This article is written by Anurag Mawai, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from Lawsikho.com. Here he discusses “Valuation of a Services Company”.

Introduction

The Union Corporate Affairs Ministry recently released data that over one lakh companies get registered in India every year, and the industrial body FICCI also indicated that this figure is surely to increase astronomically if not already a giant number seeing that India is a developing country with close to two-thirds of its population earning below the average per capita income mark of the IMF. These figures show that India as a market and as a host to corporate culture is still to show its true might and its muscles are not yet fully flexed. In this age of Startup India and Make in India where every two out of three Indian is under 35 and is roaring to become an entrepreneur and become their own boss the charm of starting a business has never before seemed so enthralling. With over 700 higher education institutions and 200 million enrolled students being churned out by the education system a massive inflow of ventures is sure to come. But a vital step of making a company is to be able to judge its profitability and its earning potential, be it for entering into a sector or buying an existing enterprise, valuation is the first step undertaken be it for a minority stake or for a massive merger and acquisition operation. The earlier viewpoint of sales or revenue earned by the company as its sole valuation index is a rather simplistic look of the entire valuation process. A real life valuation of a company is a complex and detailed exercise requiring many factors and considerations to be made. But first, let us see what purposes does valuation serve in financial decision making.

What is the need of Valuation?

Business valuation is the general process where we determine the economic value of a whole business or company unit. Valuation can be used for determining the fair value of a business for a variety of purposes, like determining the sale value for the company or even an individual investor, provide data for establishing partner ownership, taxation calculation, and even insolvency proceedings. Owners will often turn to professional business evaluators for an objective estimate of the value of the business.  Business valuation usually includes an analysis of the company’s management, its capital structure, its future financial prospects or the market value of its assets. The approaches used for valuation can vary among evaluators, businesses, and industries. Common techniques for business valuation include a review of financial statements, discounting cash flow models and similar company comparisons. Some of these business valuation techniques are highlighted as below

Approaches to Valuation

Valuation of a company in the most rudimentary form is the summation of equity owned by it and debt borrowed by it. However, if a more detailed analysis or specific decision is required then evaluators use a mix of approaches and techniques relating and depending on sector suitability or scale of operations of a company. Some of those techniques are elaborated as follows: – 

1. Valuation Multiples
2. Net Asset Value (NAV)
3. Discounted Cash Flow (DCF)
4. Economic Value Added  
5. Market Value Added
6. Average Fair Value

A. Valuation Multiples

The most common method to determine valuation of a service firm is by using a Valuation Multiple, it is a factor used to multiply an economic profit for deriving a figure meant to represent the business value of the firm. Valuation multiples are financial measurement tools which evaluate one financial metric as a ratio of another, for making different companies more comparable. Multiples are the proportion of one financial metric (i.e. Share) to another financial metric (i.e. Earnings per Share). It is an easy way to compute a company’s value and compare it with other businesses.  Let’s examine the various types of multiples used in business valuation. 

There are two main types of valuation multiples:

1. Equity Multiples
2. Enterprise Value Multiples

Similarly, there are two main methods of performing analysis using multiples:

1. Comparable Company Analysis (“Comps”)
2. Precedent Transaction Analysis (“Precedents”)

Elaborating on the types of valuation multiples

1. Equity multiples

Investors make use of equity multiples in determining valuation especially when they aspire for minority positions in companies. The list below shows some common equity multiples used in valuation analyses. The equity value (or net asset value) is the value for the shareholders after any debts have been paid off. We can determine the company’s equity value when we value a company using levered free cash flow in a DCF model. If we know the enterprise value and have the total amount of debt and cash at the firm, you can calculate the equity value as shown below.  

Equity value formula

Equity value = Enterprise Value – total debt + cash

Or

Equity value = Number of shares x share price

 Various Equity Multiples are listed below: –

• P/E Ratio –  Also called Price to Earnings Ratio. This is the most commonly used equity multiple as the needed data for this ratio is easily accessible and mostly found in public documents. It is computed as the proportion of Share Price to Earnings Per Share (EPS)
• Price/Book Ratio – This Multiple is not used in service firms as tangible assets are not that much of the final value this is useful in case where assets of the company are the prime drivers of its earnings; it is computed as the proportion of Share Price to Book Value Per Share.
• Dividend Yield – used for comparisons between cash returns and investment types; computed as the proportion of Dividend Per Share to Share Price
• Earning Yield– It shows percentage of a company’s earning per share, and to determine if share of the company is overpriced or underpriced, it is the inverse of P/E ratio the formula is Earning per Share/ Market price per share.
• Price/Sales – used for firms that are currently making losses. It is used for quick estimates; computed as the proportion of Share Price to Sales (Revenue) Per Share

However, a financial analyst must take into account that companies have varying levels of debt also and that is an important factor which ultimately influences equity multiples valuation outputs.

