BIBLIOGRAPHY AND REFERENCES
4. Based on the figures of the above steps we will forecast accounts receivable, accounts payable, and inventory
5.1 VALUATION APPROACHES
There are many valuation approaches and methods that one could use to value a company.
Amongst the most common approaches are the following:
1. the net asset approach, 2. the market approach, and 3. the income approach.
The net asset approach treats the business as a set of assets and liabilities where their net difference represents its net equity. Before applying the net asset approach both assets and liabilities should have been adjusted to their fair market values. The fair market value as described by the International Financial Reporting Standards (IFRS) is the price, in terms of cash or its equivalent, that a buyer could reasonably be expected to pay, and a seller could reasonably be expected to accept, if the business were offered for sale on the open market for
CHAPTER 5
Business Valuation
a reasonable period of time, with both buyer and seller being in possession of the pertinent facts and neither being under any compulsion to act.
The drawback of this approach to valuation as outlined above is that it fails to capture the value of a company’s intangible assets. Most companies have some intangible value that stems from brand-name recognition, relationships with clients and customers, reputation, experience, and knowledge, along with a variety of other values that are not captured in accounting num-bers. For example, the value of Apple or Microsoft has little to do with its land, buildings, and equipment; rather their value is derived from their worldwide brand recognition. The net asset approach is most often used in cases where a business is not viable as a going concern and is about to be liquidated (liquidation value) or where there are no intangible assets and its value as a going concern is closely related to the liquidation value of its underlying assets (e.g. a real estate holding company). In the latter case the net asset approach is used as an aid to assess the risk associated with the other valuation approaches, i.e. what could be the worst case scenario.
The market approach determines the value of a business based on comparisons with similar companies for which values are known. It compares the subject company to the prices of similar companies operating in the same industry that are either publicly traded or, if privately owned, have been sold recently. Under this approach 2 broad categories of multiples are calculated:
Listed comparable multiples
The Enterprise Value (EV)/sales, EV/EBITDA and P/E multiples are derived from compar-able listed companies and are then applied to sales, EBITDA, and net income of the subject company in order to obtain its enterprise value (EV) or its market value (P/E method);
Comparable transactions multiples
The EV/sales, EV/EBITDA, and P/E multiples in recent comparable transactions are observed and then are applied to the sales, EBITDA, and net income of the company to be valued in order to obtain its enterprise value or its market value (P/E method);
This measure of value, the so-called “Enterprise Value” or EV of a business, is the value of its debt plus its Market Capitalization (Mkt Cap) minus the cash deposits that it holds.
Enterprise Value = Mkt Cap + Debt − Cash, where Mkt Cap = No of shares outstanding × Price per share
Exhibit 5.1 presents typical values of the 3 most common multiples derived from listed companies. For example, a company with an EBITDA of €3.2 million would have an EV according to the mean value of the EV/EBITDA multiple of 2014:
Enterprise Value = 15.6 × €3.2 million = €49.9 million
Similarly Exhibit 5.2 presents typical values of 2 common transaction multiples derived from recent transactions between companies operating in the same or similar industries as the company to be valued. For example, the above company with an EBITDA of €3.2 million would have an EV according to the mean value of the EV/EBITDA multiple of 2013:
Enterprise Value = 8.9 × €3.2 million = €28.4 million
The drawback for this approach is that for privately owned businesses there is a lack of publicly available comparable data. Moreover it is difficult to construct a representative and
adequate benchmark set of comparable peers in terms of size, markets, product range, and country of operations. This approach can be used in conjunction with the other approaches in order to effect the so-called “triangulation” of results. This involves determining the fair value of a company by using all relevant methods in order to cross check one with another.
Sometimes the value of the company is derived as a weighted average of all the relevant results by various methods.
Finally, the income approach estimates the value of a company by considering the income (benefits) it generates over a period of time. This approach is based on the funda-mental valuation principle that the value of a business is equal to the present worth of the future benefits of ownership. The term income does not necessarily refer to income in the accounting sense but to future benefits accruing to the owner. The most common methods under this approach are capitalization of earnings and discounted cash flow. Under the capi-talization of earnings method, normalized historic earnings are capitalized at a rate that reflects the risk inherent in the expected future growth in those earnings. The discounted
EXHIBIT 5.1 Typical presentation of comparable multiples derived from listed companies
Company Price Market Cap EV 2013 2014 2014 2013 2014 Company 1 € 15.3 € 7,256 € 7,579 10.2x 11.2x 18.1x 11,05x 10,65x Company 2 € 17.0 € 3,202 € 3,802 11.3x 10.7x 11.2x 21.6x 20,85x Company 3 € 8.0 € 8,537 € 9,737 12.7x 12.8x 7.1x 32,55x 32,65x Company 4 € 13.2 € 3,296 € 3,096 17.1x 16.1x 8.5x 6,35x 5,95x Company 5 € 6.7 € 892 € 1,015 3.1x 3.5x 13.3x 7,05x 7,65x
Mean € 4,637 € 5,046 10.9x 10.9x 11.6x 15.7x 15.6x
Median € 3,296 € 3,802 11.3x 11.2x 11.2x 11,05x 10,65x
Low € 892 € 1,015 3.1x 3.5x 7.1x 6,35x 5,95x
High € 8,537 € 9,737 17.1x 16.1x 18.1x 32,55x 32,65x P/E
EV/Sales EV/EBITDA
Listed Multiples
EXHIBIT 5.2 Typical presentation of comparable multiples derived from recent company transactions
Target Acquirer 2012 2013 2012 2013
Company 1 (UK) Company 2 (FR) 3,2x 17,8x
Company 3 (UK) Company 4 (UK) 6,0x 15,2x
Company 5 (US) Company 6 (US) 1,2x 4,6x
Company 7 (CAN) Company 8 (US) 2,5x 8,2x
Company 9 (LUX) Company 10 (NL) 4,4x 9,6x
Mean 3,5x 3,5x 12,5x 8,9x
Highest 6,0x 4,4x 17,8x 9,6x
Lowest 1,2x 2,5x 4,6x 8,2x
Transaction Multiples
EV/Sales EV/EBITDA
cash flow method discounts projected cash flows back to present value at a rate that reflects the risk inherent in the projected flows. This rate, sometimes called the hurdle rate, dis-count rate, or simply the opportunity cost of capital, is frequently the company’s WACC (Weighted Average Cost of Capital), which reflects the company’s financial structure and the risk related to the sector.
