Valuation is a science and an art
“Price is what you pay. Value is what you get.” — Warren Buffett Valuation is tough because it’s not an exact science. No two companies are precisely alike. Each business owner will have a unique scenario. While there are plenty of valuation methods a candidate or business can choose from, here are the three most popular choices. Each of these applies differently to specific contexts and the one a candidate will choose depends on the relevant facts of each unique case. Taking the example of performing a valuation on a distressed company, the first thing a candidate must decide is whether the company’s value should be derived as a liquidation value or a going-concern value. There are three methods for doing so:The Comparable Company (Market Comparison) Approach
This two-step approach derives a distressed company’s enterprise value (EV) from the EV relative to the earnings potential that the market has assigned to each of its peers. First, the candidate must calculate a financial performance metric for the debtor, such as normalized earnings before interest, taxes, depreciations, and amortization (EBITDA). Second, they must determine the multiple of a healthy comparable company’s market assigned EV to its corresponding EBITDA. Together, these two inputs are multiplied to calculate an EV estimate for the distressed company. This approach poses a number of risks that should be screened for in a candidate:.- Are they choosing the best debtor performance metric?
- Are they basing their valuation on the right financial performance period, given the debtor’s current financial situation?
- Are they comparing companies that are truly relevant to the distressed company in question? What has convinced them these comparisons were the right choise? question.
- What approach are they taking to normalizing EBITDA ahead of valuation (non-arms-length revenue, start-up costs, inventory, etc)?
The Precedent Transaction (Comparable Transaction) Approach
Rather than derive the EV from market-assigned EVs, this method attempts to calculate the bankrupt company’s EV from the prices paid by purchasers in recent acquisitions of comparable companies. Complications may arise when deciding which transactions involved comparable companies and adjusting for any control premium which a buyer may have paid. Typically, this approach should be utilized to verify valuations obtained by other methods due to the singularity of each transaction.The Discounted Cash Flow (DCF) Approach
Last but not least, the DCF approach generates the EV based on the present value of a company’s projected cash flows. To calculate EV, first the candidate will need a five-year projection of the company’s cash flows. These cash flows will be then discounted back to present value using a weighted average cost of capital (WACC). Second, the candidate should calculate a terminal value by applying the EV multiple or perpetual growth rate to the final year of projected cash flows. Lastly, the terminal value should be discounted back to the present using the WACC. The amount is then added to the present value of the projected near-term cash flows to derive the EV of the company. The difficult part is choosing the correct inputs for this approach.Which method should they use?
All of the above approaches may not be equally useful for every case. And there may even be additional suitable methods, depending on the relevant facts and unique situations. U.S. courts tend to use multiple approaches in any given case to establish a sort-of checks and balances system. The comparable company and comparable transaction methods should be used together with the DCF method because the first two rely on data from outside companies while the DCF method yields a valuation generated from the performance of the company in question. Q: Lambda, a social network designed to link fraternities and sororities around the US, has seen its membership steadily rise to 20 million regular users but has not been able to turn a profit. How would you value a social network with revenue but no profit? This poses an intriguing situation for the candidate, who needs to get more information to better understand the company they’re valuating. The questions they choose in order to gain the data they need can be telling:- What audience is the social network reaching out to?
- Who are their competitors and how is their offering different?
- How do they generate revenue?
- What is their growth rate and which metrics are used to measure this?
- What stage of the business lifecycle are they in?
- What stage of funding are they in? How long is the company’s cash runway before additional funding is required?
- What does their capitalization structure look like?
- What is management’s plan for the company going forward? What is their exit strategy?
- What assets, technological or otherwise, have been developed that could provide value to others?
- Historical revenue and expenses or financial statements
- Industry data and growth rates
- Discount rates
- Cost of capital
- Tax rate and all tax-related information
- Purchase price
- Salvage value, if anything is being sold
- The importance of an accurate sensitivity analysis, to showcase how each variable has impacted the final valuation.
- Terminal growth assumptions will drive a large part of the final growth value, so any such analysis must be backed with clear justification for these assumptions.
- Identify the most relevant competitors. They should look for other pharmaceutical companies that are producing similar products.
- Research their current market capitalization, and come up with a median PE ratio.
- Adjust expectations based on any specific nuances of the public company they’re trying to value. What differentiates this private pharmaceutical company from its peers and how do these differences adjust the valuation up or down?
- Time horizon - DCF relies on finding a present value for future cash flows. Longer-term outlooks add uncertainty, particularly as they tend to trend upwards, to account for expected rises in interest rates, for example.
- Capex assumptions - Cash flow projections are also subject to swings based on capex assumptions. Capex is particularly hard to predict given its discretionary nature: e.g. management cuts a large planned investment or not in a difficult year. This can snowball, leading to small annual capex variations having a dramatic impact on valuation.
- Working capital assumptions - Mature companies can generally predict the future relationship between working capital and earnings while a young company might have built optimistic forecasts into its future cash flow. The candidate needs to identify these differences and account for them, to avoid complicating the model.
- Debt/equity ratio - Rates of return on debt and equity are likely to differ broadly over time, largely as the former is fixed at a set interest rate unlike the latter. Their evolution should be measured carefully for how they weigh into the valuation.
Avoiding bias at all costs
“The direction and magnitude of the bias in your valuation is directly proportional to who pays you.” — Aswath Damodaran, NYU Stern School of Business Bias in a valuation process is an ever-present risk. An investment banker can provide a value his client wants to hear to get the deal done. Public perception of a brand can equally be a major drag factor on a valuation, albeit influenced by different factors. The right independent valuation professional must be able to see through any potential bias and focus their efforts solely on the business and its market pricing. Q: A company is looking for a valuation ahead of a potential acquisition after a successful product launch. However, its market perception remains affected by negative press reactions after repeated delays. How would you ensure this does not skew the valuation? When faced with this situation, a candidate should first understand where such pressures are coming from and seek to remove them from the equation. Many valuators may see such uncertainty as making their life harder and seek to dismiss it, choosing to rely on fundamentals instead. However, in scenarios where bias pressures are evident, the right candidate must proactively seek to understand them and how to account for them.- What public statements have been made about the company by executives concerning its potential value?
- Is the acquisition contingent on a specific value being provided to the buyer?
- To what extent did the market reputation of the company spur the interest in acquisition, above and beyond its growth or revenue?
- What marketing and PR strategies have been rolled out to counter earlier bad press? Have these strategies been successful in reversing public perception, and how has this impacted growth expectations?
That’s How It Should Be Done
Without a doubt, hiring the right finance professional to value their company is one of the most important decisions a business owner can make. True expertise in this domain requires deep understanding of the various valuation methods, both for their theoretical scope and their practical applications. However, this is not always enough. The right candidate should preferably also have extensive experience valuing similar companies, preferably in the same industry. This article originally appeared on Toptal.https://www.businesscreatorplus.com/the-vital-guide-to-hiring-valuation-experts/
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