NPV and IRR for a buyer of MarkerCo, given a certain asking price.
Lesson Goal (00:04)
The goal of this lesson is to calculate the return on investment an investor would receive for buying some or all of MarkerCo.
Calculating Net Present Value (00:15)
In this lesson, we assume that a potential investor wants to buy all of the shares in MarkerCo. The return on investment depends on the purchase price for the company, and the value of the future cashflows from the company.
Calculating the Net Present Value, or NPV, is straightforward. We subtract the purchase price from the equity value of the business. The result is the NPV. This means that the NPV is higher when the purchase price is lower, as we would expect.
Calculating the Internal Rate of Return (01:21)
To calculate the Internal Rate of Return, or IRR, we need to calculate the relevant cashflows from the model. In the purchase year, the cashflow will be the purchase price minus the existing cash balance which can be used to fund the purchase. In future years, the cashflows will be the unlevered free cashflows and the terminal value from our Excel model. Once we’ve identified the relevant cashflows, we simply use the IRR function to calculate the Internal Rate of Return.
We can also analyze the impact of different scenarios on the IRR by using the switch cell to switch between different scenarios. The IRR updates automatically when we do this. We can also create a sensitivity analysis for the IRR based on different values of the exit multiple and the purchase price. This helps us identify what conditions will make the investment a good deal.
The Art of Valuation (03:34)
When valuing a company, a lot of subjective judgments are required. As a result, valuation can be considered an art as much as it is a science. For this reason, it’s good to apply a margin of safety if investing in a company. You should assume you are overvaluing the business by a certain amount, for example 20%. You should then only invest if it makes sense to do so at this lower valuation. A skilled investor combines tried and tested valuation techniques with superior knowledge of a company and industry to deliver excellent results.
Now that we have a valuation for our company, a would-be investor would want to know what return he will get on his investment for buying a stake or all of MarkerCo.
The easiest return to model is if the investor purchases all of MarkerCo. So, in this, our first course in valuation, we'll assume that the would-be investor wants to buy all of MarkerCo's shares. The return on investment is dependent on two things. How much the investor thinks that MarkerCo is worth, and the price he pays for the company. When we approach MarkerCo's CEO, he tells us that the business could be bought for 240 million dollars. And so further up the page, I've entered this value as the asking price of the business. To calculate the MPV on this transaction is very easy as we already have the discounted cash flow calculations completed. So we simply subtract 240 million from our valuation to get the MPV.
So I'll select our implied equity value.
And then enter the asking price. And this gives me a net present value of 83.5 million. Next, let's calculate the IRoR. The internal rate of return or IRoR, is a little more difficult as we need to extract the cash flows from the model. At the end of 2015 or day zero, we need to pay 240 million, but we also have the existing cash on the Balance Sheet on day zero of 69 million which we can use. So in 2015, I have the cash figure and I subtract the asking price of the business. For the remaining years, I simply pull the free cash flows that I calculated previously including the terminal value. So I'll scroll up.
And select the relevant cash flows which will be the annual unlevered free cashflow and the terminal value. And I'll copy across for the remaining cells.
I can now calculate my IRoR by writing equals IRoR and selecting the cash flows.
This tells me that buying the company for 240 million under my best case scenario gives me an IRoR of 20%.
Let's now check what our IRoR would be if we used the pessimistic scenario. So scrolling up.
I select pessimistic and when I get to PgDn, I can see that this effects my IRoR so that it now equals to only 8%. With control zed, I'll flip this back to base.
As you can probably guess, I often run a sensitivity on our IRoR based on say exit multiple and perhaps selling price.
And this tells me that my IRoR will range between 13% and 26% for different exit multiples and selling prices on my data table. From this table and other lessons in this course, you've probably noticed that valuation is as much an art as it is a science. Different but justifiable methods for valuation can lead to very different answers. As a consequence, I would always recommend using a margin of safety if you are ever thinking of buying a business or purchasing the shares of a company. The margin of safety assumes that your valuation is always out by 20% on the down side. So if you think that a company is worth 100 million dollars, assume it's worth 80 million dollars and see if the investment thesis still holds. Because valuation is more an art than a science, lots of money is to be made and lost when buying and selling company shares. The ultimate difference is your ability to apply superior knowledge about the company and its market to tried and vested valuation techniques that will hopefully help you out perform and make excellent investment judgements. In this course, I have simplified a lot of the details to help you understand the basics of valuing a company. For example, MarkerCo has no debt to speak of, no intangible assets or any complications around the equity structure. In future lessons, we will include many of these additional complexities to further enhance your ability to value companies.