2. Enterprise Value (EV) multiples

The second type of valuation multiples are Enterprise Multiples, these are used when decisions are about mergers and acquisitions. As these instead of giving the value of equity share give an idea of the value of the entire enterprise. This is also appropriate in startups where the venture is not big that it has gone public. Enterprise value removes the complications to valuation caused by the capital structure. But equity funds do not use this method as this also does not give a clear picture of future returns for equity investors. The information required in this method is not public and instead is requisitioned by the company planning to do the merger or acquisition. The enterprise value (which can also be called firm value or asset value) is the total value of the assets of the business (excluding cash).

When you value a business using unlevered free cash flow in a DCF model you are calculating the firm’s enterprise value.

If you already know the firm’s equity value, as well their total debt and cash balances, you can use them to calculate enterprise value, using the below formula

Enterprise Value = [ Number of shares x share price] + Total Debt – Cash

 The list below shows some common enterprise value multiples used in valuation analyses.

• EV/Revenue –  This is a rather rudimentary form of deriving enterprise value as it shows the Enterprise value as a proportion of revenue. The definition of revenue can differ in respect of accountancy methods and taxation so this metric is slightly affected by differences in accounting and other considerations having its impact on the final ratio.
• EV/EBITDAR – This is slightly refined view compared to EV/Revenue as it is mostly used in industries in the hotel and transport sectors; computed as the proportion of Enterprise Value to Earnings before Interest, Tax, Depreciation & Amortization, and Rental Costs
• EV/EBITDA – EBITDA can be used as a substitute of free cash flows; most used enterprise value multiple; Enterprise Value / Earnings before Interest, Tax, Depreciation & Amortization
• EV/Invested Capital – used for capital-intensive industries; computed as the proportion of Enterprise Value to Invested Capital

There are more equity and enterprise value multiples used in company valuation, this article only presented the most common ones. More readings and a thorough understanding of each multiple and related concepts can help analysts better apply multiples in making financial analyses.

The above metrics of Equity and Enterprise Valuation can be analyzed with two common approaches to valuation multiples Approaches are macro techniques which dictate the viewpoint and the entire methodology for using these valuation tools These approaches are

1. Comparable Company Analysis – This method gives an analysis of public companies that are similar to the company being valued. A valuation expert will gather share prices, market capitalization, capital structure, revenue, EBITDA, and earnings for each similar company.  Comps is a relative form of valuation which requires other similar companies for evaluation, unlike a discounted cash flow (DCF) analysis, which is an intrinsic form of valuation and can be done as the basis of the company’s strength on its own.

Steps required for a Comparable Company Analysis

Finding the right comparable companies- An analyst needs to find the detailed description and industry classification of the company, then a search for databases of similar companies in either the same industry or the same locality is considered.

The criteria for including a company in the comparable list are usually Industry classification, Geography, Size (revenue, assets, employees), Growth rate, margins and profitability.

• 1. 1. Gathering Financial Information- After the list of comparable companies is compiled then the financial information of these companies needs to be gathered. This information can vary depending on industry and company’s stage in the business cycle, for mature business metrics like EBITDA are used while for early stage companies Gross Revenue or Sales also suffice for this part either soft wares for financial gathering can be used or it can be done from quarterly financials though the second option can be really tasking.
     2. Setup Comp tables – After all the information has been gathered then a table for comp analysis needs to be framed the heading of this table will be composed of following heads
        1.  Company name
        2. Share price Share price
        3. Market capitalization
        4. Net debt
        5. Enterprise value
        6. Revenue
        7. EBITDA
        8. EPS
        9. Analyst estimates
     3. Calculate comparable ratios- After the financial information and analyst estimates have been calculated then ratios for valuation need to be derived some of the common ratios are as follows
        1. EV/Revenue
        2. EV/Gross Profit
        3. EV/EBITDA
        4. P/E
        5. P/NAV
        6. P/B

2. Precedent M&A Transactions – This method analyzes past mergers and acquisitions (M&A) for companies in the same industry, which can be used as a reference point for the company that is being valued. Learn all about performing precedent transaction analysis. Precedent transaction analysis is a method used in company valuation where past M&A transactions are used for valuing a comparable business today. Commonly referred as “precedents”, this method of valuation is common when valuing an entire business as part of a merger/acquisition and is commonly prepared by those involved in investment banking, private equity, and corporate development.

