Written by Megha Agarwal Singh, Director of Strategy for Lombard Global, Inc.
Edited by William Billeaud, President of Lombard Global, Inc.
How much would you pay for a business? Knowing what assets are worth is what determines intelligent decision making – to make a portfolio investment, pay for a takeover, sell your business and financing when running a business. In a complex business world, knowledge of the valuation process and distinguishing one process from another can be the key to getting the highest and the best value of your investment so you may need a business valuation specialist in you want it 100% correct.
In order to conduct a business valuation, the business owner has to first determine the type of valuation that needs to be conducted. The two most popular approaches to business valuation are – “Discounted Cash Flows” and “Multiples” methods. Discounted Cash Flow is the method the investor must calculate and project a 5 – 7 year cash flows based on trends, market outlook and other assumptions. The cash flows are then discounted to determine a present value and a terminal value. The company’s value is the total of the present value and the terminal value. This approach is highly dependent on assumptions and biases of the analysts.
While most class rooms focus on DCF, another more market driven and popular approach is the “Multiples Analysis”. This approach is driven by comparing how the market values other similar assets. It generally of two types:
Comparable Analysis (Private Company) – This is a common market approach to value the company by examining previous acquisitions/ transactions of similar target companies. Key income statement multiples of EBITDA, EBIT are compared and these multiples are then applied to the target company. In case of Private Equity, the biggest hindrance is the access to such comparable data, particularly in emerging growth markets.
Comparable Analysis (Public Company) – In this market based approach the multiples of a comparable public company are used. Publically traded companies usually trade higher than private companies because of higher investor confidence and transparency. Therefore when valuing a private company using a public listed company’s multiples, an additional appropriate discount rate is applied in order to reach the correct valuation.
Reasons for Popularity – There are several reasons that attribute to the popularity of this approach.
a) Simple- The valuation based on multiples and comparable firms can be completed in far lesser time with fewer assumptions. Multiples can help user avid potentially misleading precisions of other approaches such as the DCF.
b) Relevance- A relative valuation can more accurately represent the general mood of the investors in the market and can gauge the risks associated.
c) Easy- A relative valuation is easier to understand and simpler to present to the clients than Discounted Cash Flow or any other method.
Some Pitfalls – The strengths of the relative valuation method are also some of its biggest weaknesses.
a) Simple- The fact that this valuation is relatively simple and combines many growth drivers into one estimate, it also presents the risk of being erroneous as it is nearly impossible to break down the drivers.
b) Too High/Low – The fact that this approach correctly gauges investor confidence and sentiments for a particular industry and businesses, it also poses the risk of valuing the assets too high or too low. This was more visible during the housing and the internet bubble, where similar assets were valued too high due to investor sentiments.
c) Bias- As with any valuation, there is a scope for bias. Lack of transparency in the assumptions make the valuation prone to biases.
While the multiples approach remains one of the most popular approach of valuing a business in private equity markets, it comes with its own set of risks. These risks become even more prominent when the investments are in emerging growth economies where access to information is minimal and most industries are still on the path to organization. The extent to which these valuation pitfalls can be avoided is imperative for a successful and profitable investment, highlighting the need for proper due diligence and recognition of those risks in order to manage them.
Megha Agarwal Singh is Director of Global Strategy and Finance at Lombard Global. As such, she is responsible for both internal and external strategic direction of the firm’s professional services offerings and its technology direction. Megha possesses years of strategy consulting experience with Deloitte and Ernst and Young and financial experience with UBS. She has worked both with multinationals and SMEs in various settings. As a management consultant she has been instrumental in the establishment of global infrastructure and has formulated business strategies and strategic plans for large investment banks. Megha has authored papers published in technical magazines across the globe and has been a speaker at international professional conferences. She holds an MBA (Global Finance & Strategy) from the Thunderbird School of Global Management, a Certificate in Finance from the University of California – San Diego and a Bachelor’s Degree in Planning- Real Estate and Project Finance and The School of Planning and Architecture in New Delhi, India. Apart from academic and consulting work she has been strongly associated with various non-governmental organizations and conducted successful fundraisers for the support of education.