Company or Firm Valuation is one of the most important process for anyone who is considering to invest into a company’s debt or equity, or acquiring the company or the firm. A number of tools and methods are used to value companies.
As Aswath Damodaran says that Value is not just a Number. The distinction he makes by the above statement is that the firm’s value and its share price differ and the share price may not always show the true picture (value) of the firm. Thus valuation becomes a requisite when investing in or acquiring any firm.
In this article I will try to explain most common valuation tools known as intrinsic (or fundamental) valuation, and relative valuation (or valuation by comparables).
Both the methods are based on the cash flows and thus takes into considerstion the time value of money (future and present value), the risk factor, and the accounting performance. Let us understand each of the three in detail.
Time Value of money
We are all aware that the value of a Rupee today will not be equal to its value say 5 years down the line. We are also aware of the fact that any valuation is done to understand the current position of the company and the returns expected from it after a few years. Hence, it is important to take into consideration the change in the value of money which is also called as Time Value of Money because money, with time, changes and depreciates with time. To put the concept of time value of money in the most simplest words, what you can buy in Rs. 100 today, will cost you anything more than Rs. 100 say for example, it may cost you Rs. 130 after 3 years.
Similarly while preparing the cash flows it is equally important to take the time value of money as an important factor. This is simply because you do not want to pay more than what the company’s actual worth or value is. Time value of money is also the cause for the future cash flow to be worth less than the similar cash flow today. In order to reflect the effect of time value of money in the future cash flow, the “discounting” method is used and the extent to which the future cash flow has been discounted or affected by the time value of money is determined by the “discount rate”. Based on the type of the Cash Flow, the formula for discounting the future cash flow is modified. The following document contains the discounting formulae used for different types of Cash Flows.
With the expansion of markets and globalisation, every company is exposed to a number of macroeconomic risks apart from the internal risks. Macroeconomic factors can either make or break the company. Thus, the risk associated with the investment made in the company must be taken into account. This risk factor also helps to determine the minimum acceptable return from the investment made in the company. Thus expected return from the investment made is calculated as a sum of the risk free rate and the beta.
Risk free rate is the rate at which the investor is sure that he/she would receive a constant return on the investment made and will receive the entire principal amount at the termination. Usually, rate of return of government securities and bonds are taken as risk free rates.
Beta on the other hand refers to the amount company’s exposure to macroeconomic risk that the investor cannot get away with. Beta is relative risk measure standardised at one. If the beta is above 1, the company is exposed to the market risk, and vice versa.
The above formula for expected return is usually used in the CAPM (Capital Asset Pricing Model).
Every company prepares three statements viz. Balance Sheet, the Income Statement, and the Statement of Cash Flows. Based on these statements, a number of ratios can be determined such as Return on Capital Employed (ROCE), Leverage Ratio, Debt-to-Equity Ratio, etc. Based on the purpose for which the valuation is being prepared, these ratios help to go a step closer to the goal. For example, as an acquirer who is looking for a quick business scaling (in a hypothetical situation) will not acquire a company with a high leverage ratio or interest expense ratio as the company will not be able to scale its operations quickly within a few years as the amount will go in debt repayment more than towards generating revenue.
Intrinsic or fundamental valuation
The fundamental value of any company is nothing but the present value of the expected cash flows. This method utilises the DCF (Discounted Cash Flow) model for valuation of the company. In this model, the company’s free cash flows are calculated to determine the fundamental value of the company. Free Cash flow refers to the cash flow remaining after all the payment of taxes and all the investments.
One of the important aspects here is the going concern principle of any entity which says that the company is started with the motive to run it for generations without demolition. However, while calculating the true value of the company, we cannot calculate estimates for 30-50 years. In such a case, we calculate the enterprise value (value of the company) based on the cash flows for a certain number of years and assume the further valuation based on the terminal value. One of the simplest formula of Terminal Value can be given as:
FCF of the last year*(1+Terminal Value Growth Rate/(rate of WACC – Terminal Value Grwoth Rate))
(* = multiplication)
Thus, a simplified structure of a classic DCF Model can be given as follows:
*Change in WC i.e. Working Capital is nothing but the difference between Current Assets and Liabilities.
*Capex is the Capital Expenditure which can be calculated as change in PP&E and other long-term investments i.e. PP&E and other long-term investments (2018) – PP&E and other long-term investments (2019).
*PV i.e. Present Value is calculating using the formulae for the cash flows mentioned in the section of Time Value of Money.
*EV i.e. Enterprise Value is nothing but the sum of PV of Annual FCFF.
Relative Valuation or valuation by comparables
In relative valuation, the company’s value is found based on the valuation of the similar companies in the market. Since a comparison is made between the company being valued to the other companies in the market, it is also called as valuation by comparables.
Thus the ideal three basic steps involved in relative valuation are:
- Find the market values of the similar firms in the market
- Generate standard market value from the values of the firms
- Adjust for differences between the firm’s valuation and the market value standard
Market values can be estimated of the following:
- Market value of equity: The market capitalisation or the price per share
- Market value of firm: The sum of market values of both debt and equity of the firms
- Market value of enterprise value: Market value of firm less Cash
A number of multiples are used in order to standardise the market valuations. These multiples can be directly applied to the company’s financials to get its valuation.
The multiples used can be as follows:
Both the valuation methods require you to make forecasts and assumptions. The main advantage of fundamental valuation is that it is flexible, allows you to incorporate everything you know about a firm, and allows for extensive sensitivity and scenario analysis where you can change a few numbers (thus changing a scenario) to find the changes in hte firm’s response and the degree of change the firm shows (sensitivity to the change). The main advantage of valuation by comparables is that it is quick and relatively easy, and that it allows you to utilise the information contained in market prices.
Company Valuation is way more than what is mentioned in this blog. This is only the overview of two approaches to valuation. Each can be studied and practiced in depth and applied better.