Business Valuations: A Guide to Understanding Methodologies and Best Practices for Valuing Companies
Introduction. Valuations advisory is a professional practice. There has been a revival of “the fundamentals of valuation and critical due diligence for mergers & acquisitions (M&A), capital markets, and investment opportunities” post mortgage crisis and credit crunch.[1] There are varying valuations theories, which are used in different scenarios. There are particular metrics, which analysts use to determine attractiveness of target business. The “valuation revival” brings new theories with which analysts strive to arrive at accurate valuations for new types of businesses.
The various business valuation methods. Aswath Damodaran teaches at New York University Leonard Stern School of Business and has been a “mover and shaker” in the field of valuation for the past few decades. Professor Damodaran categorizes valuation methodologies/models into three categories: intrinsic valuation, relative valuation, and contingent claim valuation.[2] Joshua Rosenbaum and Joshua Pearl authored the book, Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. In their book, they discuss two categories of valuations: fundamental-based and market-based approaches. Rosenbaum and Pearl were motivated to write their book to share a collection of experiences and realizations from their time working at investment banks. While these experts separate methodologies into categories, the methodologies can be used together to form a complete valuation. The use of multiple methodologies adds strength to the target’s valuation, because each methodology has different assumptions, which generate strengths and weaknesses.
Intrinsic (fundamental-based) value can be found through calculation of the present value of a business’s expected cash flows. This process is known as “discounted cash flow (DCF) analysis.” In this method, cash flows are projected, but projection length varies from industry and growth stage of the business. A five-year period typically illustrates a company’s business cycle. The projection should end at a point when the business’s growth rate stabilizes. The steady (constant) growth rate helps to determine the target company’s terminal value. In the discounted cash flow methodology, the valuation analyst/banker must make some assumptions, supported with proper rationale: historic rates, adjusted for current market trends. Discounted cash flow analysis requires a “discount rate.” This “discount rate” is commonly referred to as the weighted average cost of capital (WACC). The WACC is equal to the factor of after-tax cost of debt and percent of debt in the target’s capital structure plus the factor of the cost of equity and percent of equity in the target’s capital structure. The cost of equity is equal to risk free rate plus the factor of levered beta and the market risk premium. In the simplest form of discounted cash flow, the cash flows are divided by a factor of the WACC depending on the period. For example, the present value of expected cash flow three years from today equals the cash flow divided by WACC at the third power. The value for money is derived with time; presently held money can potentially earn returns. Once the total discounted value of the expected cash flows is determined, the target’s terminal value must be calculated. The target’s terminal value accounts for the value of cash flows after the projected period (for example, the value of cash flows after a five-year cash flow projection). The “terminal value typically accounts for a substantial portion of a company’s value in a DCF, sometimes as much as three-quarters or more.”[3] There are two popular methods to determine the target’s terminal value: the exit multiple method and the perpetuity growth method. Exit multiples usually equal enterprise value divided by a revenue multiple (typically earnings before interest, taxes, depreciation, and amortization). The terminal value is the factor of the final projected cash flow and the exit multiple. Terminal value by the perpetuity growth method takes the final projected cash flow and assumes that it will grow at a perpetual growth rate. The perpetual growth rate usually matches the target company’s industry growth rate. Perpetual growth rates most normally fall in the two (2) to four (4) percent range; nominal gross domestic product growth range for the United States on average.[4] It is good practice to compare the exit multiple and the perpetuity growth method for increased accuracy. The terminal value should then be discounted with the WACC. The discounted terminal value and cash flows can be summed to determine the target company’s enterprise value. Because discounted cash flow method has necessary assumptions, a sensitivity analysis can provide an accurate range for target’s enterprise value. A sensitivity analysis takes a range of exit multiples and WACC rates. The sensitivity analysis inputs can be taken from a relative valuation approach known as comparable company analysis. Before going into relative valuation approaches, it is important to note that different variations of DCF method exist: risk adjusted discount rate approach, certainty equivalent cash flows method, adjusted present value approach, and excess returns approach.
