Valuation: The Cornerstone of Business Divestment and Investment

Valuation: The Cornerstone of Business Divestment and Investment

If you’re a private company business owner or shareholder and looking to ready the business for divestment, selling shares to partners, or putting it out into the market for private equity professional investment, or for internal accounting purposes… commissioning a sophisticated valuation is the starting point.

Valuation is the cornerstone of financial analysis, allowing one to assess the worth and true fair value of an asset or company.

Why sophisticated?

Too many people rely on a simple multiple based approach. Favourite multiples are EV/EBITDA (Enterprise Value to Earnings Before Interest and Depreciation & Amortisation) or P/E (price-to-earnings).

Multiples are great and useful for very specific purposes. It has some distinctive drawbacks.

Before we look at these handicaps, a brief overview.

EV/EBITDA is the classic multiple, referencing the EBITDA number and multiplying by the multiple to achieve the Enterprise Value (EV) – the total value of the business due to all debt and equity stakeholders. EBITDA as we know is the proxy for operating profits before non-cash depreciation.

The multiple is easy to understand, it is quick, and it compares well to industry or sector-based averages. Specific industries and companies of related maturities have relatively standardised multiples.

For instance, mining, manufacturing or industrial sectors will typically be bankable and primed for raising capital at an average of 3.0x to 3.5x, while FinTech and the technology sector is comfortably around 5.0x, and financial sector companies even higher at 7.0x to 8.0x.

The P/E (price-to-earnings) multiple references the price (market capitalisation or 100% marketable equity value) of the business against net profits. The market capitalsation is derived from the EV by adjusting for net debt.

Similarly, the P/E is relatively standard for various industries and sectors. The P/E multiple should always be higher than the EV/EBITDA, quite simply because the net profit component (denominator) is smaller than operating profit (accounting for debt repayments, taxes, and depreciation and barring other curiosities). The lower denominated increases the multiple.

Following the example above, the mining, manufacturing or industrial sectors will be matched to the above EV/EBITDA at an average P/E of 5.0x to 8.0x, while FinTech and technology sector is comfortably 10.5x, with Financial sector companies even higher at 15.0 to 16.0x.

Multiples are great when you are therefore looking for peer comparisons between companies in a specific sector, hence a market-based approach.

Drawbacks to multiples.

First, the multiple is historical based, it only represents the current static view and historic performance of the company.

Second, and perhaps most importantly, the multiple approach does not present a window into the working capital and capital investment (capex) cash flow movements.

The EV/EBITDA multiple specifically does not account for the business’ utilisation of debt and equity in its capital structure. A firm might be highly geared with high risky debt versus another company in the same sector (say direct competitors). While both companies have the same EBITDA, the actual fair value of these businesses are not the same.

The multiples are also too sensitive to accounting adjustments and methods employed by one firm over another – specifically with respect to non-operating expenses.

Gold standard DCF.

In contrast, and not to get too technical, the sophisticated DCF (discounted cash flow) methodology is a complex model that extrapolates the firms cash flows forward, adjusting for normalised earnings, accounting for the movements in working capital and capex, and importantly, incorporates the cost of capital and the time value of money – both fundamental in correctly unpacking and understanding the fair value of a firm.

The WACC (weighted cost of capital) built out explicitly for the company according to the CAPM (capital asset pricing model) is the rate employed to discount the future cash flows to a present value, and in so doing, allows one to consider the company specific factors, the timing and risk of the cash flows.

Drawback of the DCF income method is that it can become complex, and it requires careful consideration of the cost of capital (WACC) and the sensitive assumptions that drives the forecasted cash flows. The quality and integrity of the data is therefore very important.

The DCF provides an intrinsic value of the company, based on fundamentals. A comprehensive and flexible methodology.

In short, multiples must not be the primary valuation technique, instead its power sits as a reasonability check and comparison to the DCF fair value.

Towards the tail of the DCF.

Consider early growth stage companies, such as FinTech or technology business that are spending and developing their IP/technology, still rolling out their tech into the market for wider adoption. The cash flows are small compared to the development cost of the said IP/tech. In these special instances the DCF valuation of a business is likely to be negative, since their earnings is negative. The only way to show value is on the balance sheet via a Net Asset Value (NAV) approach by accounting for the actual development costs and other related expenses as a build-up of an intangible asset.

For most cases, whether insurance or annuity companies, manufacturing or mining, services or anything really – the ability to generate cash flow comes from the operating asset, which may be the actual human resources, the machinery, tools or assets utilised to offer goods or services.

Historical cash flows inform future cash flows in a stable business. The margins achieved informs the margins one can extrapolate into the future and specifically also informs potential growth scenarios.

The DCF methodology accounts for these nuances and scenarios.

In the example above of the negative equity value tech company, the value sits in the tail (in the future cash flows, 5y or 10y into the future).
In the DCF one accounts for this through the Terminal Value (TV), also discounted to present and added to the present value of the explicitly extrapolated cash flow. Combined, these values add up to the EV.

A base case, or a version of the business as-is today (as it operates today) can be extrapolated and approximated via projecting stable cash flows, with growth that is based on historically achieved average margins (excluding any shocks and pandemic style historical swings).

A management case in contrast will almost always be a more optimistic view of the future growth.

The reliance on the tail and the TV is a potential pitfall of the DCF, yet this is something we’ll delve into more in future articles.

Link to LinkedIn article