A company valuation is carried out to determine the intrinsic value of a business (i.e. what is it worth today) and also to see what it is worth in 12-month time (one-year price target). Valuations are carried out by analysts for various reasons. The most common reason is to identify buying and selling opportunities of publicly listed companies. Other reasons include valuing a company for a merger or take-over acquisition.
When valuing a business as a going concern, there are three main valuation methods used by market practitioners: (i) intrinsic value approach, (ii) market approach, and (iii) cost approach. All three methods try to identify the value at which two market participants agree on, in an arm’s length transaction.
An essential part of every valuation, irrespective of the valuation approach used, is the business financial projections. These usually cover from two-years up to and sometimes even exceeding 10-years forecasts. Projections are normally supplied by management, as inherently a third party cannot have the same company insight as those managing the company on a day to day basis. Unfortunately, local public listed companies are very discrete in projecting future financial performance, with only a few entities indicating a one-year financial forecast. It is worthy to note that, public listed entities which have accessed the capital markets through a retail bond issue are required to annually publish a ‘Financial Analysis Summary’, which includes a one-year projection.
It would be encouraging if more equity issuers follow the international norm, where it is customary for management to publish more than one-year financial performance, especially for growth companies. Transparency is essential for financial markets and communication from management boosts investor confidence and the public’s will to invest.
Intrinsic value approach
The discounted cash flow (DCF) approach is a form of intrinsic valuation and is the most thorough approach to valuing a business. It entails forecasting of a company’s cash flows and discounting the cash flows to arrive at the current present value. This is achieved by utilising an appropriate discount rate which reflects the risk of the business. The DCF is based on a company’s fundamentals and expected future performance. According to the DCF, the value of a company is not a function of demand and supply for a company’s stock, but it is based on a company’s ability to generate future cash flows for its shareholders.
There are two common approaches to calculating the cash flows that a company generates being, the free cash flow to the firm (FCFF - unlevered DCF) and the free cash flow to equity (FCFE - levered DCF). FCFF is actually the cash available to bond holders and stock holders after all expenses and investments have taken place, whereas FCFE is the cash available to stock holders after all expenses, investments, interest net of tax and capital payments to debt-holders. FCFF is discounted using the weighted average cost of capital (WACC), which represents a weighted average of the cost of equity and the cost of debt. In contrast, the FCFE is discounted only with the cost of equity, which is naturally higher given that debt financing is cheaper than equity financing. Both approaches should theoretically arrive at the same value, however in practice this is near to impossible.
Naturally, the further out an analysts goes with projects, the greater the subjectively. Hence in practice projections range from two years to 10 years depending on the conviction of the forecasts going forward. The industry as well as management’s projections and more importantly management’s ability in the past to meet or exceed guidance will play a crucial role in identifying the number of years forecasted in the valuation. Subsequently, practitioners make some high level assumptions to arrive at the lump-sum business value after the final forecasted year.
This sum is referred to as the terminal value. The terminal value is calculated with two main methods, (i) growth in perpetuity and (ii) exit EBITDA multiple. The former is based on an assumed terminal growth rate and an expected yearly maintenance capital expenditure. As the name implies the exit EBITDA multiple is based on an assumed multiple on the EBITDA of the final forecasted year. Personally, I prefer to utilise the growth in perpetuity for a mature company as the terminal growth rate of a growth company is much more subjective than that of a mature company.
Market approach
The market approach values a company by comparing its multiples to its peers, hence it is also a form of relative valuation. Trading multiples include, but not limited to the Price to Earnings (P/E) and the Enterprise Value to Earnings before interest, tax and depreciation/amortisation (EV/EBITDA).
A caveat of this approach is that in a situation where market participants are limited or incorrectly priced, the market approach is impractical.
Cost approach
The cost approach is also a form of relative valuation where the company being valued is compared to other companies that have recently been sold or acquired. As expected, this approach has the same downfalls of the market approach, and can easily become stale-dated and no longer reflective of the current market conditions as time passes.
Conclusion
All valuation methods have some degree of assumptions and one can never be fully accurate on the value of a business. Nonetheless, with further transparency from local issuers and a continuation in the trend of private issuers accessing the local capital markets, investors’ confidence can continue to strengthen.
Disclaimer: This article was issued by Rowen Bonello, research analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.