Though discounted cash flow method is a common valuation approach and quite fundamental for various assets’ valuations, relative (market-based) valuation approaches add an extra dose of reality and more value preciseness for assets that do not have current market prices (like private companies or real estate). Relative approaches can help provide a smoother and more realistic business value because relative valuation methods derive the target’s value from competitor/similar businesses. Why reinvent the wheel? Relative valuation is the second category of valuation practice. Aswath Damodaran gives three important guidelines for relative valuation: “finding comparable assets that are priced by the market… scaling the market prices to a common variable… adjusting for differences across assets.”[5] Pearl and Rosenbaum state that, “comparable companies analysis (“comparable companies” or trading comps”) is one of the primary methodologies used for valuing a given focus company, division, business, or collection of assets.”[6] Many private businesses may have different accounting standards. The benefit of valuing a public company is that it is required to file its financial accounts periodically. This requirement gives public company valuation analysts a basis for valuation. Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition states that “Step I” of comparable companies analysis is to “select the universe of comparable companies.”[7] This may be easier said than done. Aswath Damodaran writes about the potential struggles of selecting the target company’s universe in his essay, Valuation Approaches and Metrics: A Survey of the Theory and Evidence. Comparable companies are “similar in size, product, geography.”[8] Of equal importance, comparable companies should have “cash flows, growth potential, and risk similar to the firm being valued.”[9] Certain industries contain many businesses while other sectors may not be as saturated with competition. The next step in comparable companies analysis is collection of each comparable company’s financial reports. Important comparable company metrics will be found, including: earnings before interest, taxes, depreciation, and amortization (EBITDA), enterprise value, equity value, profitability, and sales. These metrics can be used to rank the target and the comparable companies, otherwise known as benchmarking. Benchmarking finds comparable companies that most closely compare to the target. Next, multiples are calculated. Multiple usage choice is typically based on the target’s industry. An average of the comparable companies’ multiples is applied to the target’s metric to determine the target’s enterprise value. Multiples based off of enterprise value are most commonly used. Pearl and Rosenbaum write, “the most widely used trading multiples… such as enterprise-to-earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) and price-to-earnings.”[10] Enterprise value based multiples are inclusive, and “are independent of capital structure and other factors unrelated to business operations.”[11]
Another relative valuation model that can be used to support comparable companies analysis solution is the precedent transactions approach. The precedent transactions approach takes comparable companies’ acquisition histories to calculate the target’s value. The precedent transactions approach follows a similar process as comparable companies analysis, except that deal-related financial information must be found in addition to the comparable companies’ financial reports. Other considerations must be made as well. The market conditions may have been different during the time of the precedent transactions. Certain industries, like technology, have had high value acquisition periods, or price bubbles. Current market conditions can vary significantly from past market scenarios, and including unadjusted comparable transactions can inaccurately value the target company. The types of buyers involved in each comparable deal should be examined as well. Strategic buyers are more likely to pay premiums for synergy or to acquire a unique quality of the target company. Financial buyers don’t typically pay premiums because they are primarily concerned with realizing return on investment. Financial buyer deals inclusion in a precedent transaction valuation may not provide a worthy valuation for a strategic buyer. After the due diligence has been completed for the precedent transactions approach, analysts typically use enterprise value or equity value driven multiples to calculate the target’s value.[12] Because no two companies are the same, using the comparable companies analysis should be used in conjunction with other valuation models to maximize valuation accuracy.
Valuation approach is chosen situationally. Each valuation method has different strengths and weaknesses. At the same time, one type of valuation method can be used to check another method’s solution. Valuation methodology is dependent on the target business’s given information. DCF approach should be used when a business “whose cash flows are currently positive and can be estimated with some reliability for future periods, and where… discount rates are available.”[13] DCF approach does not work when a firm is troubled and going bankrupt. DCF analysis only works for assets with positive cash flows. DCF analysis similarly should be checked closely when being used in cyclical firms. Like economically troubled businesses, cyclical firms realize negative cash flows in recessions. DCF cyclical business valuations may vary because of optimistic or pessimistic assumptions made by analysts during recessions or boom times. Some businesses have underutilized or unutilized assets. Using DCF analysis would not fairly value these underutilized or unutilized assets because they have the potential to generate higher cash flows than recorded. DCF analysis does not fairly value patents or product options that do not currently generate cash flows. Firms that are in the process of restructuring (whether the business is purchasing/selling assets, or changing its capital structure or ownership) may be difficult to project future cash flows. Because of this difficulty, DCF analysis towards these firms may not complete a fair valuation either. A firm in the acquisition process may be difficult to value using DCF analysis because of synergy value determination and change of management may influence cash flows and risk. Private firms contain assets that are not publicly traded, so there is no basis for historical returns or risks for the privately held assets. It would be difficult to use discounted cash flow analysis to value private firms.
Relative valuation approaches fill in the shortcomings of the DCF analysis assumptions. Relative valuation approaches are the most commonly used methodologies in the practice of valuation. Multiples used in the relative valuation approaches place comparable companies on the same playing field. While multiples embody value that cannot be defined in DCF analysis, multiples still have the potential to be misused. This “embodiment” includes assumptions made in comparable valuations, which may lead to inaccurate valuation of the target because the analysis is based on potentially inaccurately valued comparable companies or precedent transactions.
