- November 11, 2022
- Posted by: Ramkumar
- Category: Strategy
My Learnings On Business Valuation
I have been in M&A and Business valuation for ~15 years. Over these years, I have valued more than 1000 companies and worked on 300+ M&A deals. After every deal, I chronicle my learnings on that deal and what I could have done better. In this post, I provide my learnings on business valuation and the areas that budding M&A consultants/Investment bankers must focus on when they evaluate companies.
Cash Flow Management
The focus for any analyst working in corporate finance is to understand the following:
- First, how do firms make sound investment decisions?
- How do firms make good financing decisions?
- Finally, how do firms manage the cash flow while working on the above two points?
I have always believed Cash flow is like oxygen and earnings are like food. While one can survive without food temporarily, one cannot survive without oxygen. Thus, we need to analyse quickly if the firm suffers from cash flow issues.
A good investment decision is when a firm’s investment return exceeds the cost of capital for funding the investments. Conversely, a good financing decision is when a firm obtains the capital needed for investments at the lowest possible rate.
Thus a firm’s investment and financing strategy must align with each other. So one cannot do a proper valuation without understanding the product/market in which the firm operates. Then, after understanding the business strategy, we can analyse the firm’s financial strategy.
So, before valuing any firm, i understand its product market and corporate strategy. Then, i look at its financing strategy on the investment and financing side. Financial policies dictate whether the firm can grow internally or through mergers, its optimal capital structure, its debt policy (it chooses short-term/long debt, secured/unsecured debt with fixed/floating rate) and its dividend policy.
Once i understand the corporate, financing and investment strategy, i build Pro-forma income statements and balance sheets using ratio analysis. If the firm is cyclical, we can average its fluctuations in the operating income to determine the financing requirements; if the firm is not cyclical, we can use the existing financial statements. For instance, in retail, year-end sales are significant and impact the firm’s receivables, inventory and debt financing. Then, with proforma projections, we estimate future cash flows and determine if the project has a positive NPV.
A firm can generate cash internally or externally. When the firm generates cash internally, it happens through sustainable growth.
Growth rate = RoE * (1-dividend payout ratio)
We can qualify the firm’s ROE through the Dupont formula.
ROE = Net Income/Sales * (Sales/Total Assets) * (Total Assets/Equity).
Firms look at external financing when they can’t generate cash through internal accruals. The cost of financing depends on the firm’s capital structure, operating cash flows and how distressed the firm is. When the firm is distressed, it faces the risk of bankruptcy, and thus it will receive financing at the highest costs or will not receive any financing.
When the firm changes its strategy from capital-intensive to labour-intensive, it can change its capital structure, using its excess debt capital to fund any new investments. As a result, a firm with volatile cash flows must have a low debt ratio, while a firm with stable cash flows can use a higher proportion of debt to reduce financing costs.
When a firm has excess cash, it can do the following:
- First, it can deploy cash to grow faster internally.
- It can acquire companies.
- It can increase dividends, repurchase stock or pay down existing debt.
On the contrary, a firm suffering from cash flow issues must slow growth, sell its assets, cut dividends and issue equity/debt.
A firm can reduce its financing cost by maintaining an optimal capital structure. The firm’s cost of capital determines its risk and return. Thus, as the firm changes its debt-to-equity ratio, its WACC changes. When the funds its investments with debt, its WACC reduces because interest expenses are tax deductible. However, beyond an optimal debt/equity ratio, the firm’s WACC will increase because the business risk increases, leading to an increase in the levered beta resulting in the potential risk for bankruptcy.
When we make a pro forma build-up of a firm’s balance sheet and income statements, we must consider whether the firm can service the debt and meet the covenants. In addition, we must analyse the firm’s competitors’ capital structure and evaluate if the firm’s debt/equity ratio is higher than the industry.
Mergers and Acquisitions
Three elements of a good M&A process are:
We can value a firm using the following approaches:
- Discounted Cash flow
- Earnings or cash flow multiples (EV/Sales, EV/EBITDA, P/E ratio).
- Asset multiples (Price to Book value, Replacement value).
- Comparables (oil reserves, ounces of gold, no of subscribers)
- Option valuation approach.
We calculate the free cash to a firm as follows.
Unlevered Free Cash Flow = EBIT*(1-tax) + Depreciation – Capex – Change in non-cash and non-debt-working capital.
Then, we calculate the investment risk as follows.
WACC = D/(D+E)cost of debt(1-tax rate) + E/(D+E)*Cost of equity.
We arrive at the cost of equity using the CAPM model.
Thus a valuation must include three components:
- Initial Investment cost
- Present value of the projected cash flows
- Present value of the terminal value.
It is better to divide your valuation as cash flows from the forecast period and cash flow from terminal value to understand the contribution of terminal value to the firm’s value. In addition, it is better to compute the terminal value in multiple ways, from Gordon’s growth model to an exit multiple, because the project’s NPV depends significantly on its terminal value.
A firm’s value is a function of higher growth in the cash flows and lower risk. Higher cash flows come from price increases or lower operating costs. A lower cost of capital happens when firm access external capital at a lower cost and uses debt to reduce its tax shields.
In an M&A, the buyer pays a premium to the seller and recovers the premium through synergies in the deal. The synergies can come from increasing revenues, reducing costs or reducing the cost of capital.
Valuation Is An Art and Not Science
When we value a firm, it comes with multiple assumptions and scenarios. Ultimately, these assumptions are estimates, and thus, we must do a sensitivity analysis to examine how our assumptions affect the outcome.
Though my peers use multiples/comparables to determine the firm’s value, i am an advocate of discounted cash flows. The reason is not that the DCF approach is more accurate than other approaches. Instead, I use DCF because it forces me to estimate future cash flows and the assumptions that drive future cash flows. When i estimate free cash flows, i review the firm’s depreciation schedules, its CAPEX, and its working capital condition. Thus, there is a seldom chance of me missing something in evaluating a firm’s value as it forces me to think through all the missing pieces affecting its valuation. With multiple approaches, as we use a single multiple, we can easily miss other factors affecting a firm’s value.
For a successful valuation, the value is in the economics of the product market and capital market. Therefore, the value is not in the numbers because the numbers flow from economics.
In valuations and M&A, People matter because people operate in their self-interest. Thus, i always focus on the motivations of CEOs, Investment bankers and board. All the stakeholders will operate in their self-interest. Thus, doing numbers is essential, but humans make the final decision. Hence we need to factor the human behaviour.
When we value a firm, a vital part of the analysis is to identify where the value comes from and then explain the same to decision-makers in a simplistic manner. If we cannot do that, we have not done the valuation correctly.
Finally, a successful valuation analyst is always cynical. They constantly question what people want, what they are getting, and where the value is to them. Thus, it would help if you were sceptical of what people tell you.