How to value a business?

Disclaimer: I am not an expert and below is based on my limited exposure of this area. This is a work in progress and I would keep updating it as I broaden my understanding.

Before discussing various methods of valuation, we should keep in mind that complex models don’t necessarily lead to better results. Accuracy of valuation depends upon the correctness of the assumptions and that is quite subjective. There are some thumb-rules and best practices but even those might not be applicable universally.

There are 3 components of enterprise value:

1. Valuation of operating assets, i.e. valuing operations of the business. This can be estimated using free cash flow method of valuation.
2. Valuation of non-operating assets such as investment in assets not directly related to the core business. This can be estimated using market value method of valuation.
3. Valuation of opportunities and uncertainties. For example a company can have patent rights or some other intellectual rights.  This can be estimated using real option method of valuation.

There are 2 components of valuation. The first is determining the present value of explicit time horizon. The second is estimating the terminal value of the business with an assumption that after the explicit time horizon, the business will reach to a stable stage without much of growth opportunity. To calculate terminal value, perpetuity value method is used with the growth rate as industry or economy (usually take as 3%) growth rate. A conservative value should be taken for this growth rate otherwise one would get terminal value as significant proportion of the total value. There may be some companies that may be able to sustain their above-average growth rate because of superior innovation abilities or advantages such as patent rights.

Utilizing above components, following is an approach for valuation:

Decide Explicit Time Horizon

The 1st thing to decide about is an explicit time horizon. This depends on the company and its business. For example if the business is cyclic in nature, explicit time horizon should be longer. Taking time horizon too short will undervalue the business whereas taking it too long won’t be appropriate as we can’t foresee too far in future.  Thumb rule is to take time horizon as 7-10 years.

Divide Explicit Time Horizon in 2 Parts

Divide the time horizon in 2 parts with up to 5 years as first part and remaining years as second part. Till 5 years, one should forecast each line-item of Profit and Loss statement and then forecast cash-flow. Afterwards one should forecast each line-item of balance sheet for reality-check.

For subsequent years in second part, forecasting won’t be realistic. Hence focus should be on value drivers such as growth rate, ROIC and WACC. While forecasting one thing should be kept in mind that forecasting is not extrapolation. Factors such as discontinuation in the business may play a role. Technology may be a big reason for disruption the business as in case of telecom or computer hardware business.

Valuation is about find a range of numbers within which value of the business will lie. So one shouldn’t take perfectionist attitude.

Estimate target capital structure

One thing that should be kept in mind is that the target capital structure may differ from current capital structure. For example, presently there may be high proportion of debt that would reduce over time. Factors such as how quickly the company can achieve its target capital structure and how much internal resources would be generated would come into play.

Determining WACC

WACC depends on target capital structure and tax regime.

For cost of equity, CAPM could be used where,

Re = Rf + β(Rm – Rf)

So what should be value of Rf? For USA it could be 30 years government bond. For India, volume and number of transactions for 30 years bond is not significant. Hence, we can use 10 year government bond for Rf.

Rf also changes with time and we shouldn’t try to forecast Rf.

Next is the value of β. Though β is available from various databases (example capitaline) and stock exchange etc, don’t use this value. In stead useregression model to regress return on stock (y-axis) to return on index (say BSE 500). The slope of the curve will be β. Software package such as MS Excel can be used to calculate β.

This β should be the average β of the industry and for the company in question. Also this β is equity beta (levered β), i.e., it is affected by the capital structure of the company. For calculating unlevered beta check earlier post. So for a set of comparable companies, find levered β using regression model. Then find unlevered β for each of those companies and take average. That would be unlevered β for the industry. Use this unlevered β and target capital structure to find the levered β for target capital structure.

Market premium, (Rm – Rf) refers to the expectation of investors and it’s not the actualized value. But this is more stable than Rf. For India, limited data is available from 1991 onwards. Through various empirical studies, value of market premium for developed countries has been found in the range of 5.5% to 6.5%. Using this range as a benchmark and adding country risk to it, market premium for India can be found.

A developing country would be more risky as compared with developed country due to various reasons. The market in that country can be volatile which implies more risk. This risk be due to political reasons or due to frequently changing economic policies in that country. For example, if Moody downgrades credit rating of India, the country risk would increase. For India, an additional 2% is added to the country of developed country. So in Indian context, the market premium would have a value in the range of 7.5%-8.5%. It’s worth pointing out that other people may have a different estimate for market premium for India. Important here is to keep in mind that valuation depends heavily on the assumptions and it only gives a range of value rather than a precise value.

Next is calculating cost of debt. It can be estimated using interest expenses from Profit and Loss statement and taking opening balance of debt.

For calculating WACC check earlier post.

Forecasting

First one should forecast each line-item of Profit and Loss statement and then forecast cash-flow. Afterwards one should forecast each line-item of balance sheet for reality-check.

From P&L statement, multiple for each of expense to revenue ratio is developed and, using these multiples, expenses are forecasted. Revenue forecast is done by forecasting both volume and price. Information required for volume forecasting can be obtained from public reports, board-of-director reports etc. Factors such as industry growth rate, market share of company, price-pressure, global ambitions of the company etc should be considered.

Similar exercise is done for forecasting each line-items of the balance sheet. There are lots of assumptions and judgments involved. For example, how will the company be able to sustain the growth, maintain d/e etc. So scenario analysis is done from growth considering the finance available to fund the growth.