Investors are required to evaluate ventures and companies according to a variable risk perception based on the analysis of financial data and the determination of profit multipliers based on which they will make the investment. For example: if the profit multiplier per share is 4 and the annual operating profit per share before depreciation and interest is 10, the price that will be determined per share is 40. This estimate is based on the share price on the stock exchange, market estimates, analyst estimates or calculations according to valuation methods. The investments themselves are made based on the assessment of whether the value of the multipliers will increase or decrease as well as by what percentage of the base price.
The Cowley model was created to enable the refinement of valuation results obtained for companies traded on the stock exchange as well as private companies, in the form of quantifying qualitative variables that are supposed to affect the viability of the investment in the medium and long term. The “improvement interest” of Cowley’s model usually offsets the discount or multiplier interest and improves the yield in the medium and long term.
A model for checking internal risk examines financial reports of a company or enterprise and determines the risk interest which is a component in the valuation of the company or enterprise.
The relationship between the models
A model for testing internal risk is based on the principle of standard deviation analysis. regarding the company’s sales, gross and operating profit and according to a normal distribution of risk perception (t-risk distribution) in different scenarios of cross sensitivities.
The Cowley model examines quality indicators such as management and personnel, industry risks, industry competition, bargaining ability with suppliers and customers, etc. Although some of the variables are qualitative, some of them can be measured according to estimates derived from the financial data and analysts’ market assessments, but also through quantitative variables.
The functions used by the Cowley model assume that the second derivative of the rising functions (improvement) is less than 1 up to a maximum point, while the functions that increase risk (decrease) are higher than 1 up to a minimum point, a fact that corresponds to the perceptions of risk and caution of investors – who see mainly risk.
How to use the models
The investment market is relatively complex, the uncertainty and the external effects on it affect the judgment of investors when it is not always possible to quantitatively assess their significance. Let’s take for example two identical companies in terms of the starting point, sales and assume that they operate in the same industry. The stock market information system, various rumours, analysts’ reports, the reputation of the management team and the promotion of market promoters, may determine the value of the stock, although the relationship between the return and reality in the medium and long term is not necessarily what was observed, whereas one company that was not selected for investment will advance more than the other.
The Cowley model will answer the quality of the investment for the medium and long term, while the internal risk model and the discount rate will allow a realistic value check for the current profit multiplier. Any investor who makes use of these models and builds them into his system of considerations may reach higher return values on his investments in the medium and longer terms.
To illustrate how to use it, we will present the relevant formulas after calculations of the internal risk interest rate and the discount rate following the interest rate optimization of the Cowley model.
Determination of internal risk interest rate and discount rate: calculation result of internal risk interest rate (Ri)+ risk-free interest rate (Rf) = discount rate (Rc)
The resulting multiplier is:
Ps – profit multiplier
In addition to the internal risk according to the aforesaid, the interest that will be obtained after using the Cowley reclamation model will be the result of the internal risk interest Rc plus the risk interest according to the Cowley model Rr as follows:
Psr – improved profit multiplier (after Cowleys’ model optimization)
Rcr – Capitalization factor after adjustment of Cowley’s model
The updated multiplier result is as follows:
conclusions
Despite the connection between the models, it is not a binding connection. The computation of Ri replaces the public’s corporate multipliers. Anyhow, it is recommended to use both models to get good and improved results in the medium and long term. It should be noted that most of the data are taken from the company’s financial statements, sectoral assessments, macroeconomic effects and more, which are also used while providing values that are translated into functions of the Cowley model.
The purpose of the Cowley model is to translate qualitative assessments into quantitative ones, which enables the improvement of the quality of investments in the long term.
The internal risk interest model (Ri) enables an informed determination of the discount rate according to the standard deviations and the cross-sensitivity tests of variables that determine sales cycles, gross profit, and operational profit.
Hence, private corporations can use both models, but public ones, usually use only the Cowley model, since the financial data is derived in most of the cases from the stock exchange market.
The consumers of these models are investment companies, private investors, holding companies, venture capital companies and more. The advantage of using these models is clear, but their application requires an in-depth analysis and understanding of the functions that determine the final values of each model.
