Valuation is a process or method employed by which one quantifies the fair value of an asset. Fair value is the approximate worth of an asset and valuation is the process through which we arrive at the fair value. Fair value is also known as the intrinsic value of any asset. Understanding valuation is important to the entrepreneur, investor or employee because as the business grows the need to raise capital arises or there may be
“Price is what you pay; value is what you get” -Benjamin Graham
The above quote amply highlights the difference between price and value. Price is a determinant of demand and supply factors while value is the real worth of an asset. Demand and supply factors can be varied right from the emotional decision to personal needs. Price is fluctuating in nature and value is relatively stable.
One should know the worth of the business he has invested into. The decision to continue in business or stay invested depends on the ability of a business to create value on a sustained basis. Any business functions and thrives in a dynamic environment. Therefore, one must understand that valuation is not a one-time affair it is a continuous process.
The following points will ensure the need for valuation clearly;
Raising of capital become easy-When the worth of the business is known the capacity to raise capital also becomes clear. It becomes easier to plan business expansions and fund mergers & acquisitions.
Valuations depend on many factors. Typically, they depend on the company size, profitability, competitive edge, market share, growth rate etc.
Typically, there are three approaches to the valuation of a business
This method is used to value companies that have substantial tangible assets in their books like real estate companies, infrastructure companies or holding companies.
Particulars | Amt in lakhs | |
Book value | Fair value | |
Property, Plant and equipment | 1000 | 1200 |
Current Assets | 500 | 600 |
Intangibles | 200 | 300 |
Total Assets | 1700 | 2100 |
Current liabilities | 300 | 300 |
Debt | 150 | 150 |
Total liabilities | 450 | 450 |
Net assets | 1250 | 1650 |
Name | EBITDA | Sales Rs.Cr. | CMP Rs. | P/E | Div Yld % | EV Rs. Cr | EV/EBITDA | EV/Sales |
TCS | 49667 | 184868 | 3743.5 | 36.8 | 1.0 | 1382567 | 27.8 | 7.5 |
Infosys | 30016 | 115676 | 1717.3 | 33.6 | 1.6 | 711603 | 23.7 | 6.2 |
HCL Technologies | 20760 | 82695 | 1162.0 | 28.6 | 2.8 | 313108 | 15.1 | 3.8 |
Wipro | 17175 | 74697 | 560.3 | 25.4 | 0.2 | 306714 | 17.9 | 4.1 |
Tech Mahindra | 7583 | 42260 | 1434.2 | 27.1 | 1.1 | 138832 | 18.3 | 3.3 |
Average | 25040 | 100039 | 1723.4 | 30.3 | 1.3 | 570565 | 20.6 | 5.0 |
Example: A company ABC Ltd. Operates in a similar environment as the above-mentioned companies. What should be the value of the company for that company?
Particulars | Sales Rs. Cr | EBITDA (Rs. Cr) |
ABC | 5000 | 1250 |
EV multiplier | 5 | 20.6 |
Enterprise value | 25000 | 25750 |
The number of shares outstanding Rs. Cr | 20 | 20 |
Value per share | 1250 | 1287.5 |
This is because money grows with time – as one has the opportunity to invest money at a required rate of return known as opportunity cost.
Future value = Principle X (1+ rate of interest) ^ N
Where N is the number of years for which the investment is made
Future value = Cash flow / (1+ rate of interest) ^ N
Where N is the number of years for which the cash flow will be received
Particulars | year1 | Year2 | year3 | Year4 | Year5 | Total |
Cash flow | 2000 | 2000 | 2000 | 2000 | 2000 | 10000 |
Discount factor | 0.905 | 0.82 | 0.744 | 0.676 | 0.558 | |
(10% opportunity cost) | 1810 | 1640 | 1488 | 1352 | 1116 | 7406 |
With the above concepts of the time value of money let us understand the discounted cash flow or income-based approach to valuation. The cash flow-based approach has two main elements- the projected cash flow period and the terminal value period. The projected cash flow period is a high growth period and the terminal cash flow period is a stable growth that extends beyond the stable growth period for perpetuity.
The discount rate used here is known as the weighted average cost of capital (WACC). It is calculated by averaging the cost of each source of capital (both debt and equity), weighted by the proportion of each component.
We shall use the NPV formula as given above for the high growth period and add to this the terminal value growth period discounted by the formula:
PV of terminal cash flow = Terminal FCF / (WACC – terminal growth rate), where FCF is free cash flow
Let us understand this with an example:
Particulars | Year1 | Year2 | year3 | Year4 | Year5 | Terminal value Year6 |
Cash flow from operations (Rs. Cr) | 441 | 485 | 534 | 587 | 646 | 665 |
Growth (%) | 10% | 10% | 10% | 10% | 10% | 3% |
Less: Captial expenditure (Rs. Cr) | 90 | 100 | 95 | 110 | 120 | 70 |
Free cash flow (Rs. Cr) | 351 | 385.1 | 438.6 | 477.0 | 525.7 | 595.0 |
A discount factor of 12% | 0.893 | 0.797 | 0.712 | 0.636 | 0.567 | 0.507 |
Discounted cash flow (Rs. Cr) | 313.4 | 306.9 | 312.3 | 303.4 | 298.1 | 301.7 |
Terminal value (Rs. Cr) | 6611.5 |
Enterprise value (sum of discounted cash flow) (Rs. Cr) | 1835.7 |
Add: Terminal value | 6611.5 |
Less: Net debt (assumed value) (Rs.Cr) | 200 |
Equity Value (Rs. Cr) | 8247.3 |
Per-share value | 164.9 |
Outstanding no. of shares (assumed value) Rs. Cr) | 50 |
Choosing the right valuation model is not an easy task. The valuation method should be matched as far as possible to the peculiarities of the business, like the growth, leverage, dividend policy etc. There is no one best valuation model available. One has to match a valuation model to a business depending on the data available. Valuation also relies heavily on the professional judgement, knowledge, experience and exposure of the personal valuing the business.
There are broadly 3 approaches to the valuation of a business
The valuation depends on the quality and availability of data and the professional competency, experience of the person valuing it.
As Benjamin Graham puts it “Price is what you pay and value is what you get” explains the difference. Price is determined by demand and supply but the value is created over some time as the business grows.
Valuation has its advantages. It creates a benchmark for future growth. It also helps one understand the worth of a business as the starting point for price negotiations of mergers & acquisitions. It also helps in raising capital.
No. Valuation is an ongoing process.
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