Using valuation skills in taking business decisions is prerequisite for success in today’s business world. Explicitly or otherwise, all financial management decisions are based on some valuation models, which endeavour to identify the true or fair ‘value’ of the underlying asset .
There are several methods of valuations, including:
- Net Asset Value (NAV) method,
- Profit Earnings Capacity Value (PECV) method,
- Discounted Cash Flow (DCF),
- Market Comparables (aka Multiples), etc.
While each method has certain plusses and minuses, the DCF method, which is based on sound and scientific principles of corporate finance, is most commonly and often applied method amongst the valuation practitioners across the globe. The focus of this article, however, is not on the suitability/ superiority or otherwise of a particular valuation method, but to introduce the various steps involved in the valuation of a business, company, brand or any underlying asset (referred to it as ‘target’), whilst using the DCF methodology.
The activities one must perform to conduct a valuation exercise as per DCF methodology is listed below. Many of the activities may be, and at times are, carried out simultaneously.
- Conduct a detailed study and analysis of the target’s historical financial performance. Analyse the performance based on a thorough ratio analysis.
- Study industry dynamics and potential in which the target operates as also the industry groups which the target depends upon for its business.
- Project the future financials, based on management’s plans/ expectations, for the explicit forecast period.
- Compute free cash flows to the firm (FCFFs) from the projected financial statements.
- Calculate the weighted average cost of capital (WACC), which in turn requires the estimation of:
- Cost of debt
- Marginal tax rate
- Risk free rate of return
- Beta
- Market risk premium
- Target, long-term, sustainable Debt:Equity ratio
- Using the WACC as the discounting rate, calculate the present worth of the explicit FCFFs.
- Estimate terminal growth rate (‘g’).
- Use ‘g’ and WACC to compute terminal value (being the firm’s value at end of the explicit forecast period). Discount it to present by using WACC as the discounting rate.
- Calculate Enterprise value, by adding the present values of FCFFs and terminal value.
- Deduct the current value of debt from the above to arrive at the target’s equity value.
The above list is but a simplistic summary of a process that most, if not all, regard as arcane and arduous in practice. The above is a good representation only of the steps required to be taken for a valuation process and does not highlight the various practical problems/ hurdles faced by a practitioner at each of the above steps.
On the plus side, DCF methodology requires estimation of various dependent parameters, thence forcing the valuer to focus separately on each value driver which may have a significant impact on the value. DCF is a very robust methodology, which can work wonderfully right if the underlying assumptions are reasonable and the application is realistic.
CA Pratik Singhi, an alumnus of IBS Mumbai’99, is a rank-holding Chartered Accountant and a rank-holding Cost Accountant. He is a valuation enthusiast and is admired for his knowledge of the subject. He conducts workshops on valuation and also teaches at, inter-alia, IBS - Mumbai and Hyderabad.
He can be reached at pratiksinghi@gmail.com. |
