Valuation of a business or financial asset is the ascertaining of it’s worth and involves a lot of judgement. In India, a valuation report can be given only by a Registered Valuer registered with IBBI (Insolvency and Bankruptcy Board of India) for purposes as defined by section 247 of the Companies Act, 2013, and the Companies (Registered Valuers and Valuation) Rules, 2017. Such purposes include valuation for Merger and Amalgamation, Issue of capital, Issue of Sweat equity shares to directors and employees, and many such cases.
Business valuation is usually done using one or more of the 3 methods below:
- Income Method: Also called the discounted cash flow (DFC) method, this method is for a going concern where there are positive cash flows and the value of a running business is more than the value of net assets.
- Market Method: This method is adopted when there are market comparable, i.e. other companies of similar size, business activity and other attributes, that have already been valued by the market.
- Asset Method: This method can be used when the above methods do not apply, such as for liquidation of business, and the business is valued mainly for the assets available.
Valuation involves calculations using multiple valuation methods and evaluating various factors that can affect the value of a business or securities such as growth, cash flows, cost of capital, industry and marketability of securities.
Lets illustrate the valuation of a typical income generating business. We can use the income method and validate with the Market multiple method using the following steps:
Using the Income Method, we follow the steps below:
- Determined the free cash flow based on profit and loss statement with adjustments. Calculated the free cash flows by taking Profit after Tax (PAT), added back depreciation and interest and reduced working capital and capital expenditure increases and tax provisions. Based on growth provisions in revenue and costs, cash flow for future 5 years, known as the explicit period, can be calculated.
- Determined weighted average cost of capital (WACC) to allow for discounting of cash flows. This will be aggregate of cost of equity and debt. Cost of equity can be calculated using CAPM (capital asset pricing model), having the risk free returns, a beta, and risk premium as variables. Next, Cost of debt can be calculated using after tax interest rate. To fine, WACC we can be adjusted for liquidity of securities, country risk etc.
- Discount the cash flows to get a NPV for the explicit period of 5 years. Let’s say it is 22 M$.
- Next, we used Gordons Growth Model to calculate a terminal value, which incorporates steady cash flow growth, and discount the same using WACC to get a NPV for the non-explicit period (perpetuity). Let’s say it is 78 M$.
- The Enterprise Value is Explicit Period Value plus Perpetuity values, thus 100 M$.
The above value can be validated using the Market Multiple Method, which broadly we use the following steps:
- Identifying a comparable publicly traded company for market multiple purposes.
- Calculate the Enterprise Value/EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple of this comparable company , Lets say it is 20.
- Calculated the EBITDA of our company and multiply the comparable company EV/EBITDA * Our Company EBITDA to arrive at an Enterprise Value of our company, say 90 M$
Comparing the Income Method and Market method we find their values were varying by about 10%. Taking an average of the Income and the Market Method, we got an average value of 95 M$. For the report, the Enterprise Value is given as a range of 90 to 100 M$, and stating the assumptions, evidence and analysis performed.
Today we find that Startups with no profits and no positive cash flow but instead with promise and potential and with just revenue growth, app users, prototype, idea, technology or intellectual property commanding huge valuations. All these indicators are only a proxy or leading indicators for the potential profits to be made if the startup grows and become another Amazon or Google, hence the valuation comes with high risk. For valuation of startups we need new methods such as the Berkus Approach, and the Valuation by Stage approach, where leading indicators and parameters other than cash flows are given value. Ultimately, value is what the market is willing to pay and indeed currently, the players who are driving the market are very bullish and giving a huge premium for the loss making small technology enabled startups compared to larger but older profit making companies.
