The shift in how financial modelling courses work is noticeable. A decade ago, delegates were fascinated by financial models, sometimes quite irrespective of their predictive power. Careers were built, and consultancies prospered, on the basis of understanding how to build complex financial models. Those days are now over. Today, the emphasis in both modelling and valuation courses is on how to generate plausible assumptions that can generate equally plausible DCF valuations.
But there is still a fundamental contradiction at the heart of valuation. Analysts and investors alike realise that the plausible DCF valuations models generate often simply do not match reality.
The current state of play with FMCG companies demonstrates the contradiction to perfection. Analysts call current FMCG values ‘outrageous’. Merrill Lynch in India, for example, suggest that FMCG valuations are threatening to diverge materially from their equivalents in other markets. Certainly, companies defying accounting scandals to trade at 40-60 times forward earnings – yes, you read that right, 40-60 – imply a complete reversal of single figure historical growth in earnings if anything like a match between these valuations and a DCF model can be achieved. Tax cuts and other regulatory reforms can only have a one-off effect, whereas to achieve anywhere near this kind of growth would mean a doubling of consumer spending within a decade, and then again in the following decade.
This in itself might not actually be too implausible, but the DCF modelling implications of this kind of valuation are astounding. Suppose a discount rate of 12% and a revenue growth rate of 10%, neither terribly unreasonable assumptions in themselves. But when combined with a forward net income multiplier of 40, the necessary number of years to support this valuation is no fewer than a staggering 85.
There are many reasons to doubt the plausibility of this number. First, companies simply do not usually live this long; the average lifetime of companies is undoubtedly shrinking, not least in the FMCG space. Second, the high brand values that have supported FMCG companies’ valuations have been generated by consumer loyalty which is now under threat. One has only to look at queue-less Starbucks in London or Sandton to see the writing on the wall for the global FMCG brands that dominated the brand rankings of the 2000s and which provided double digit total returns for the whole decade and often many more before. Think Coca-Cola, Nestlé, Unilever, Johnson & Johnson or SAB. 25% above ‘unbranded’ equivalents is looking increasingly impossible to achieve across the board, as smaller companies develop brand loyalty of their own, especially from Millennials who are looking to local specialisation – McKinseys reports that Millennials are four times less likely to buy from established food companies than baby boomers. Their expectations of food safety, in particular, do not appear to vary according to the size of the seller. The rise of plain packaging legislation globally also threatens at least some FMCG companies, tobacco in particular – ironic, given the rapid rise of the cannabis industry in Canada and some US states. Third, privileged relationships with retailers, supermarkets in particular, are now wide open to disintermediation and disruption from online delivery mechanisms, which the IoT and the blockchain can only reinforce. Economies of scale in FMCG actually seem to be in retreat, playing to the advantage of VC companies and corporate venturing from established players, which are investing in smaller FMCG firms, boosting their valuations in turn. The evidence in the USA in clear: FMCG companies’ growth in total returns lagged the S&P 500 by 3% in the five years to 2017, compared to outperforming it a decade ago. The largest global companies in particular are exhibiting sluggish growth, even when compared to GDP, let alone to online retail. Curbing expense growth brings risks of short-termism. Threats to global trade and exchange rate volatility has not played to their advantage either.
The real cause of the continued defiantly high FMCG valuations, especially in developing markets, remains of course supply and demand. When pressed, investors shrug at the financial models that are shouting overvaluation. They admit that the lack of alternative investments is the real cause for the continued enthusiasm for the sector. If a company fails to deliver in the short term, the future can be called in aid. The use of comparables as an FMCG valuation method, assisted by a growing reservoir of valuation databases providing data on net revenues, produces only a continuation of the myth. Provided there is no one to question forecasts that remain hazy, the conditions are right for the continuation of what in other times might be described as a bubble.