Steps used in Precedent Transactional Analysis are elaborated as under

• 1. 1. Search for comparable transactions- The analyst will need to find historical transactions in recent history (ideally) and in the same sector or industry. The transaction should be matched with various indexes like 
        1. Industry classification
        2. Type of company 
        3. Financial metrics 
        4. Geography 
        5. Company size 
        6. Product mix 
        7. Type of buyer 
     2. Analysis of transactions- After sorting the transactions and collecting the data analyst needs to filter those transactions which have the required information matching the criteria and similarity to the desired company, and remove those transactions where some information will be missing or may not be public or may be incomplete.
     3. Apply Valuation Multiples- When a list of companies and the transactional details have been finalized then Valuation Multiples can be applied. The most common multiples are EV/EBITDA and EV/Revenue. These valuation multiples could range from 5X to 1X.

Usage of multiples in valuation analysis helps in making rational judgments for analysts and companies, particularly true when multiples are used for providing valuable information about a company’s financial status. Furthermore, multiples are also relevant as they involve key statistics which are pivotal to investment decisions. Additionally, the simplicity of multiples makes them an easy tool for most analysts.

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But, this simplicity is also considered a disadvantage because of the fact that it simplifies complex information into just a single value. This simplification is prone to misinterpretation and makes it a challenge to break down the effects of various factors.

Next, multiples represent a single instance of a company’s status rather than a period of tim.they do not easily show how a company grows or progresses. Additionally, multiples reflect short-term data instead of long-term ones. Thus, the resulting values are only applicable in the short-term and not in the longer future.

B. Net Asset Valuation Method (NAV)

NAV is usually calculated on the basis of market value but in case market value is not available then book value can be used.  

It is calculated 

NAV per equity share = (Total Assets – Total external Liabilities)/ Total number of equity shares
This method is usually used for entities which own assets having prominent value. 

C. Discounted Cash Flow

Discounted cash flow (DCF) is a valuation method used for estimating the value of an investment based on its future cash flows. DCF analysis calculates the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of the investment, then the company is considered valuable to be invested.

DCF is calculated with following components CF = Cash Flow, r = Discount rate (WACC)

The Equation for calculation of Discounted Cash Flow (DCF) is as follows

DCF = Cash Flow / (1+r)^n  

where n is the time period

r = is the discount rate used for estimating future cash flows If a firm is evaluating a potential project, they may use the weighted average cost of capital (WACC) as this discount rate. The WACC is the average cost which a company pays for capital through borrowing or selling equity.

Sum of cost of capital of equity (Ke), Cost of capital of retained earning (Kr), Cost of preference shares (Kp) Cost of capital of debt (Kd) multiplied by their respective weights. Weights are usually determined on the basis of book value or market value of securities.

DCF analysis can be done

1. Estimate the future cash flows according to the process given below

2. After that determine the Weighted Average Cost of Capital (WACC) i.e. cost of securities which are to be adjusted with appropriate weights suited to the security of the company as given in the formula above

3. Then apply the Free Cash Flow and WACC to the formula of DCF = Cash Flow / (1+r)^n.

D. Economic Value Added

Excess return earned by company over and above the minimum desired return. It is the difference of after tax EBIT and Multiple of capital employed and overall cost of capital. For example, let’s assume Capital employed in Rs. 100 crore and overall cost of capital is 10% so the company will have to at least earn Rs. 10 crores to cover its cost, now suppose the said company is earning Rs. 12 crores so the economic value added is Rs. 2 crores. If the EVA is positive, then the investment should be pursued.

E. Market Value Added 

This is a very basic method of valuation which does not go into details of the financial metrics. The basic objective of using this method far reaching applicability of the valuation method for as many companies as possible even enabling cross sector comparisons. But this method does not take into account geographical or market based subjective conditions so it is not to be relied upon for its accuracy in turbulent market conditions.

The method for calculation of Market Value Added approach is as follows: –

Market Value Added = Value as per market – Value as per books  

Value as per market is calculated as the multiple of market share price x number of shares of the company

F. Average Fair Value

This method comes to play after almost all avenues have been exhausted and as such it is not very detailed. When a reliable estimate cannot be derived from one method alone due to absence of data or no comparable companies being available, then more than one method valuation is averaged and this valuation is called Average Fair Valuation

Conclusion

While there are some industry wide accepted methods for valuation, it isn’t an exact science it is an art. The entire process is filled with a series of assumptions and estimations. Additionally, the valuation methods are easily manipulated based on the time period of which the analysis is being done. No single valuation method can give a foolproof method for future performance of the company, as that has various other macro factors involved too all of which are impossible to account for. Although the availability of detailed data in case of public companies makes the analysis more realistic still there are chances of it being biased as well. Hence no single Valuation method can serve as a panacea and the only help that these methods can do is in analyzing complex data to provide certain trends for more informative decision making. The rest, as they say, is subject to market risks.

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.