Valuation As A Source Of Insight
Entrepreneurs are in business to build value. The question is: how much value is actually being built? Valuation can help provide the answer. The process is more than a technique, it is a benchmarking exercise which can typically be carried out before making key decisions.
It is part of the due diligence process that is aimed at sifting the wheat from the chaff and therefore helps parties properly to assess the price for a deal.
Valuation can be used to help select a business strategy, start a new line of business and expand an existing one. It can also be used before entering important transactions, such as buying or selling a business, spinning off a bundle of activities from a larger organisation, bringing in outside shareholders for the first time, attracting a strategic partner and raising new equity or going public.
What the entrepreneur needs to realise is that he or she will usually know much more about the business than the equity investors he or she is trying to attract.
On the face of it this should be reassuring to investors but, in fact, it often frightens them. Why? Because the entrepreneur may not only be more aware of the good news, about the business, but also the bad. While investors know there will always be some lemons around they cannot always identify them.
Principles
The purpose of valuation is to gain understanding not arrive at a number. Once it is understood why, how and when the business is expected to make a profit, the problem of what value to place on the profit stream is already largely solved.
By analysing the profit equation, valuation helps reach a sound business judgment about the value of the business. It cannot, therefore, be divorced from critical aspects affecting the business and requires a clear understanding of the profit drivers and their mechanics. Otherwise, valuation is a garbage-in and garbage-out exercise and not worth undertaking.
For investors, only the future pays never the past. Valuation attempts to simulate the future. Information about the businesss past and the managements track record help in assessing expected performance, but the buyer will only pay for the future.
The entrepreneur has probably made considerable sacrifices but investors consider only the business prospects these create, not their costs. Consequently they are called sunk costs. Endeavours bear no entitlement to compensation only prospective benefits do.
Entrepreneurs sometimes find it hard to come to terms with this merciless approach. If errors have been made or bad luck has struck, it could well be that prospective value falls considerably short of historical value.
The worst that could happen is that the entrepreneur sticks to these sunk costs as value benchmarks. This could prevent the business from attracting the equity oxygen it needs to grow, to develop and, in some cases, survive. It is always better to have an actual market price that is low than not to have a historical value that is high.
Cash is king. For the valuation, the prospects of the business must be laid out in cash flow terms. Again, this is because the business is considered from the investors perspectives.
To buy business assets or shares in the business, the investor gives up a scarce resource cash.
The investor also wants cash back. He or she needs to know how much cash the business is expected to return to investors while maintaining the business in optimal shape. This is called free cash flow (FCF). Valuation must provide insight into the FCF generating power of the business and determine its current market price for the investor.
Cash today is worth more than cash tomorrow. No entrepreneur will argue with that. So future FCFs must be discounted back to the present to determine what they are worth today their present value (PV). Discounting means calculating how much cash is needed now to produce the expected FCFs through interest, interest on interest and returning the cash invested. The PV is an amount that produces a cash flow stream equal to that of the FCF stream.
Of course, the higher the interest rates, the lower the PV. This time value of money, which incorporates inflation, is given by the yield on a default-free government bond which is equal in length to the FCF stream. For a five-year sterling stream this would now be around 7 per cent, making 1,000 in five years worth 713 today, and 1,000 during five years in a row, 4,100.
To take more risk, investors want higher expected return. In other words, there is no free lunch. Again, no entrepreneur will take offence at this. But an interesting paradox arises. Where is the risk if you get a higher return?
Discount rates
The answer is that while we are fairly sure about the amount of risk we are taking now that is, the amount that could be lost and the likelihood of losing it we remain uncertain about what the future return is going to be. The price is what you part with and risk. The return is only what you expect.
The higher these risks, the poorer the quality of the FCFs and the more the market will downgrade these to a low PV. The deeper the PV
is downgraded for poor quality, the higher
the expected return these cash flows represent relative to that PV. In other words, the worse
the possible downside, the higher the upside must be.
It is not unusual to find discount rates of 60-80 per cent per year for start-ups or first-round equity financing to reflect these uncertainties. (See Equity funding Part 3, page 6.)
Risk-adjusted discount rates are what is called the cost of capital, known as k, or the expected return after corporate income taxes that a prospect must offer to attract investors. Investors establish their requirements on the basis of the alternative risk return opportunities available in the market, the actual marketability of the project and their own relationship to its management.
To compensate for general equity risk, the market has paid on average over the past 70 years an arithmetic premium of around 7.5 per cent over the bond rate. To compensate for the risk of a particular company relative to the stock market, that premium must be adjusted by a factor from 0.40 for businesses with relatively highly stable revenues and low operating leverage to 2 for equity that is highly exposed to the business cycle because of commercial, operating and financial risks. A safe project would command a k of around 10 per cent, a risky one 22 per cent.
But entrepreneurial projects are more often than not illiquid. Selling them may require considerable time and effort. Illiquidity imposes additional costs and risks to investors for which they want additional compensation. This can easily increase the discount rate by 5-10 per cent.
In addition, suppliers of risk capital often offer advisory, monitoring and networking services along with their capital. These consume a lot of time and could risk damage to reputations. They must be compensated. Fees are out of the question. Capital gains are not. This adds an additional 20-40 per cent to the discount rate.
