Company Valuation need not be difficult. There are essentially three main ways to value a company:
- Balance sheet methods which include book value, adjusted book value and liquidation value
- Profit and Loss methods including profit multiples, price earnings ratio, sales multiples, EBITDA multiples
- Discounted Cash Flow methods, including cash flow to equity, free cash flow,
There are two other methods, which we will not be discussing in this lecture. They are:
- Value Creation such as Economic Value Added (EVA)
- Options methods including Black Scholes
Lets consider why we would want to value a company?
It is important to make the distinction between the perspective of the buyer and the seller. The value will also differ for different buyers.
For a buyer, the valuation process will establish the maximum price he will be prepared to pay for the business.
For the seller, the valuation will show him the minimum price he will be prepared to receive for the company.
Do not confuse the value of a company with the price a buyer may be prepared to pay for it. The two things are very different.
The Purposes of a Valuation
A valuation of a company will be useful in a range of circumstances. These include:
- In an M&A transaction helping the buyer and seller separately to come to a view and ultimately an agreement on the price.
- When valuing Listed companies to establish whether they are either over valued or under valued compared to their market value.
- When preparing a company for an initial public offering (IPO) on a stock market, which will be used to help the company correctly price its shares
- For evaluating the outcome of the financial performance of senior management under a incentivisation programme.
- To help identify strategic drivers in a business
- To assist management teams and their advisers in the strategic planning process.
Balance Sheet Methods of Valuation
This is the first of the main valuation methods which we highlighted above. The methodology is based on valuing the value of the assets of the business.
Book Value considers the net worth attributable to the holders of equity and is the net difference, hopefully positive, between the assets and liabilities of the business.
Adjusted book value attempts to take account of some of the potential pitfalls which may occur as a result of accounting conventions. These include:
- Adjusting or updating the value of land and property
- Adjusting for the impact of bad debts
- Removing the overstatement of value caused by obsolete stock
A different perspective may also be gained by considering the Liquidation value of a business. This assumes that the assets are sold, potentially at short notice and at conservative values and these proceeds used to pay back all the liabilities of the business. This is a way of estimating the minimum value of the company.
In Summary, book value has little actual correlation with market value and, in my view, is not a very robust way to value a business.
Profit and Loss Account Methods
These methods focus on the sales and profits of the business to establish a value for the company.
One of the most common methods used in the public markets is the Price Earnings Ratio which compares the company market value as a ratio of its earnings per share. This shows how high the market values the company on a per share basis and provides a very useful, if simple, comparative ratio when looking at one or more companies.
You can of course reverse this to arrive at a value by multiplying the earnings of the company by the ratio.
Shareholders may receive a dividend from the company and this cash flow and its future projections can be used to derive a value of the business. The dividend is considered as cash perpetuity and this is used, with a terminal value, to discount to the present the value of the business, using the same discounting method that we will meet when considering discounted cash flow methods of valuation.
The dilemma for a business is that the payment of dividends distrubutes cash to shareholders which otherwise might be used to grow the business. This method would derive a higher value for high dividend paying companies when in fact, the growth of lower dividend paying business would in reality exceed that of the high dividend businesses.
For years Microsoft did not pay a dividend for exactly this reason.
Sales multiples are a somewhat crude method of company valuation and are common practice “rule of thumb” ways to value a business within a certain industry.
While this can be used informally when discussing comparative valuations for two businesses in the same sector, this method provides little more than an indicator of value.
Other sales multiples can be derived from different profit multiples.
The two most common are EBIT – Earnings before Interest and Tax
EBITDA – Earnings before Interest, Tax, Depreciation and Amortisation.
The latter is particularly useful in M&A and Private Equity transactions because it values the business independent of its financing structure by removing the costs of Interest, Tax and historical goodwill and acquistion depreciation, the two latter figures being purely book entries and having no impact on cash flow.
Technology Company Valuations can be compromised when they are valued very highly compared to conventional approaches reflecting anticipated stellar growth
In these cases, it is necessary to resort to the rather simplistic approach of pure sales multiples on the basis that there are seldom any earnings to value!
Discounted Cash Flow is one of the most robust valuation methods when its component parts are calculated correctly.
The underlying basis is to discount the free cash flow forecast back to the present to arrive at a value of the business today.
The methodology is very sensitive to some key assumptions
- The forecast earnings growth of the business into the future
- The discount rate used to bring this forecasted cash flow back to the present
- The number of years in the forecast, typically 5 to 10.
- The assumption of the terminal value of the business in its final year.
The Free Cash Flow that is measured is the Unlevered Cash Flow, which is to say that the costs of debt financing are removed from the forecast, enabling the business to be valued irrespective of its financing structure.
There are several steps to creating a cash flow forecast
1. Create an integrated profit and loss, balance sheet and cash flow model of the business
2. The model should ideally calculate the cash flows for at least 10 years or the modeller runs the risk that the terminal value will be a disproportionately large part of the valuation
3. Calculate the terminal value in year 10.
4. Using an appropriate discount rate, discount the cash flow back to the present time.
The Discount Factor used is the Weighted Average Cost of Capital of the business.
The theory behind this is the Capital Asset Pricing Model if you want to investigate this in more detail right now. For the moment, it is enough for us to consider that the method calculates a discount rate for the equity and debt separately and then combines them in a weighted ratio depending on the mix of debt and equity financing the company.
When preparing a Discounted Cash Flow valuation, the following factors must be given careful consideration:
The future cash flows will be heavily dependent on the assumed returns on future investments and the assumed growth rate for the company’s sales.
The Return on Equity, represented by the Equity portion of the WACC, comprises:
- A risk free rate
- A market risk premium of beta
- A further discount fact for company specific operating risk and
- A discount factor for the company’s financial risks.
The calculation of this discount rate can be highly contentious and the end valuation is very sensitive to the assumptions made in its calculation.
The Break Up Value considers the value of the company as a sum of the parts of it’s different businesses where their values are independently assessed. This assumes that the separate businesses would be sold on a going concern basis.