Harry is a magical pig. He sheds gold coins. You want to estimate Harry's value, what are your thoughts?

Here are the answers you shared with me and my interpretation. The different points that follow will allow me to introduce the most used valuation models in the world. I have taken the liberty of grouping several of your answers together when they had common characteristics. 

The concept of future flows

How many gold coins is Harry disposing of daily? What is the value of these gold coins?

This question seems obvious, yet when it comes to valuing a business, the thought process is not straightforward for everyone.

Some of my colleagues who work in private equity have even shared with me that it is common to meet business leaders who are ready to sell their baby for the amount of shareholder's equity on the balance sheet. However, in finance, we value according to what the investment will bring us in the future, this is the main idea behind the most used valuation model in the world: The DCF (Discounted Cash Flows) by which we calculate the operational value of a business by adding up the future cash flows that creditors and shareholders will receive, taking care to discount these flows according to the moment when they will be received (the more distant a cash flow is, the less weight it will have in the final value). We value a potential, the risk of which is modelled by a discount coefficient. To model Harry's value, it is therefore essential to gather information on his future production. Obviously, in order to make coherent assumptions, we will base ourselves on historical production and on the evolution of prices for the type of product that Harry transforms, but the flows generated in the past will not be taken into account in the calculation of Harry's value.

What is Harry's life expectancy and how old is he? How has his production changed recently?

In order to value Harry, we quickly realize that making assumptions is something that cannot be avoided. Harry is a magical pig, but does that mean he will live forever? You'll have to consider several scenarios and carefully monitor Harry's behavior to understand if his health deteriorates. On markets, it's the same: we can't be sure of anything. Analysts constantly study different scenarios, weighting them according to their probability of occurrence and updating them when new information becomes available.

Think in terms of value, not price

In what environment will Harry live? Is his owner a gold trader?

These are all very interesting questions. They lead us to consider the notion of value, which is very different from price. It is important to understand 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, and depending on who gets their hands on an asset, its profitability may change. Is Tiffany &Co worth more when it is consolidated into the LVMH group? And what about Porsche if it is taken out of the Volkswagen group? It is obvious that M&A analysts ask themselves these different questions to determine the amount they are willing to invest.

If Harry's owner is a sharp negotiator who knows the gold market well, this will undoubtedly be a real advantage. The same goes for a seasoned pig farmer who knows his animals well.

Investments

Does Harry need a pen? Do you need to buy a van to transport Harry? Can we improve Harry's living environment in the hope of increasing his production?

We're coming back to some fairly obvious questions that several people have raised. Thinking in terms of 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 are made, they will have a more or less significant weight. It may be worthwhile to locate Harry near a foundry as soon as possible to optimize the transformation process. Each new cash outflow must be carefully considered based on the profitability gain created. Similarly, Harry's profitability must be compared to the cost of financing to be sure that the leverage created is value-creating.

What does Harry eat? How much does it cost? How long will it take our customers to pay us?

Still in this notion of investment, the question here is about working capital. Even if Harry is magic, he certainly needs to eat! Nothing is lost, everything is transformed, isn't it? If feeding Harry allows him to increase his production, the future owner will not ask himself thousands of questions before taking the plunge. However, will he be able to financially advance the increase of 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 some of his finances for this purpose? Again, if the owner of the pig is a good negotiator, he could possibly ask his customers to pay earlier, for example upon delivery of the gold, or even earlier. This strategy would allow him to optimize his cash management.

Management

Is Harry's talent hereditary? Can Harry reproduce himself?

My interpretation of these different questions is not straightforward, as you will agree. I'm making the connection here with the management style of a company. Will Harry's owner be able to raise him in the right conditions, will he be able to make the right decisions? Let's say Harry can breed, maybe that 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're relying on the executive's judgment. We will be sure to study the results of his past experiences in order to understand his management style.

Is Harry the only magic animal?

This is a rather surprising thought when you stick to Harry's framework, but it is ultimately the first reflex that investors have when it comes to putting a price on something: are there comparables? Perhaps a golden goose was sold a few days earlier? How much did the buyer pay to get his hands on it? Does the chicken produce less than Harry? Are the eggs harder to sell than the coins Harry is getting rid of? This question obviously leads us to consider comparative valuation by multiples, another model widely used when a representative sample is found or when data on a company's past performance is lacking.

This reflection may also lead us to believe that Harry is not in an oligopolistic situation. If the owner discovers the day after his purchase that his neighbor is hiding a magic chicken in his garage, then he will be hard pressed to negotiate his sale price with the local gold miner, as will his grain suppliers who have been dealing with his neighbor for years.

Harry's residual value

If Harry dies tomorrow, is there anything left to sell?

Now that's a novel question! What about Harry's net asset value? When a business comes to the end of its life, its value approaches that of its net assets (what is left when all the assets are disposed of and the debts paid off). Even if Harry's future looks bright, the possibility of a tragic event occurring must be considered. So even though it is appropriate to value Harry based on the cash flow he will generate, it is essential to calculate his residual value. Basically, is Harry edible and how much does he weigh?

The notion of responsibility

Is exploiting a pig badly perceived by the market, are my values in line with such a business? What happens if the owner starts to feel sorry for Harry?

Now we come to extra-financial issues that can have a significant impact on Harry's value. Clearly, if we assume that humans have no empathy and that animal abuse is just a fantasy, we expect investors to flock to the town square when Harry is put up for sale. How much will the ethical values of the crowd influence potential buyers? Clearly, Harry will always find a buyer, and he will potentially make a good deal if his price falls without the protests against the farmer affecting the pig's production capacity or the price of gold. But it is clear that if, in the long run, this can have an impact on Harry's selling price and thus the future owner's capital gain, he must take this 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 ways of thinking that were discussed not only by the students in class when the professor asked us to do so, but also by you, when you reacted to the twitter post that I published a few weeks ago. Together, we put our finger on several key points of financial evaluation, but you will agree that this is not an exhaustive list. This playful 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 you know is reluctant to use DCF valuation, ask him to value Harry and he will realize by himself that the logic behind this model is far from being illogical.