Have you ever thought expanding your business operations lately and needed help with fund raising strategies? Or are you looking out for selling all or a portion of your business’ operations and require expert help on merger and acquisition strategies? We, for one, know what a mammoth responsibility it is. But did you know that prior to deriving those decisions, there is a whole lot of analyzing and calculating that goes on behind-the-scenes?
A whole lot of studying and comparison and complicated calculations is what is done at the analysts’ end. So you must be wondering what this process involves. Is it something that you can do or at least try your hand at, right? Allow us to take you through the journey and you can decide for yourself.
The First Step
Infosys recently acquired a Czech based consultancy firm called GuideVision in September, 2020. What do you think they must have considered before the acquisition? Consideration of the performance of Guide-Vision seems like a good starting point. But what else is at play?
After evaluating the standing of the firm in the market, it’s time to evaluate its business and its economic value. The technical term for this process is “Business Valuation”.
What is Business Valuation?
It is a general process of determining the economic value of a business and is done for arriving at decisions some of which include arriving at sale value, establishing partnerships, divorce proceeding, funding and merger and acquisition strategies.
Why is valuation important?
Since, it helps the investors get an idea of the economic value of the company, it aids in making informed decisions before investing. As the saying goes ‘Better Safe than Sorry’, knowing the risk we are to undertake is always the better option.
How to Valuate a Business?
Now that we know ‘what’ is to be done, let’s focus on ‘how’ it is done?
There are various methods of business valuation that help estimate its unbiased value. Business valuation generally includes using objective measures and evaluating all the aspects of a business.
These are a few common methods practiced for valuation.
- Discounted Cash Flow (DCF) Method
This method estimates the value of investment based on the expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of the money it will generate in the future.
The value of $100 in the future is worth less than that of $100 today because inflation. Using a discount rate, the discounted cash flow helps arrive at the present value of the expected future cash flow. If the DCF is higher than the current investment, it could result in positive returns.
So, for instance, if the DCF price per share of ABC Ltd. is Rs. 105.96 and its current trading value is Rs. 75.88, it tells us that ABC Ltd. is theoretically undervalued and could generate positive returns in the future. Thus, we may invest in the company.
- Comparable Company Analysis (CCA) Method
This method evaluates the value of a company using the metrics of other businesses of similar size in the same industry. CCA operates under the assumption that the similar companies have similar valuation multiples. Analysts compile a list of available statistics for the company being reviewed and calculate valuation multiples in order to compare them. The most common valuation multiples include (Enterprise value) EV/EBITDA and Price to Earning (P/E).
After completing the process of CCA inclusive of appropriate selection of comparable companies, determination and calculation of metrics and multiples to be used, the company’s valuation ratio is derived. And it is this ratio which helps determine whether the company is under/over-valued.
Let’s understand through an example. ABC Ltd. has an EV of Rs. 10,000 and EBITDA of Rs. 1,000. So, its EV/EBITDA is 10:1. Other similar companies in the market have an EV/EBITDA ranging from 11:1-13:1. This shows that ABC Ltd. may slightly be undervalued. And if other qualitative factors stand in its favour, then we may invest in the company.
- Multiples Method
Also referred to as the multiple analysis or valuation multiples, it is a theory based on the idea that similar assets sell at similar prices. It assumes that the type of comparing ratio used in the comparing firms, such as the operating margins or cash flows, is the same across similar firms. Based on this ratio, it’s decided whether a certain company is over/under-valued.
Enterprise value multiples and equity multiples are the 2 categories of multiple valuation. Enterprise value multiples includes ratios of enterprise value to sales (EV/Sales), EV/EBITDA, etc. Equity multiples include ratios of price to earnings (P/E), price to sales (P/S), etc.
Let’s have a look at an example. Say companies A, B, C and D have similar asset structure and operations and operate in the beverage industry. The most common equity multiple, the P/E ratio, of the 4 are listed below.
The P/E ratio mean or average is calculated by adding all of the above ratios and dividing it by 4. So,
37 is the average P/E ratio of the 4 companies above. Now what we know from this is, the companies B, C and D are all traded at a discount to the P/E ratio mean using the multiples method.
- Asset-based Valuation
It is a form of valuation in business that focuses on the value of a company’s assets or fair market value of its total assets after subtracting the liabilities. The net asset value of the company is the focus in this method.
The 2 types of asset-based valuation include asset accumulation method which is similar to the balance sheet, while excess earning method is used to work out intangible assets like goodwill. Most companies use the appropriate asset valuation method when they are experiencing liquidation issues.
Typical examples that use this valuation approach are companies in the investment niche- like financial or real estate investment, where assets are calculated based on income or market approach. Businesses offering professional services like accounting/law firms also use this method to determine their goodwill.
After knowing about the various methods, you can see for yourself that business valuation requires much more than just science. It needs profound knowledge along with expertise, accuracy and attention to detail. Whatever your purpose may be for getting a business valuated, an experienced professional seems to be the smart choice!
Mantraa’s leadership team has 35 plus years of experience in the fields of Corporate Finance, CFO services and risk advisory services. We have undertaken business valuation of some of the most prestigious and industry’s revolutionary companies across the globe. Your search for a proficient and most trusted financial consultant pretty much ends with us!