Before continuing further I would like to explain briefly the concepts of present value and opportunity cost of capital. The concept of present value is based on the so-called “time value of money” which states the obvious fact that getting €1,000 today makes more sense than getting it a year from now because you could invest the money and have more than €1,000 in a year’s time. The sooner you get the money, the more it is worth to you. Present value is closely related to future value in the sense that if you invest today €100 at 10% in a year’s time you will get €110. The €100 is referred to as the present value of the investment whereas the
€110 is termed the future value of the investment after 1 year. Their relationship between the 2 values can be expressed in mathematical terms as:
€110 = €100 × (1 + 10%), or FV = PV × (1+r)
where r is the interest rate you will get in a year.
If instead of 1 year you invest the €100 for n years, the above equation can be rewritten as:
FV = PV × (1+r)n, or
PV FV
r n
=
(
1+)
Note in the above equation that the factor:
1 1+
(
r)
nis less than 1 since r is greater than zero and n is greater than or equal to 1. This factor is called the discount factor and is the value of €1 received in the future. It is usually expressed as a reciprocal of 1 plus a rate of return which in turn represents the reward to investors for accepting delayed payments. The above equation calculates the Present Value (PV) of an investment of Future Value (FV) at the year n from now discounted at a rate of return r. It is the backbone of the DCF technique and we will go back to it later in this chapter. Let us now come to the opportunity cost of capital. The time value of money is represented by the oppor-tunity cost of capital which is fundamental to investment decisions, and is a significant input to a DCF analysis. The opportunity cost of capital or hurdle rate or discount rate is so-called because it represents the return forgone by investing in a specific asset rather than investing in securities. You can think of it as the rate offered by equivalent investment alternatives in the capital market.
Let us now return to the DCF technique – we said that it expresses the present value of a business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, dis-counted to the present time at an appropriate discount rate. If we denote by CFi the future cash
flow of a business at year i, where i = 1 ... n, and r is the appropriate discount rate then the value of the business is given by the following equation:
Value of a Business CF (1 r)
CF (1 r)
CF (1 r)
CF (1 r)
1 1
2 2
3 3
= 4
+ +
+ +
+ +
+ 44
n n
CF (1 r) ...+
+
Although there are different notions of value, for the purposes of this book, when we dis-cuss the value of a business from now on we refer to the fair market value as described above.
The objective of any valuation is to estimate the fair market value of a company at a specific point in time (i.e. at a given date). There are a large number of factors to consider when esti-mating the common stock value of any business entity. These factors vary for each valuation depending on the unique circumstances of the business enterprise and general economic con-ditions that exist at the effective date of the valuation. However, fundamental guidelines of the factors to consider in any valuation have been established.
The most commonly used valuation guidelines require careful consideration of each of the following:
(a) The nature of the business and its history since inception.
(b) If it has a sustainable competitive advantage that is a competitive advantage not easily copied by rival companies and thus maintained over a long period of time.
(c) The economic outlook in general and the condition and outlook of that specific indus-try in particular. Michael Porter’s 5 forces model provides a framework that models an industry as being influenced by (1) the threat of new entrants; (2) the bargaining power of suppliers; (3) the threat of substitute product or services; (4) the bargaining power of customers; and (5) the rivalry amongst existing competitors. This framework is a useful tool for industry analysis.
(d) The financial condition of the business in terms of liquidity and solvency.
(e) The earning capacity of the company.
(f) The market price of stocks of corporations engaged in the same or a similar line of busi-ness having their stocks actively traded in a free and open market, either on an exchange or over the counter.
Moreover, the Discounted Cash Flow (DCF) method is used to determine the present value of a business on the assumption that it is a going concern. In the normal case, a com-pany is established to operate for an indefinite period in the future. So, on the basis of the going concern, we should always assume that the business under valuation will continue its op erations in the future.
A final note, before we proceed onto the next section, is that the DCF method ignores control issues; this is unlikely with the comparable transaction method which includes what is known as a control premium and hence results in a higher valuation. Valuing a controlling block of shares of a company gives a different result compared to valuing just a few shares of that company. This difference is the so-called control premium and is the premium a buyer is willing to pay in order to acquire control of the company and be able to run it in their own way (the assumption being that it will be run more effectively and efficiently). Control premiums make sense for the following reason. If the buyer attempts to buy a large number of shares of a company on the market, he will probably have to offer more than the current market price per share. As he buys more and more shares, the price will go up. In addition, the gossip that someone is trying to take over the company will keep forcing up the share price. In general
the value of a controlling block of shares is greater than the market value, since the controlling shareholder can actually decide on the fate of the company and derive considerable benefits by improving its performance. Nevertheless the value of control will vary across firms and it is greater for poorly managed firms that present more room for improvement. As a rule of thumb, control premiums can vary between 5% and 30% or even higher depending on the particular firm, the industry in which it operates, the timing of the acquisition, the room for improvement in the way it is managed, etc.
In the rest of this chapter, we will describe the DCF method in more detail and apply it to the case of SteelCo described in Chapter 3 in order to find its enterprise value and its value per share.