Article 10: Valuation — Part Two
Methods of Valuation
In the previous write-up, ‘Article 09: Valuation — Part One’ we covered the Bermuda triangle of valuation where we unraveled the typical *misconceptions* about the process of valuing a company. In this article, we will try to unpack the most commonly used approaches for valuation.
Before we get into valuation methods, we should expand on one key topic — cash flow.
According to Investopedia, cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows, or more specifically, maximize long-term free cash flow (FCF). FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets (property, vehicles, stocks, bonds, etc.). FCF represents the cash available for the company to repay creditors or pay dividends and interest to investors.
A cash flow statement gives you a clear understanding of how much money you actually have on hand. It also states the information about cash equivalents i.e., money in your bank account, a short-term investment like gold, or any other asset which can be converted to the form of cash in hand. A positive cash flow (cash inflow > cash outflow) is generally a sign of good financial health. One might as well fashion a half-corollary of the law of conservation of energy: “an asset can be converted from one form to another”; half-corollary because assets can be created and destroyed, unlike energy.
Let’s look at what happened during pandemic-inflicted lockdowns last year. Consider an apparel manufacturer Apparel Co., based in Surat (Gujarat) that supplies jeans to wholesalers and retailers across the country. As soon as COVID hit; all retail outlets were shut; the consumer shunned jeans for pajamas (who wears jeans now?!?). But why does it matter? As the store’s stocks became non-moving inventory it impacted the top line meaning the store owner had no income source for the month while his expenses like rent, salaries, loan repayment were still ongoing; and you guessed it right, he axed the suppliers’ payments. Impact? Disruption of trade equation — rather considerable one at that.
The apparel industry was one of the biggest casualties of the pandemic. When buyers withhold payments, it kicks off a pernicious cycle. The manufacturer Apparel Co. can no longer ship the next batch until they clear payments and that affects the manufacturer, his suppliers, and all the stakeholders involved. Due to lockdown and heightened financial pressures many companies had to simply throw in the towel because they had no money to keep their business going. As one can see, maintaining cash flow is of paramount importance for keeping businesses alive. Even though a company’s valuation (future prospect) might sound impressive, a lack of cash flow can kill businesses.
By and large, there are different categories of cash flows in a business’s finances. The image below will give you more understanding of these categories.
Managing cash flow involves operational excellence — it is about keeping the business alive. Ensuring the right valuation means strategic excellence — making the max from available resources.
This pushes us to understand the Methods of Valuation. In “Article 5 — When to involve a Shark?” we discussed the 5 stages of a Business Life Cycle and now we plan to discuss how Methods of valuation can be connected to the business life cycle.
You can read the diagram below as follows: DCF method can be applied to all phases right from the ‘Introduction phase’ to the ‘Decline phase’ while liquidation is applicable only during the ‘Decline phase’. The logic behind this kind of phase-based mapping is that at different stages different parameters are available for calculation and based on what is the purpose of doing valuation, the method is defined. By and large, this would hold true for most businesses.
Let’s dive in:
A. Discounted Cash Flow (DCF) Method:
DCF method helps determine the value of an investment based on the present value of FCF which depends on the projected CF & discount rate. The assumptions of cash flow essentially depend on the potential of the idea and its execution while the discount rate depends on the risk of the idea (industry) hence impacting the cost of capital. If the DCF is more than the current cost of investment, the opportunity could result in positive returns.
Sounds simple? Well, not quite. Prediction of future cash flows would rely on a variety of factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities. Estimating future cash flows too high could result in choosing an investment that might not pay off well in the future, hurting profits. Estimating cash flows too low, making an investment appear costly which would result in missed opportunities.
This method is not referred to much in the show since it requires detailed analysis and complicated mathematical calculations, and there are simpler methods that we discuss in the coming paragraphs.
The math of the DCF is as follows:
B. Market Capitalization:
If your eyes are strained after reading the complex math, here’s a method that requires only one mathematical calculation- “Multiplication”.
Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of outstanding shares. As illustrated in the BLC curve, this method can be applied to a company that has raised capital either privately or publicly. By private funding we mean, investors taking say 10% of the company at price P. Which means the value of the company is 10P.