Value-enhancing business metrics per industry. “While valuation metrics may vary sector by sector” many analysts base valuations off of EBIT and EBITDA.[14] EBIT or EBITDA divided by the target’s enterprise value “allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields.”[15] Enterprise value can be the sum of the firm’s equity market value and net interest bearing debt. If ratios like price to earnings (P/E) or earnings to price (E/P) only account for the price of a firm’s equity. If two firms have the same total capital P/E and E/P ratios will show higher earnings yield for the firm with a more debt than equity. On the other hand, the EBIT or EBITDA to enterprise value multiple formulates the same earnings for both companies. It is important to note, however, that EBITDA itself can be greatly misinterpreted.
EBIT or EBITDA to enterprise value can be popularly used in traditional sectors, but what if the company is not generating earnings, but still has value? It is safe to value firms with healthy EBIT/EBITDA, but not all firms have stable earnings. Enterprise value is an effective metric to use as a multiple for different industry specific metrics. When determining the industry specific metric to use, first think of the target company’s basic functions. A startup company may not generate profit at its beginning stage because of entry costs. A promising startup company has high sales and users: business functions that attract buyers and investors. Valuation metrics do not need to be items found on a financial statement. Businesses that offer Internet, music, news, or television services to subscribers can be valued by using its amount of subscribers compared to its enterprise value. Variations of the EBITDA metric can be used to value businesses in the airlines, oil/gas, and retail sectors.[16] EBITDAR (“R” signifies rental and lease expenses) can be used as a metric when valuing airlines and retail businesses. These business models heavily rely on leasing property to generate value. And the better EBITDAR ratios can signify a more successful business plan. EBITA can be used when depreciation would potentially skew comparable companies analysis. Companies in the bus and rail, chemicals, and media industries have varying methods of financing for assets, and differing depreciation costs. A metric that does not use enterprise value is the price to earnings to growth ratio (PEG). PEG metric is beneficial when valuing firms in high growth sectors, like emerging markets.
2017 Valuation Trends. There are two schools of thought when it comes to valuation: the “numbers” school and the “stories” school. The members of the “numbers” school focus on generating financial models to arrive at a business’ valuation solution. The members of the “stories” school generally like to find business value by telling a story of the business’ life. The “stories school” projects future business ventures and industry trends. Aswath Damodaran teaches that both schools, though seemingly opposite, are required to arrive at a complete valuation. The two valuation schools compliment each other’s weaknesses. While the “numbers” school generates financial projections that are difficult to argue with, the “stories” school gives the numbers significance and meaning.
Business Valuation Methods
When the time comes to put up the tools and walk away from a business which you have grown to both love and hate, how do you determine a proper valuation for your privately held business? Does it have to do with the management team, your customer base, or your brand? Is it the equity held by the partners? Certainly, there must be a computing weight from many factors when it comes time to value your business before you put it on the market. There must be more than just the standard answer of “it’s all in the EBTDA.” For those interested, here are 10 pointers which should be taken into account when it comes time to sell the business.
1. Company Cash Flows
How well your business does or has done in the past is oftentimes judged by the cash flows your business has been able to garner through the years. Does it currently have cash flows? If so, what are they and how are you able to value that in today’s dollars? Many people think profits are what is important in business valuations, but really it is consistent and strong cash flows for the company now and promises of them for the future.
2. Relevant Customer Base
How does your customer base look? Is it made up of a focused niche in a small area of the country with most of the revenues coming from one client? Do you sell to consumers or to other businesses? If the business is composed of blue-chip technology companies, then you certainly are looking at a different and most-likely higher valuation than a company who sells a single consumer good whose hayday has come and gone.
3. Goodwill and a Good Story
Much of what is considered “soft” marketing materials for merger and acquisition specialists is vitally important for those looking to purchase the business, whether they are private equity investors or a publicly-traded organization. How the business is presented in the prospectus says a lot about how much you are able to cash out for. In addition, market potential is another good point which should be weighed in carefully. Which brings me to my next point.
4. The Number of Buyers
It’s a simple issue of supply and demand if several companies think your business has an extreme case of goodwill, then it may be sold for much more than it was originally anticipated you would sell it for. This can be seen on Wall Street occasionally when a company gets bid up for a price much higher than their discounted cash flows would indicate. And, the purchasing firm becomes the bearer of a large amount of “goodwill” which is written on the balance sheets. Lucky is the company who has fortune smile on them with multiple bidders.
5. Market and Industry Outlook
If the industry and overall market have a good outlook, this is obviously good for the selling company. The company future looks bright and profits are on the up-and-up. Future growth projections always look bright and rosy when the economic conditions reflect a similar vibe.
6. Depth, Breadth and Experience of Management
In many cases managers of the firm are also owners. That said, it certainly makes it difficult to value a firm based on the management when the management often ends up moving out when the new owner purchases the facility. This is important to note. However, when it comes to many larger deals completed by private equity firms, something different may also be true, the company may be keeping the management. In the case of a deep, experienced and successful management team according to past performance, this is a huge plus for the company’s outlook and valuation from investors.
