If two distribution companies are exactly the same but one has a higher inventory, which one has a higher DCF valuation?
At first, I thought that the company with the lower inventory would have a higher valuation because its FCFs would be less affected by changes in net working capital, but I am starting to wonder if this would always be true. When comparing the two companies, would a higher amount of inventory necessarily imply higher changes in net working capital? Or would it be entirely relative on how that amount of inventory changes from year to year? Any help would be greatly appreciated.
Higher inventory = lower cash flow = lower valuation
We generally model inventory as DIH, so as sales increase, a higher standing inventory value means a greater increase in inventory and greater increase in NWC = lower FCF
Think again buddy.
One with higher working capital is worth more --> buy it, make it as efficient as the peer, pocket the cash you pull out of working capital.
Isn’t this obvious?
If you have two boxes of the exact same stuff, the one with more stuff is worth more. There’s more future cash flow because you won’t have to pay for the inventory that’s already there.
I get what you're saying but I don't think its as obvious because he specifically said DCF method. If this were an asset liquidation method of valuation- then it would be obvious (one with more stuff is worth more), but for DCF it's dependent on sum of CFs, so the extra value in inventory would not necessarily affect CFs, except for the change in NWC, where you would have to make an assumption about whether the company with higher inventory would keep this high level or lower it to industry standard.
If they sell off their inventory the change in NWC would be positive, and therefore the company with higher inventory is worth more.
If the company maintains the same change in NWC as the other firm (ie, doesn't lower inventory), then there is no change in CFs and the DCF valuation should be the same (given this goes on into perpetuity).
I think its actually an interesting question.
You are incorrect that selling the inventory would be a positive change in NWC. Selling inventory --> decrease in inventory and decrease NWC, which leads to a negative change in NWC. Proof below.
Abbreviated Balance Sheet... Before selling inventory: Cash --> 50 Inventory --> 50 AP --> 25
NWC is 25 (50 Inventory - 25 AP)
After selling inventory: Cash --> 53 (hypothetical, it is increased from proceeds from selling the inventory after taxes on profit) Inventory --> 45 (decreased because you sold some inventory) AP --> 25 (no effect, stays the same)
NWC is now 20 (45 Inventory - 25 AP), so NWC clearly went down from before the sale and this is a positive effect on cash flow (which you can see in the hypothetical cash balance increase).
Companies are identical so you can take out the excess working capital. If company B would require more NWC sustainably, then delta NWC (when growing) would be slighty higher so DCF value lower.
Another incomplete interview question. Is that higher level of inventory required in the second business in order to generate the same revenue and earnings? (i.e. a wide range of SKUs needed on short notice so the elevated safety stock is required). Does the heavier inventory company need to increase inventory at the same level to grow the business?
If there's no ability to run down inventory without negatively impacting earnings/cash flow, then in theory both businesses are worth the same, and both businesses will be delivered to the buyer with their respective needed levels of working capital.
If the higher inventory needs to continually add high levels of inventory to grow, then yes the capital-light business could be worth more due to the changes in net working capital in your DCF.
To clarify, you're saying that if the inventory-heavy company requires a consistent inflow of high levels of inventory (which when unsold decrease cash flow), then because of the higher change in NWC its DCF valuation would be lower than that of a company requiring less amounts of unsold inventory? Thanks in advance.
Yes. If Company A only needs to add $1 in NwC for every $10 in earnings, as compared to Company B who needs to add $3 for every $10 in earnings, then A would generate more FCF going forward and be more valuable.
More inventory: more value. If these two companies have not reached peak market share, then the company with more inventory can earn more revenue (assuming you can achieve those sales without excessive incremental costs). So higher topline growth leads to higher DCF.
More inventory: less value. Each year the company spends too much cash on NWC, so lower DCF.
More inventory: no effect. Today's inventory levels don't explicitly affect DCF. They could still earn the same cash flows.
The question needs more clarification because how is this inventory funded - if you grow assets, then what grows on the other side of the Balance Sheet - liabilities or equity?
With these questions, lay out your assumptions and clearly articulate the implications of those assumptions. There's no straightforward answer, and if you respond like there is, you got it wrong.
Thanks for the responses, all of this makes sense. I think it is also worth noting that if, for some reason, your revenue projections in a DCF were decreasing with time, the company that would need a higher level of inventory to achieve the same revenue would actually have a higher DCF valuation.
If Company A needs its ending inventory for a time period to be 25% of COGS whereas Company B needs it to be 20% of COGS (assuming they are generating same revenue, etc.), Company A will have greater decreases in net working capital if revenue and COGS are projected to decrease in the coming years. This will result in relatively higher FCFs for Company A and, therefore, a higher DCF valuation.
Who asked this?
I was asked this question in a mock interview.
Also with decreasing top line: buy the company with the higher NWC and sell off the excess post transaction. This is what every PE does. Big gains are in decreasing NWC from 25 to 20% at once.
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