We live in a day and age where firm value has reached peaks that we only previously dreamed about. The stock market is at its highest point in history, the economy is chugging along on all cylinders, and unemployment is at its lowest point since the late 1990s/early 2000s.
Gone are the acquisitions and valuations of yesteryear – in late 2017 Disney announced it would acquire 21st Century Fox’s film and TV studios for $52 billion. Uber is currently valued at a staggering $72 billion even though the company has yet to turn a profit in any quarter since inception. How can a company that has very little in traditional assets, isn’t profitable, and lacks a CFO be valued so highly?
Enterprise value vs. equity value
To understand the intricacies of valuation, we need to first appreciate the difference between a business’ enterprise value and its equity value. The relationship between enterprise value and equity value is captured in the diagram below:
It is important not to neglect the importance of enterprise value as this is the “true” value of the business. Enterprise value allows us to look at and compare values of businesses irrespective of their capital structure. Imagine two identical companies, with the same revenue and same EBITDA. They should both have the same enterprise value.
However, these same two companies could have very different equity values based on their capital structures. One company may have lower debt due to risk aversion, inexperience or lack of knowledge. In contrast, the other company may have an optimized capital structure, unlocking return on equity.
Enterprise value is denoted as “EV”, and it is what is being referenced when you hear about “EV” multiples. Equity value on the other hand has no “shorthand” abbreviation, it is simply equity value.
Weighted Average Cost of Capital (WACC)
A business’ weighted average cost of capital is the discount rate used to calculate the present value of its forecasted cash flows. WACC and valuation are inversely related – the lower the WACC, the higher the value and vice versa. In calculating WACC each category of capital (e.g. debt, equity) is proportionately weighted. Debt providers take on less risk than equity providers as debt is often secured with collateral and is last in first out (LIFO). This means that the cost of debt is generally significantly lower than the cost of equity. Thus, a business that can take on more debt without becoming too over leveraged (overleverage can lead to bankruptcy), will decrease its WACC and increase its EV.
The formula for WACC is:
Funding that is Equity (% of Total Funding) x The Cost of Equity + Funding that is Debt (% of Total Funding) x The Cost of Debt (after Tax)
Methods of valuation
Valuation is an art and not a science. What that means is that there is a lot of “subjectivity” involved in arriving at the final valuation conclusion for a business. There are three main methods of valuation:
Public company comparatives
Discounted cash flows.
The first two methods are typically undertaken using multiples (e.g. EV/Earnings before interest, taxes, depreciation and amortization (EBITDA), Price (market price)/Earnings, etc.). We start by finding multiples for publicly listed companies and precedent transactions (e.g. acquisitions) and then apply those multiples to the business we are trying to value.
Because no two businesses are exactly alike, it is better to find as many multiples as possible rather than rely on multiples from one public company or one transaction. A multiples-based valuation approach is particularly useful when an industry is mature, uncertainty is minimal, and growth is fixed or relatively predictable.
In contrast, If a business is in an accelerated growth phase and is expected to be there for some time – then using multiples from mature competitors may undervalue the entity. For these businesses a better way of valuing them is to use a discounted cash flow approach (DCF). A DCF approach allows us to ascertain value while taking into account growth over multiple stages in the business’ life-cycle.
Once a DCF analysis is completed, we can calculate a business’ implied multiples and compare these results with public company multiples and/or readily available transaction multiples. Doing this allows us to create a sensible range of valuations.
What is Discounted Cash Flow?
Let us dive a little bit deeper into a DCF. A DCF is a valuation method which requires two main features:
A discount rate (typically WACC).
A forecast of cash flows (typically free cash flows to the firm or EBITDA).
WACC, as already discussed, is formulaic nature and can be determined relatively easily. The cash flow forecast on the other hand requires a lot of work and collaboration between a business’ accounting team, sales team and operations team. It is important to highlight that we are primarily interested in cash rather than earnings.
The easiest way to forecast cash flows is to start with a forecast of EBITDA, as this is generally a good proxy for cash, and then applying any known "working capital" uses/sources. By discounting the business’ forecast cash flows, we then arrive at a business’ enterprise value. To calculate the business’ equity value, we take the calculated enterprise value and adjust for the business’ market value of debt. Equity value and or enterprise value can then be compared to those metrics of public companies to ascertain reasonableness and to create a valuation range.
This brings us back to our original question – it’s worth how much? The business landscape over the last 10 years has been one of low commodity prices, low interest rates and high technology advancement. Institutional investors, banks and individual investors have all been chasing returns with cheap money.
The result? Everyone is looking to beat the market, using money that is effectively free, which has led to some astronomical valuations (i.e. Bird, Uber etc.). In their chase for the unicorn, investment professionals have moved away from traditional valuation methods and started attributing value to other metrics like market share, first mover advantage, data metrics and new technology. The emphasis on these “softer” attributes has resulted in valuations that may not always make sense on paper. As a result, valuations now can be thought of using this formula:
Enterprise value using traditional valuation methods + “alpha”
Alpha, or soft synergies, is not an explicit valuation metric that you will see added on a valuation report, but it is how investment professionals bridge their investment values from the traditional to the non-traditional. In reality, alpha will find its way into the valuation through an increase in the multiples used, a decrease in the WACC, or an increase in the company’s forecast cash flow, all which lead to a higher valuation. Now, in no way am I implying that that is incorrect. In fact, those softer attributes must be factored into the valuation, as they do have an impact on how a company’s cash flows will change as it grows (hopefully for the better). The danger is when an investment professional puts too much emphasis on the “soft” and misses glaring issues that exist in the business – although you may think this is difficult to do, it is not. We as humans can easily be swept by the sexiness of a new technology, a new market or a charismatic entrepreneur. For example, Theranos - a company with a $10BN valuation, that was essentially nothing more than a massive fraud – smoke and mirrors. Click here for more.
When considering a company’s valuation, whether you are investing or just curious, it is important to look at the traditional and non-traditional, and to weigh each correctly – depending on the circumstances. In the current business environment, overvalued investments are more likely to be the norm; thus, when analyzing an investment, we must attempt to sift through all the noise in order to come up with a valuation that is reasonable to unlock any undiscovered value.
In my many years of performing valuations I have come across a multitude of different approaches and expectations. At the end of the day, when we accept that valuation is more of an art and less of a science, we can then better understand the artist, the canvas and the final painting.
At Learning Strategies Group, we have more than 15 years of experience in valuing public and private businesses. We can you help your team gain a better understanding of valuations, and help you navigate this tricky, multi-variable discipline. If you would like to book a valuation workshop for your team, or to learn about other learning solutions we offer, please contact us at firstname.lastname@example.org.
Antoine Bishara is VP, Business Development for LSG in the USA. Antoine works with many organizations to enhance the workplace performance of their teams, with a specific focus on corporate finance, valuations and excel. To learn more click here.