Valuation is the Net Present Value of projected future cash flows of a company. Therefore, to calculate the Net Present Value, one has to estimate the following two things:
Valuation is calculated by using one or both of the following approaches
1) Discounted Cash Flow: In this approach, future cash flows of the company are estimated and discounted with an appropriate discount rate to determine the Net Present Value of the company. The following parameters need to be determined as part of this approach
a. What are the expected cash flows each year going forward
From a financial perspective, a business is a series of cash flows. A startup that still has losses is a series of cash flows that have only seen net annual outflows each year – and this may change to profits in the future – therefore valuation becomes a positive number. A mature steady state business like say, The Coca Cola Company, is a series of cash inflows represented by Free Cash Flows on the Cash Flow Statement. In some years, even Coca Cola may setup a new plant and net cash flows may be negative. For years that are far out, high level projections are made.
b. By what rate should each year’s cash flows be discounted to arrive at the current Net Present Value
Capital is a complex financial quantity whose economic dynamics bare similarities with a commodity like oil. The price of oil globally is determined by the Crude Oil price. Products that are manufactured after processing of crude oil have their prices determined by Crude Oil along with appropriate conversion costs. Capital is similarly priced based on risk. Price of capital is considered to be the interest paid for using that capital. The market establishes the price for a risk-free investment and then adds a premium as more and more risk is perceived in the investment. The risk-free price of capital is usually determined by the interest paid by the government when it raises capital by issuing debt. When an individual deposits money in a bank, the investment is considered to be a very safe investment and the investor is content with the return, let us say at 5%. This return is about one percentage point higher than the interest paid by the government when it raises capital through issuing debt. As the individual investor considers riskier investments the target returns sought by the investor becomes higher. The investor may look to invest in the debt of a risky company in which case the returns being offered will be 8-9% per year. Finally, in the case of equity investments which are structurally riskier than debt investments, the investor may seek 15-20% type returns. Therefore, all these returns are built after adding a certain extra premium to the returns from the risk-free asset.
The returns for the risk-free rate for government debt is determined by key macroeconomic indicators such as inflation, liquidity, growth and particularly by the central bank’s actions. The central bank monitors the key macroeconomic indicators and fixes key interest rates to ensure macro-economic stability.
The above approach is the most precise approach to valuation and is called the DCF approach. However, as one can see, the DCF approach requires several assumptions to be made. Therefore, another way to estimate valuation is by looking at what similar businesses are valued at. This is called the ‘comparables’ approach.
2) Since the above approach requires several assumptions, valuation can also be determined by using valuation ratios of similar companies and applying them to the company currently being evaluated.
In the comparables approach, similar businesses that are trading in public markets are analyzed and their valuation metrics are used to determine the valuation of the company. As an example, if we want to ascertain the valuation of a privately owned company that manufacturers carbonated drinks, then we will have to look at the valuation multiples of some listed companies that operate in that market, such as Coca Cola and PepsiCo and apply those metrics. If The Coca Cola Company is trading at 15 P/E and PepsiCo is trading at 13 P/E then the average of the two, that is, (15+13)/2 of 14 can be used to ascertain the valuation of the privately owned company. Sometimes a further discount maybe applied to the multiple because listed companies offer the advantage of exiting anytime to an investor. So, a discount such as 10% maybe applied on 14, this may result in using 12.6, that is, 14 x (1-10%) =12.6.
Valuation gets difficult in cases where there are no listed peers. This is particularly the case when valuing startups. In such cases, transactions with similar startups are used for valuation benchmarks. Data on such transactions may be limited thereby resulting in further challenges.
Valuation is more an art rather than a science. But the above approach is the main approach that is used by analysts when determining valuation for a company.
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