Valuations for high working capital

Im working on the valuation of a company with high (and uncertain) working capital … they are driven by massive payables and recievables which show in their CFO. I was previously using DCF but the terminal value is very sensitive to terminal assumptions of payables/recievables. Im also aware of the residual income model … you think that would be a feasible option? … or if u have any ohter opinions feel free to share.

Your question is outstandingly vague. Regardless of the relative size of AR and AP, all you need is their growth rate to be stable. If it’s not, then keep extending your model until it is. Yes, terminal values are highly sensitive to a lot of assumptions – because that’s often where most of the value is. Don’t see why you expect alternative valuation approaches (such as RI) to work any better if you don’t have a handle on estimates yet. If values are uncertain, then you should supplement your analysis with sensitivity analyses – providing value as a range rather than a point estimate.

DCF or any valuation model involving projects may not be the best in situation where a few key inputs are highly volatile. Extending your DCF forecast out to many years and applying a “stable state” assumption does not solve the problem at all - the fact that working capital is volatile (as described by kwblitz) would suggest that pinning down the “stable state” is the problem, not whether DCF horizon is long or short. Sometimes a simpler approach that looks at the current state instead of future may be better. If the company is asset heavy - look at the asset value Look at comparable P/E - Accounting earnings has a smoothing nature, just adjust it for extraordinary items and estimate what’s the “sustainable” earnings If you insist on DCF, then break it up into parts. Discount the cash flow before working capital to see what the company’s value is before considering working capital, then see how wide the range does WC affect value. At least this way you understand what you are dealing with and you’ll just have to build in your own margin for error to determine the value. If you can give more background info about the company in question, I am sure others can give you more insightful suggestions.

thanks DareinHacker and Zuran for your feedback … it really helped … the WC will never reach a stable state so extending the DCF is not an option. but yes it could be broken down into parts. CF before WC could be discounted and a sensitivity could be performed on CF from WC. I might end up doing tht. the RI i was thinking of using because, firstly, it doesnot give weight to the terminal value and secondly, it is based on the book values and residual income ignoring the impact of WC. Thnks again.

How would you extend out a model to make growth rate stable? Just curious, not calling you out.

Working capital intensive businesses are generally valued on a price to tangible book basis because theoretically the company can be acquired and liquidate the assests (sell off inventory, collect receivables etc . . .) They are also typically valued on a EV/EBITDA basis as short term debt is generally used to fund working capital unless CFO provides the company the flexibility to self fund. If the company is not earning its cost of capital, it should trade at no more than tangible book, and in fact deserves a discount. If they are earning their cost of capital, look at peer tangible book value premiums and forward EV/EBITDA estimates. This is much simplier and less error prone.

Nuppal, you could extend the model out inot the future till working capital assumes a more stable state … if it is caused by a one off event. like the liquidity crisis where we could possibly see ahike in reciavbles an payables. so taking apporpriate assumptions till tht event is resolved we could extend it furhter till where it assumes a more consisitent trend.