Enhancing shareholder value is a key objective for the management teams of both private and public companies. A company’s strategic plan requires a clear focus on the options to crystallise an increase in value through a liquidity event such as a flotation, an M&A transaction, or a joint venture.
In our previous newsletters we have examined strategic business options including management buy-outs, acquisitions and stock market listings. All these transactions require an appreciation of the valuation of a business and how this can be enhanced. Below, we will review the alternative methods which can be used and discuss the applicability to both private and public situations.
Valuing a business is often more an art than a science. For a public company, the market capitalisation or the equity value, of the business provides an important reference point based on publicly available information. To assess the full value of a business, the following factors need to be taken into account:
- the liquidity of the shares;
- the premium required to take control of the business; and
- the capital structure.
For private companies and divisions of public companies, straightforward mathematical formulae can be employed. These calculations generate the company’s value based on either forecasted cash flow, earnings, or by analysing the value of comparable listed companies and recent M&A transactions in an industry.
Prior to performing the arithmetic, it is important to take a strategic view of the industry and of the future prospects of the company in order to place the valuation figures in the correct context. An analysis of the competitive environment, barriers to entry, potential for substitute products and the strengths and weaknesses of the company will put the forecasted cash flow and earnings into perspective. Below, we will review the three most commonly employed valuation techniques.
Discounted Cash Flow
The discounted cash flow (DCF) approach is the most commonly used method to value companies, or specific projects. The basis of the calculation is free cash flow. This is cash available for distribution to the debt and equity providers after all planned investments have occurred, including both working capital and taxes. Adjustments are made to the financial statements for non-cash items including depreciation and goodwill. A financial model is developed of the forecasted profit and loss, balance sheet and cash flow statements for the company. Typically, a five year period is used. The assumptions underlying the forecasts are important to the integrity of the model. Furthermore, the process of developing the model and checking the consistency with the competitive strategy of the company within the industry is as important a process as the calculation of the final valuation figure.
As a going-concern a business will normally operate well beyond the 5 year forecast period. It is therefore necessary to estimate the “terminal” or “continuation” value of the business. Over time, with competition, a firm’s performance tends to converge to the industry average with 5-7% growth rather than say an initial 15-20% growth. With normalised cash flow and growth prospects a valuation according to comparable multiples will provide reasonable accuracy. This is typically an EBITDA multiple; or earnings before interest, tax, depreciation and amortisation. Therefore, the valuation of a company taking into account the time value of money can be separated into its constituent parts.
Present value of
free cash flows
Present value of
terminal value at
the end of the explicit
The resulting value represents the enterprise value of the business available to all security holders discounted with the Weighted Average Cost of Capital, or WACC. The WACC reflects the combined cost of debt and equity with the weights of these capital sources based on their market, rather than book values. The key point to highlight is that a company’s WACC declines as it employs additional lower cost debt, thereby reducing the proportion of the more expensive equity. This is due to the tax shield resulting from the tax deductibility of interest payments.
The DCF process provides a valuation of the enterprise. The value of the equity can then be calculated by subtracting the net debt (total debt minus cash) from the enterprise value of the business. As with all valuation methodologies, it is important to carry out sensitivities around the key assumptions and to focus on a valuation range rather than on a specific number. Furthermore, as we discuss in the next section, comparing the DCF valuation with alternative methods is important as a sanity check. Each valuation approach contains useful information and, relying on several approaches in combination, is likely to produce more accurate valuation ranges.
Comparable Company Valuations
A more direct approach often used in practice relies on valuation multiples including:
- Price to earnings (P/Earnings per share);
- Price to book (book value of net assets); and the
- EBITDA multiple (market value plus net debt/EBITDA).
Multiples are estimated from the prices of public companies with growth and risk characteristics comparable to the company being valued. Firms in the same industry are the usual source of comparables. Precedent M&A or IPO transactions in the same industry are likely to be a good match especially if the targets had similar growth rates and margins. M&A transactions will provide an understanding of the premium paid under recent business scenarios. In the late 1990’s the premiums paid approached the 40-50% range. Since then, management teams have become more discerning and have been able to conclude transactions within a more reasonable 15-20% range.
