Before diving into the various valuation methods, we will first take a holistic approach on value and discuss some of its key characteristics.
What is value?
Financial value is the maximum amount of money that a buyer would be willing to spend to acquire an entity, and the minimum amount of money that a seller would demand in exchange for this entity. This definition implies that value is relative and personal. A transaction between buyer and seller can only take place if the value to the buyer is higher than the value to the seller. At transaction price, both buyer and seller realise a surplus: the buyer gains a surplus for acquiring a good at a price less than the value to him; the seller obtains a surplus for selling a good at a price higher than the value to him.
Why value businesses?
In general, businesses are valued for various purposes:
- Companies quoted on the stock market are valued by share analysts who calculate the “fair value” or target price for a share of equity, and place a recommendation on whether to hold, buy or sell the share.
- In a transaction perspective, business units or companies are valued to derive a transaction price estimate used as base for negotiations in the perspective of a merger, acquisition, joint venture or divestment.
- Within companies, new ventures or projects are valued to check that they are worth being undertaken. Valuation is typically done as part (or as result) of a business plan.
It is this third aspect that will be of most interest to us here. Project valuations, although not the sole purpose of a business plan, are usually undertaken to check that the project or venture can create value to the parent company, and if any, how much. Valuation of projects is also undertaken to help rank projects and identify the most promising business opportunities.
Project values will often be used as one of multiple ranking criteria to select between projects when budget and resources are scarce and not all projects can be undertaken. Alternative or additional key financial results can be used to complement the project valuation in this selection process. Although the Internal Rate of Return (IRR) is sometimes used, we strongly recommend not using it because it is difficult to interpret and rare are those who precisely understand what it means. More on this in Section 9. Instead, we recommend looking at the peak cash requirement to fund the business, which will be a constraint in all companies as cash and budget have to be fought for. In addition, the pay-back period should be in line with expectations and acceptable to financial managers and providers of finance.
Valuation is future-based, subjective and often biased
At the outset, you should be very clear that valuation itself, although based on mathematical formulae and fairly accurate methodologies, is more an art than a science.
Firstly, a valuation will always be based on a forecast, whether it is explicit as in the NPV approach or implicit as in the Multiples approach. A forecast will always remain subjective, although it should be based on the best possible information available at the time. It is in human nature to overestimate revenues and underestimate costs, therefore cashflow forecasts are usually positively biased.
Secondly, projects have various risks so should in principle use various costs of capital to reflect the nature of the risks. As this is usually difficult or impossible, the same cost of capital is applied to all projects within a company, creating additional bias.
Finally, even assuming that cashflows are not positively biased and the correct cost of capital has been used, the traditional valuation methods do not capture the fact that the business plan will be executed dynamically and flexibly according to changing circumstances, and not in a static manner, as if everything had been decided on day one. To put it another way, the classical valuation methods do not consider that most decisions will not be taken today but tomorrow: they miss the value of day-to-day management as well as the learning effects. Therefore the standard valuation methods systematically underestimate value – a negative bias, maybe compensating the positive bias discussed above. In Part Four, we will show how business opportunities can be interpreted or structured as “options” and how this approach provides more accurate estimation of value, as well as a recommendation on the timing of investment.
Valuation and “Make or Buy” issues
Generally, a new business can either be built up from scratch or bought from a player who is already on the market. As no one would spend more money than necessary, from an acquirer’s perspective, value is the minimum of the replication costs required to build the business up yourself and the acquisition value. Moreover, an existing business can either be run as-is, or transformed to leverage synergies with another business, or liquidated with its assets sold to the highest bidder. This tells us that when looking into a business, the alternative options should be analysed and some options might provide substantially more value than others. Note that liquidation is usually the option of last resort and the worst one: a forced sale often does not even reach book value, as many assets are specific and can not be reallocated to other usage. This is particularly the case in high tech where equipment experiences sharp price decreases over time.
The “Keep as-is” and “Transform” options also show that the same business might be valued differently by interested parties depending on the synergies that they believe can be achieved with other businesses and depending on their execution skills. As a result, it might be worth selling a business to a company that is better able than you to create value from it.
Value changes over time
The fact that value fluctuates over time should also come as no surprise as the market if full of surprises that can not be anticipated. New information permanently becomes available and has an influence on value, for instance an unexpected competitive entry, a demand higher than expected for a product, or external macroeconomics changes. The best proof for changing value is provided by the stock exchange itself, which provides a market for ownership change in companies’ equity. Price for shares fluctuate on a minute-by-minute basis depending of the latest information made available and how it is interpreted by buyers and sellers.
So remember that a valuation can quickly become out of date, and you should always mention the date when the valuation was carried out in the business plan.
Value is relative to the valuer
This brings us to the following point: why value companies when they are quoted on the stock market and therefore already valued there, with the stock-market value representing a market consensus between buyers and sellers?
Firstly, you might have differing beliefs about the future of the company or you might know something that others don’t know. A substantial value gap might show that there is a strong discrepancy between market expectations and your own view of the company. In an undervalued company, improved communication with the financial market should lead to realignment between both views.
Secondly, if you are thinking of acquiring a company, the value to you might be different from the stock-market value, especially if you believe that you can better manage the business or create substantial synergies with another business that you already own.
Thirdly, most business plans that you will make will look at a single project or a business unit, not a whole company quoted on a stock exchange, so you do not have the luxury of simply checking the project value on a stock exchange in that case.