Although this method is the most common method to describe a listed company, market cap does not measure the equity value of a company. Only a thorough analysis of a company’s fundamentals can do that. The time that we are living in (COVID-19–20–21-?) 😓 is the most appropriate time period to further understand why Market Cap is not the right parameter for valuation. The financial markets today are highly unstable and are driven by shareholder sentiments. Share prices jump with the news of a vaccine launch and take a nosedive with the approaching second wave. This often over-or undervalued stock price only gives an idea about how much the market is willing to pay for the shares *at the given point of time*. Hence this method should not be used for evaluating long-term investments.
C. Revenue Multiple Method:
This method is based on benchmarking a company with similar competitors in an industry. For example, if a sock business with revenue X is valued at 1.7 X, it means the multiple is 1.7. Now if another similar sock business has revenue Y, it will be valued at 1.7 Y.
Err... Wait... In our “Article 07: The vehicles of promotion”, we discussed 3 sock businesses, but Sharks didn’t value them just based on what was the mul-factor for the previous one. Confused? Here’s why.
Well, the simplicity of the Revenue Multiple method actually makes it inaccurate since it looks at the past top-line data and doesn’t account for present/future profits, growth, and also risks, one can reach that conclusion only by looking at other metrics in the Financial statement. Though this method looks superficial, in the sense that one looks at just a competitor and puts a price tag on a company, it is still one of the most used methods. Say for an IT services company the multiplication factor is 5X while for an FMCG (fast-moving consumer goods) company it is 3X, that is particularly because the market forces push the P&L (profit and loss) of companies towards industry averages. It does make sense after all.
D. Earnings Multiple Method:
So far we have discussed three methods that can be used to arrive at an absolute valuation, now we study the Earnings Multiple method which is used to value investments on a relative basis. The earnings multiplier is a financial metric that frames a company’s current stock price in terms of the company’s earnings per share (EPS) of stock. It is a simplified valuation tool used to compare the relative costliness of the stocks of similar companies. It helps investors to also judge current performance versus past by benchmarking current stock prices against their historical prices on an earnings-relative basis.
Since Earnings multiple depends on the “profits” a company can generate, it is rather more reliable as a method of valuation. Let’s again assume a sock company Sock Co. The company has a current stock price of $50 per share and earnings per share (EPS) of $5. Yes, you guessed it right, the earnings multiplier would be $50/$5 per year = 10 years. This means it would take 10 years to recoup the stock price of $50 given the current EPS and then you would make some profits assuming the company survives!
Assume we go back by 10 years. Say at that time each share had a market price of $50 and EPS of $8, then the multiplier would have been 6.25 years.
10 years > 6.25 years → Current EPS > Historical EPS
This means the company is costlier today as compared to 10 years back.
Therefore, it means, instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the performance of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for the current interest rate.
E. Liquidation Value:
Liquidation value is the total worth of a company’s physical assets on a given day if it were to go out of business and its assets sold and that is why it becomes relevant only in the decline phase for a company to use this method. Liquidation value is determined by calculating a company’s assets such as real estate, fixtures, equipment, and inventory. Intangible assets are excluded from a company’s liquidation value. It is usually lower than book value (value of assets and liabilities), but greater than salvage value (value post useful life).
Assets are sold at a loss during liquidation because the seller must gather as much cash as possible within a short period. In short, Liquidation value is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.
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Phew!! That was heavy!
And yes, it was heavier for us. We ended up researching, writing, re-writing, debating, and iterating multiple times plus have been dealing with added pressure at work for both of us, and that resulted in delays. We hope you enjoyed learning about the valuation methods and would go back to this article when you listen to the word ‘valuation’ again. Though the conventional methods for valuation seem to classify any valuation, sometimes, a person’s point of view might increase or decrease the value of a certain thing. An original Picasso or an original van-Gogh or an original da-Vinci may be worth fifty-seventy-hundred million dollars; but unless verified, a good forgery can make dents in the collector’s bank account. Conversely, an original, if presented to an incorrect audience, could be like the joke that didn’t land or the acting bit that goes unnoticed — you get the drift.