Multiples can be applied to historic of forecast financials to obtain the present value of the enterprise or of the equity. Alternatively, the multiples are often used for the termination value in a DCF calculation. A forward multiple can give a better estimate of value because it incorporates expectations about the future. P/E multiples often differ between similar companies due to accounting differences, such as depreciation in earnings calculations. Net debt differences can also affect interest expense and earnings. For these reasons the EBITDA, or cash flow multiple is often used. For a business with good growth prospects a forward EBITDA multiple in the 8-12 times range provides a useful rule of thumb.
Revenue multiples are calculated by dividing the enterprise value by revenues. They are used to value companies for which no earnings are expected in the short-term. They can also provide an idea of value where no reliable cost information is available. These multiples are often used for technology companies with strong growth prospects. It must always be remembered that the key element in a company’s valuation is not the revenue generated, but the free cash. Many expensive acquisitions have occurred in the technology sector on the mistaken assumption that revenue growth leads to free cash flow!
Choosing the value to apply in a particular situation can only be made after a careful study of the company and its industry. A comparison of the value of similar public companies can provide a reasonable guide to value, particularly in private situations.
Valuation in merger and acquisition discussions
It is essential to have a disciplined approach to the valuation of the business and to be able to walk away from a transaction at the appropriate time.
The intrinsic value of the business is the net present value of expected future cash flows independent of any acquisition. This is the stand alone value and the basis for negotiations. Any price paid above the intrinsic value represents the control premium to be shared between the target company and the acquirer’s shareholders. This premium includes a market premium and the potential synergy value. These synergies comprise revenue enhancements, cost savings including financial engineering and tax benefits as well as process improvements.
Valuation at the time of flotation
With regard to a flotation, or a secondary offering of shares, it is typical for a company to be valued based on the comparable multiples of similar listed companies. In these offerings it is normal for the sale to take place at a slight discount to the existing equity value of companies. This discount is typically in the 2-5% range depending on the situation.
Improving valuation prospects
Whilst strong growth prospects for both an industry and an individual company are important factors in a valuation, there are a number of additional factors where a company can improve its prospects prior to a strategic transaction:
Depth of management team
Developing a core group of managers to lead a business without over–reliance on one person will be value enhancing for new shareholders. It is typical for an acquirer to enhance a management team with financial expertise whilst retaining an experienced Chief Executive and operating management team. However, in turnaround situations, replacing the top management team is often essential to revitalise the business.
A simplified share structure with one class of shares and one share one vote will enhance the transparency of the company. Private companies often have several classes of shares which have been issued during several rounds of financing. Alternatively, certain shareholders often retain voting control irrespective of the amount of financing. A simplified share structure will improve a company’s valuation, particularly when a flotation is under consideration.
An under leveraged balance sheet will provide an opportunity to a private equity firm to restructure a business, increase debt levels and improve the return on equity. Furthermore, existing shareholders should question whether the current or an enhanced management team can restructure the business and increase the value without changing ownership. This has occurred successfully at Marks & Spencer over the last 18 months following the unsuccessful bid from Philip Green who attempted a leveraged public to private transaction.
Effective Corporate Governance
A board with effective independent directors successfully challenging the Chief Executive will lead to improved decision taking compared to an autocratic board. Separating the role of Chairman and Chief Executive has improved the governance at UK companies, although in the US there remains a preference for a combined role. A more effective board structure is important for key strategic decisions including acquisitions, divestitures and flotation. All of these transactions have a key impact on valuation.
Generating a valuation is basic arithmetic. The key factor to enhancing a company’s value is through the execution of opportunities that enhance the prospective free cash flow of the business. A company’s strategic position within an industry with solid growth prospects is essential plus a well structured business and an experienced management team.
Valuation is an art and not a science, but the process of calculating a company’s value in a systematic way can uncover key growth opportunities for a business.
The views expressed in this newsletter are those of DC Dwek Corporate Finance Limited and are provided for information purposes only.