How a valuation model may inform investor relations Jim Robinson

There are many ways to value a company and over the years trends have changed, but each method has some fundamental information requirements to make the valuation fair. By looking at one of these models, all be it in a relatively raw form, it starts to paint a picture of how narrative and imagery can help guide opinion through a more thorough education process on your individual investment proposition. In the end, an analyst will 'take a view' on your prospects, however, you can help towards making it a more informed view.

Let's look at discounted cash flow, so can you review how an analyst might decide whether your company is under or overvalued, and how they arrive at a target share price. An existing and potential investor will be looking for guidance to answer these sorts of questions, so you need to inform them appropriately.

For many models, at the end of the day, it is all about cash, and in particular free cash flow. In simple terms it's about how much free cash flow a business can generate in future. This cash is used to either, invest in value generating projects, or, distribute to its shareholders. Either way it adds value to the shares.

Understanding how much cash will be available is very difficult. It involves taking a view on what they think will happen in the future, so you can help to shape that picture of things to come.

By making projections on revenues, profits, taxation, possible investments and exceptional items as well as many other non-financial factors like marketplace, strategy, quality of management and a company’s capabilities, an analyst will engineer what he or she thinks will be the amount of cash that can be generated over a period of time.

Investors have different investment strategies, and for many managers the funds which they operate will legislate the time horizon for investment. This will clearly have an impact on the calculation. It is important to understand the shape of your investment proposition and articulate it clearly, remembering that investors don't like surprises.

The basic principle of net present value is that £1 today will be worth less tomorrow and a lot less in 5 or 10 years time (taking into account inflation and the business risk compensation). It is the analyst's job to guess the potential ‘free cash’ that can be generated by a business and determine how much the value of that cash would be worth today.

In effect they will apply a discount factor to any future cash to compensate for having to wait for it, allowing for the fact that you may not pay it back at all.  £1 in 5 years time may only be worth 20p in today's money. You will need to explain your view on the level of risk the investor is taking and the time frame in which it will be generated.

That done, based on their best guess, the value arrived at divided by the shares in issue gives a target price, and thus a buy or sell recommendation.

So how does that change IR? Well by putting yourselves in the position of trying to guess your future cash flow, you will build up a picture of what information you will need to use, or indeed the information you feel should be used to reach that guess. Therefore, a little reverse engineering on those information inputs starts to shape your communication strategy.

At Jones and Palmer we try to review your business communication needs at arms length (something we like to describe as an outside-in perspective, as opposed to an inside-out perspective), and hope to add some structure to your communications, enabling outsiders to reach the right view. Please feel free to give any one of our Account Directors a call to discuss how we can help.