Chepakovich valuation model
Encyclopedia
The Chepakovich valuation model uses the discounted cash flow
valuation
approach. It was first developed by Alexander Chepakovich
in 2000 and perfected in subsequent years. The model was originally designed for valuation of “growth stock
s” (ordinary/common shares of companies experiencing high revenue growth rates) and is successfully applied to valuation of high-tech companies, even those that do not generate profit
yet. At the same time, it is a general valuation model and can also be applied to no-growth or negative growth companies. In a limiting case, when there is no growth in revenues, the model yields similar (but not the same) valuation result as a regular discounted cash flow to equity
model.
The key distinguishing feature of the Chepakovich valuation model is separate forecasting of fixed (or quasi-fixed) and variable expenses for the valuated company. The model assumes that fixed expenses will only change at the rate of inflation
or other predetermined rate of escalation, while variable expenses are set to be a fixed percentage of revenues (subject to efficiency improvement/degradation in the future – when this can be foreseen). This feature makes possible valuation of start-ups and other high-growth companies on a fundamental basis, i.e. with determination of their intrinsic value
s. Such companies initially have high fixed costs (relative to revenues) and small or negative net income
. However, high rate of revenue growth insures that gross profit (defined here as revenues minus variable expenses) will grow rapidly in proportion to fixed expenses. This process will eventually lead the company to predictable and measurable future profitability
. Unlike other methods of valuation of loss-making companies, which rely primarily on use of comparable valuation ratios, and, therefore, provide only relative valuation, the Chepakovich valuation model estimates intrinsic (i.e. fundamental) value.
Other distinguishing and original features of the Chepakovich valuation model are:
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
valuation
Valuation
-Economics:*Valuation , the determination of the economic value of an asset or liability**Real estate appraisal, sometimes called property valuation , the appraisal of land or buildings...
approach. It was first developed by Alexander Chepakovich
Alexander Chepakovich
Alexander Chepakovich was born in 1963 in the Republic of Belarus.In 1985 he graduated from the Belarusian National Technical University , in 1993 - from the University of British Columbia , and in 2000 - from McGill University...
in 2000 and perfected in subsequent years. The model was originally designed for valuation of “growth stock
Growth stock
In finance, a growth stock is a stockof a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry...
s” (ordinary/common shares of companies experiencing high revenue growth rates) and is successfully applied to valuation of high-tech companies, even those that do not generate profit
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
yet. At the same time, it is a general valuation model and can also be applied to no-growth or negative growth companies. In a limiting case, when there is no growth in revenues, the model yields similar (but not the same) valuation result as a regular discounted cash flow to equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
model.
The key distinguishing feature of the Chepakovich valuation model is separate forecasting of fixed (or quasi-fixed) and variable expenses for the valuated company. The model assumes that fixed expenses will only change at the rate of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
or other predetermined rate of escalation, while variable expenses are set to be a fixed percentage of revenues (subject to efficiency improvement/degradation in the future – when this can be foreseen). This feature makes possible valuation of start-ups and other high-growth companies on a fundamental basis, i.e. with determination of their intrinsic value
Intrinsic value
Intrinsic value can refer to:*Intrinsic value , of an option or stock.*Intrinsic value , of a coin.*Intrinsic value , in ethics and philosophy.*Intrinsic value , in philosophy....
s. Such companies initially have high fixed costs (relative to revenues) and small or negative net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
. However, high rate of revenue growth insures that gross profit (defined here as revenues minus variable expenses) will grow rapidly in proportion to fixed expenses. This process will eventually lead the company to predictable and measurable future profitability
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
. Unlike other methods of valuation of loss-making companies, which rely primarily on use of comparable valuation ratios, and, therefore, provide only relative valuation, the Chepakovich valuation model estimates intrinsic (i.e. fundamental) value.
Other distinguishing and original features of the Chepakovich valuation model are:
- Variable discount rate (depends on time in the future from which cash flowCash flowCash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
is discounted to the present) to reflect investor’s required rate of return (it is constant for a particular investor) and risk of investment (it is a function of time and riskiness of investment). The base for setting the discount rateDiscount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
is the so-called risk-free rate, i.e. the yield on a corresponding zero-coupon Treasury bond. The riskiness of investment is quantified through use of a risk-rating procedure. - Company’s investments in means of production (it is the sum of tangible and intangible assetIntangible assetIntangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset...
s needed for a company to produce a certain amount of output – we call it ‘production base’) is set to be a function of the revenue growth (there should be enough production capacity to provide increase in production/revenue). Surprisingly many discounted cash flow (DCF) models used today do not account for additional production capacity need when revenues grow. - Long-term convergence of company’s revenue growth rate to that of GDP. This follows from the fact that combined revenue growth of all companies in an economy is equal to GDP growth and from an assumption that over- or underperformance (compared to the GDP) by individual companies will be eliminated in the long run (which is usually the case for the vast majority of companies – so vast, indeed, that the incompliant others could be treated as a statistical error).
- Valuation is conducted on the premise that change in company’s revenue is attributable only to company’s organic growth rateCompound annual growth rateCompound annual growth rate is a business and investing specific term for the smoothed annualized gain of an investment over a given time period...
. This means that historical revenue growth rates are adjusted for effects of acquisitions/divestitures. - Factual cost of stock-based compensationCompensationCompensation can refer to:*Financial compensation, various meanings*Compensation , various advantages a player has in exchange for a disadvantage*Compensation *Compensation , by Ralph Waldo Emerson...
of company’s employees that does not show in the company’s income statement is subtracted from cash flows. It is determined as the difference between the amount the company could have received by selling the shares at market priceMarket priceIn economics, market price is the economic price for which a good or service is offered in the marketplace. It is of interest mainly in the study of microeconomics...
s and the amount it received from selling shares to employees (the actual process of stock-based compensation could be much more complicated than the one described here, but its economic consequences are still the same). - It is assumed that, subject to availability of the necessary free cash flow, the company’s capital structureCapital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
(debt-to-equity ratio) will converge to optimal. This would also have an effect on the risk rating of the company and the discount rate. The optimal capital structure is defined as the one at which the sum of the cost of debtDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
(company’s interest payments) and its cost of equityCost of equityIn finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow...
(yield on an alternative investment with the same risk – it is a function of the company’s financial leverage) is at its minimum.