7. Industry-Specific Consolidation
As the big companies within a specific industry get bigger and the small companies continue to get purchased, it is very evident that prices for the smaller fish rise in accordance.
8. Company History
How successful has the business been in the past? How have systems been implemented that will allow this success to continue forward into the future? If the company has had great successes in the past, then the buyers will expect a repetition. The price goes up.
9. The Industry and Business Type
Intellectual property and specialized tacit knowledge help to up the value of a company. Also, if you are in the technology field sometimes companies can be valued at 10x to 20x their value on paper. This may seem crazy, but it is part of the intangible goodwill spoken of previously.
10. Market Dominance
This is obvious. If you are a big fish in a small pond, you’re worth a great deal more than all the other small fish. Nuff said.
Computing Your Business Valuation
Business valuation requires relatively basic computation. Difficulty arises from selecting proper methodology to value the target. Some firms have assets that do not currently generate cash flows but can still hold high value. Recently, many technology startup companies have come into existence. It often takes time before startups generate revenue, but they have proprietary ownership of valuable assets: most often technology, subscribers, or content to name a few. These special types of assets may have high earnings potential long term, if certain factors fall into place. For example, a technology may be high tech and unlike any other technology on the market, but a startup company does not have the capability to obtain high market exposure. The technology might not be valued highly using the traditional DCF or comparable companies analysis. Instead, the assets can be valued using probability theories or a slightly more complicated method known as contingent claim valuation. For example, contingent claim valuation can deal with companies that have natural resource reserves, valuation of equity in a deeply troubled company, or a young biotechnology company.[17] After exploring Aswath Damodaran’s online Valuation (Undergraduate)- Spring 2017 course archive, it appears that trends in 2017 valuation are influenced by new characteristics of target businesses. Mergers and acquisition deals have become more common in these fields because of technological development, more accurate asset data, and new scientific accomplishments. While the fundamental and market-based valuation approaches could be administered in valuation of these companies, a lot of the value in untraditional scenarios is derived in the success of application. Options pricing models can be applied for reasonable valuation. Options contracts have historically been used for traditional assets. Aswath Damodaran describes three types of options. The first, “options to delay” are assets that look bad to invest in today, may be valuable tomorrow. Proprietary rights can hold value even if they do not currently generate cash flows. The second type is the “option to expand” an asset may not look good today, but with acquisition, a company can turn the asset into a highly valuable cash flow. This is otherwise known as bootstrapping. Finally, the “option to abandon” is the choice to walk away if the asset is not doing well. Value is derived in the ability to walk away from future projected costs.
Conclusion. The great recession caused higher concern for investments choices. Valuation is a mode to potentially minimize investment risks, if completed correctly. The most commonly used valuation approaches are DCF, comparable companies, and precedent transaction analysis. Each approach produces accurate valuation solutions dependent on industry and different business characteristics. New business structures form because of complexity of assets, improvements in science, and technological advance. Valuation theories must accommodate these new business types, and efforts have been made to do so at academic centers of business and valuation.
Sources:
[1] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[2] Aswath Damodaran, “Valuation Approaches and Metrics: A Survey of the Theory and Evidence,” Damodaran Online (blog), November 2006, http://pages.stern.nyu.edu/~adamodar/.
[3] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[4] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[5] Aswath Damodaran, “Valuation Approaches and Metrics: A Survey of the Theory and Evidence,” Damodaran Online (blog), November 2006, http://pages.stern.nyu.edu/~adamodar/.
[6] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[7] Ibid.
[8] Pignataro, Paul. Financial Modeling and Valuation. Somerset: John Wiley & Sons, Incorporated, 2013. Accessed March 30, 2017. ProQuest Ebook Central.
[9] Aswath Damodaran, “Valuation Approaches and Metrics: A Survey of the Theory and Evidence,” Damodaran Online (blog), November 2006, http://pages.stern.nyu.edu/~adamodar/.
[10] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and “Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[11] Ibid.
[12] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[13] Aswath Damodaran, “Investment Valuation,” Second Edition. John Wiley & Sons, Inc., 2002.
[14] Joshua Rosenbaum and Joshua Pearl, “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisition,” John Wiley & Sons, Inc., 2013.
[15] Joel Greenblatt, “The Little Book That Beats the Market,” John Wiley & Sons, Inc., 2006.
[16] “Industry Specific Multiples,” Valuation Academy, accessed April 7, 2017, http://valuationacademy.com/industry-specific-multiples/.
[17] Aswath Damodaran, Session 22: The Essence of Real Options, Youtube.com, performed by Aswath Damodaran (2013; New York, NY: New York University Leonard Stern School of Business, 2015.), Online video.
Matthew O’Connor contributed to this report.
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