In short, the illiquidity, service and reputation considerations tend to swamp competitive capital market risk return requirements in the downgrading of expected FCFs to determine the PV of an entrepreneurial project.
The business entity creates the value, not the securities that distribute it. This simple but powerful principle helped two famous economists, Miller and Modigliani, win the Nobel prize.
The entity approach to valuation starts with valuation of the business as a business, regardless of how it is financed. It discounts the FCF from operations at the k of the business cost to obtain the PV of the business entity. In the absence of any financial debt, this would correspond to the value of the companys shareholder equity. If there is such debt, its market value is deducted from the business entity value to obtain the PV of the equity.
While it is good to be with the right company, it is better to do the right thing. Investment bankers and dealmakers typically make comparisons to price cash flow forecasts. This valuation against peers is a legitimate due diligence tool for intermediaries and a useful consistency check. But it should not become an alibi for lack of scrutiny.
Application
The discounted FCF approach applies these principles extensively and involves six steps:
Forecast FCFs during the forecast horizon;
Estimate k;
Estimate the continuing value, that is, the value at the horizon;
Discount these to the present to obtain the business PV;
Add cash and marketable securities;
Deduct financial debt to get the equity PV.
This building block approach is popular since it reveals where value is derived. It is also linked easily to regular business information and circumstances.
For example, the FCF of a particular period is nothing more than net operating profits minus taxes paid on these (Noplat) plus depreciation minus the investments that had to be made during the period to generate the cash.
These investments are the increase in
working capital requirement (the investment necessary to operate the fixed assets such as increases in receivables or inventory, which tend to be proportionate to sales) plus net capital expenditures.
In other words, the FCF approach recognises realistically that to create more value, most businesses require investment. No investor can eat the cake (withdraw cash) and have it too (leave cash in the business to create more value).
Take a company that stops growing after a few years. At the horizon the company plans simply to replace assets without any further investment.
In this case, FCF will coincide with Noplat and Noplat will never grow. It is then akin to a perpetuity and its value at the horizon is simply Noplat divided by k. If the company is expected to grow after the horizon, a realistic long-term sustainable growth rate of FCF will have to be built in to estimate continuing value.
Or consider a company that operates under perfect competition unlikely for start-ups or initial financings but not unrealistic at some time in the future.
In that case, you pay for what you get and get what you pay for: the cost of further expansion investments (I) will be equal to the PV of the FCFs that these investments will generate. This is like buying bonds in an efficient bond market: they earn the competitive return but nothing more.
The cost of such investments is equal to the present value of their expected free cash flows: I = PV(FCF). The difference between the PV(FCF) and I is called the net present value (NPV) or the economic value added (EVA) of an investment. Under perfect competition or in an efficient bond market it is zero: NPV=EVA=PV(FCF)-I=0. Under these circumstances, expansion does not add value and FCF is also equal to Noplat. It is as if the company were only replacing existing assets.
The comparables approach
While discounted cash flow is the best way of organising valuation according to our seven principles, price to earnings (p/e) and price to book value (p/b) ratios are the next best variants.
The p/e ratio indicates how expensive one unit of earnings really is. The more that unit of earnings can grow without asking for more cash from the shareholders and the more the unit pays out in cash to the shareholders without reducing future growth and the lower the k, the better the quality of the earnings unit and the more expensive it will be.
The p/b ratio indicates how many currency units of shareholder value one currency unit of shareholder investment has created. It is a measure of what management has done with a unit of shareholders money: create value (p/b > 1) or destroy it (p/b < 1). The more the prospective profitability of the business exceeds its k and the more there are such profitable investment opportunities, the higher the market value of that capital will be relative to its original cost.
The comparables approach to valuation multiplies the earnings (E) or book value (B) of the business to be valued with the p/e or p/b ratio of a comparable company to determine what the business would be worth if it would command these p/e or p/b ratios.
If applied properly, these approaches should reach similar valuation results because they also work with forecasts about the business, its cash flows to investors, growth and cost of capital. Unfortunately, they rely extensively on accounting numbers and are often used as an alternative to proper analysis by simply plugging in a p/e or p/b ratio without proper investigation of the true comparability between the businesses. Because accounting data involve many discretionary adjustments and few businesses are really comparable at all times, this method can lead to confusions.
Actually, p/e and p/b ratios are highly variable within industries and over time. Companies in the publishing sector in the Netherlands recently had p/e ratios ranging from 8.3 to 24. Between 1949 and 1995, the average S&P 500 p/e ratio was 13.9, ranging between about 6.9 in 1980 and 22.5 in 1961. The S&P 400 p/b ratio ranged from about 0.4 to 1.9 between 1960 and 1994 with an average of slightly less than 1.1.
Conclusion
Discounted FCF, p/e and p/b approaches should all lead to the same valuation results. The more complex a situation, the more the profit equation and the uncertainties surrounding it require thorough analysis.
The discounted FCF method forces that analysis. That is why some people criticise it for requiring too many estimates and approximations and for being too academic. But in our opinion, it is always better to be approximately right than to be exactly wrong.
Diligent investors know this. That is why the more complicated the discounted FCF is, the less they will be satisfied with shortcuts.
The financials of a business plan are a check on its overall consistency and attractiveness. Discounted FCF analysis helps to determine how much value the business is actually expected to build. Isnt this what valuation is all about?