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Company Valuation

Finance

1/8/2023

Analyzing the value of a company under the framework of "valuation" is a relatively new concept. Until the 1990s company valuations were conducted primarily by accountants. Having an accurate picture of a firm's past performance is a good starting point for projections into the future, as long as

  • the corporation is mature
  • it has a strong foothold in the industry with ubiquitous products & services
  • the underlying business model cannot be easily disrupted

In those cases of a steady state, a forward projection is straightforward, by assuming average growth rates in the Income Statement and the Balance Sheet. External factors like inflation, the cost of borrowing money, geopolitical crises, and the cyclicity of the business pose uncertainty in the valuation. History allows the incorporation of various risks in the planning of the company's future business. There are statistical models that can help with that.

Now, which businesses fulfil these requirements? There aren't many I would say. Mostly in the consumer business like beverages, hygiene articles, or clothing. But also here we see the Internet acting as a disruptive element. A lack of innovation in business can endanger the otherwise healthy company.

Why do we need valuation anyway? Whenever a company is open for an acquisition or a merger (M&A) with another company there must be a way to determine the fair market value (also called intrinsic value), so that the shareholders can be adequately compensated and can benefit from a deal's synergy or from the return of investment.

Valuation is also used by banks to assess the creditworthiness of a firm applying for capital, or by Private Equity firms seeking opportunities in young companies with large growth potential.

So, what are the competing methods that go beyond accountancy-based forward projections to determine the value of a company?

Broadly they can be divided into four approaches:

1.) Market Capitalization

2.) Precedent Transactions

3.) Comparable Companies Analysis

4.) Discounted Cash Flow Method

Let's take a look into each of them:

Market Capitalization

This can be applied to publicly traded companies and is straightforward: multiply the current share price by the number of shares outstanding.

Precedent Transactions

This method utilizes the so called "multiples" paid for comparable companies than the target. The multiple can be defined as how many times the Implied Enterprise Value (EV) of the target exceeds its EBITDA (Earnings Before Interest payments, Taxes, Depreciation and Amortization) of the last 12 months. This is denoted as the EV/EBITDA multiple.

The Enterprise Value can be implied from the current share price, the amount of fully diluted shares outstanding in the market, total debt, non-controlling interest and the cash & cash equivalents.

In the medical device industry the median EV/EBITDA multiple lies historically around 22x (see link). To take an example of Siemens acquiring Varian Medical Systems (in the field of oncological treatment). Just before the acquisition Varian was traded in the stock market with a multiple of 38x compared to the estimated earnings, whereas the S&P 500 Health Care Index had only a multiple of 18x. (Mathematically this is not the same as looking at the EV/EBITDA multiple, but the trend of a higher premium is the same).

Comparable Companies Analysis

The basic idea is to use similar companies as a reference point in the valuation of the company at hand. Prevailing market conditions and benchmarks allow for a reliable assessment, rather than just looking at the target alone. The "Comps" exhibit business and financial characteristics, risks and performance drivers that are comparable to the target company. Often similar performance ratios are used as in the precedent transaction approach: EV/EBITDA or Price-to-Earnings Ratio (P/E ratios). The benchmark figures are then applied to the target's relevant future financial numbers to infer a market-driven fair value.

This method requires from the analyst detailed financial and business knowledge and rests on the experience of collating information from various disparate sources and making sound judgements on their relevance and reliability. To allow an apple-to-apple comparison several adjustments have to be applied, such as excluding the influence of non-recurrent items and differences in the capital and debt structure. EV/EBITDA considers these.

Also influences from taxation and changing regulatory requirements might skew the results to give an unrealistic valuation.

Discounted Cash Flow (DCF) Method

The DCF Method can be dated back to John Burr Williams in 1938: "The intrinsic value of any business today is determined by the cash inflows and outflows, discounted at an appropriate discount rate, that can be expected during the remaining life of the business". Before 1990 the method was used for the analysis of the stock market when looking for investment opportunities.

It can be also used for determination of the Enterprise Value in the context of M&A and Private Equity. What are the steps involved?

In practice, a spreadsheet (e.g. Excel) is developed where the past 3 years are used to estimate the increase in sales for the next 5 years. Many items of the Income Statement and the Balance Sheet can be extrapolated when putting them into a relationship with benchmarks, such as revenue, Costs of Goods Sold (COGS) or profit margins. A thorough analysis of the business model, the product portfolio and R&D pipeline is performed against competitors to validate the growth assumptions. (We assume that we have access to the company's figures, either because its shares are traded publicly, or through a due diligence arrangement).

Next, the Free Cash Flows (FCF) are calculated for each upcoming year, based on the Operating Profit, and adjusted by tax payments, Depreciation & Amortization, Capital Expenditure and Change in Net Working Capital. A Terminal Value (TV) is added to the total PV for the value of the business beyond the 5 projected years (steady state).

The Present Value (PV) of these future cash flows are calculated by using the Weighted Average Cost of Capital (WACC) as a discount factor, and adding all individual discounted PVs to one present value, the Enterprise Value.

This Enterprise Value is usually substantially higher than the book value (accounting-based) because expansion opportunities of the business have made a major contribution to the inferred value.

WACC is a critical figure that determines how risky the fulfillment of these expectations is, both with respect to the overall market and the target firm. Investors want a larger compensation if the risk is elevated (=higher risk premium compared to risk-free investments), reflected in a higher discount rate. The expected cash flows must be larger to balance the reduction of the PV of those cash inflows, as WACC - representing the cost of capital - resides in the denominator of each sum element of FCF to be discounted (=lowered in value when "pulled" to the current year).

The big disadvantage of this method - compared to the previous methods - lies in the fact that market sentiments and prevailing market conditions are not reflected in the valuation estimate.

Aggregation of results

One should always use various valuation methods to arrive at a robust range, with a careful assessment on plausibility and cross-checking the assumptions. A sensitivity analysis might be helpful to get a feeling for the dependency on the input values such as growth, profit margin and WACC. Excluding unrealistic outliers might be necessary as a result of the sanity checks.

Usually the precedent transaction values are higher than from any other method, because of synergy and market control gained by the acquirer. They are represented by a premium paid on top of the fair market value.

The effect of tighter regulations can render any valuation useless. Like in the case of the medical devices industry where the EU Medical Device Regulation can lead to substantial prolongation in the return of investment: The cash flows are shifted further into the future. Paired with a higher risk of attrition, the discount factor (remember: it is a surrogate for the business and financial risk) is less favorable. This brings a double penalty in the discounting of future cash flows to present value, making some of the promising innovations not worth pursuing commercially.

Final comment

"Valuation is more an art than science", as they say, nicely summarizes that a good valuation requires a multi-disciplinary skill set encompassing financial, business, and domain knowledge in regulatory, technical and R&D. In pharma and medtech also clinical expertise and reimbursement knowledge are needed to judge the worthiness of product development or acquisitions.

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