Introduction Company valuation is the process of assessing the total economic value or current worth of a business and its assets. Valuation is commonly conducted using three approaches: namely, Discounted Cashflow Method (DCF), Market Approach, and Net Asset Value. The different valuation methodologies Discounted Cashflow Method (DCF) – It is the process of estimating the …
Company valuation is the process of assessing the total economic value or current worth of a business and its assets. Valuation is commonly conducted using three approaches: namely, Discounted Cashflow Method (DCF), Market Approach, and Net Asset Value.
The different valuation methodologies
Discounted Cashflow Method (DCF) – It is the process of estimating the value of an investment based on its expected future cash flows discounted to present value. In this approach, the valuation varies depending on the assumptions made around growth rate, discount rate, terminal value, and cash flow assumptions.
Market Approach – This is determining the value of a company by comparing it to similar companies that have been sold in the recent past. In this approach, there are two methods: the guideline transactions method (based on valuation multiples obtained from mergers and acquisitions similar to the subject company) and the guideline public company method (based on valuation multiples derived from publicly traded companies similar to the subject company).
Net Asset Value – This is the value of the equity in the business after deducting the company’s liabilities from its assets. It is conducted by simply taking the total assets in a company’s balance sheet and deducting its liabilities (both short term and long term).
The subjective factor in a valuation
Valuation is an objective process but involves some level of subjectivity based on the valuer’s judgement and professional experience; thus, it’s advisable to use an expert to conduct business valuations. Valuation based on DCF, for instance, is sensitive to the discount rate/cost of capital applied to the projected cashflows to discount them to the present value.
In this article, we will seek to understand the different approaches valuers use in selecting a discount rate when using the DCF methodology, the challenges posed by the different approaches and how they can be mitigated. This is a four-part series on valuation challenges and how to resolve them.
Calculating the discount rate or the cost of capital
The cost of capital can be looked at from two different perspectives, as a cost to the entity that needs the funding or as a required return by the provider of the funding.
The implication is that if you computed the cost of capital for a company you are valuing and arrived at, say, 20%, the number might be different from the required rate of return the investor is using to evaluate the company based on his required rate of return. So assuming the investor’s required rate of return is 30%, the cost and the return expectations would differ by 10%.
The question that naturally follows is which discount factor should be used in discounting the cashflows for valuation purposes? To answer this question, the adage holds true, the value lies in the eyes of the beholder. Applied to this case, this would mean different investors would apply different discount factors in calculating the valuation depending on their cost of funding and hence their required rates of return.
This poses a challenge to the entrepreneur as they would have computed an intrinsic valuation based on their capital structure and the costs of the different funding sources. This is where it gets exciting. For the entrepreneur to close on a funding round, a negotiation will establish if the deal gets done or not. In this negotiation, the discount factor may or may not feature. At the end of the day and from a purely commercial perspective, the investor decides to invest based on this simple mental question.
If I invest at this price and work with the entrepreneur over the next X years, will I be able to exit and meet my return (IRR 30%)?
If the answer is affirmative, they invest; if not, they pass on it.
So how do we compute the cost of capital/discount factor?
We still have not answered how you compute the cost of capital or discount factor, so how do you do it? The answer is simple but complex. It is simple because to obtain the cost of capital or WACC (Weighted Average Cost of Capital) as it is commonly referred to, all we need to do is to calculate the costs of the various sources of funding for the Company and then weight them based on their contributions to the total capital mix. That is the simple bit. The complex bit is around computing the costs of the different sources of capital, especially the cost of equity. Below we deal with how to compute this cost of equity.
Computing the cost of equity
The most used approach for computing the cost of equity is the Capital Asset Pricing Model (CAPM) approach. The approach makes certain assumptions which make it hard to apply. The assumptions made include:
There are other assumptions, but let’s focus on these. As can be seen, these assumptions are untrue for most markets, especially in Africa, which would affect the efficacy of the methodology.
We hope this was the whole challenge, but unfortunately, it is not. More on this below.
How does this methodology work?
The methodology works on the following premise, your cost of equity should always be higher than the risk-free rate (the return the government (considered risk free) gives you for investing in a long-dated investment instrument, ie a government bond for 5 – 10yrs). It will be higher than the riskiness of equity (company) being considered.
The cost of equity (Ke) is equal to the risk free rate (Rf) added to the risk premium (Rp). This is represented by the equation below:
Ke = Rf + Rp
Ke – Cost of equity
Rf – Risk free rate of return
Rp – Risk premium
This formula is further broken down as follows:
Ke = Rf + MRP X βi
and further broken down to
Ke = Rf + (MRR – Rf ) β
Ke – Cost of equity
Rf – risk free rate of return
βi – beta value for the financial asset
MRR – average return on the capital market or return on a comparable market index such as the NASI 20 Index for stocks over a long period, say 10 years.
So, what are the additional challenges:
It is not uncommon to compute the market rate of return and find it to be lower than the risk-free rate. Beta values can also be spurious especially due to stock markets that are illiquid and that are not perfect (perfect information, no transaction costs or taxes)
How players respond to these challenges
Due to these challenges, several valuers use inputs provided by Aswath Damodaran. In his computation, the market risk premium for a country is obtained by adding the equity premium for the US market to the country’s risk. It is also assumed that the US market has zero country risk, which is a notional belief. A country’s risk premium is a multiple of the country’s rating-based spread (based on Moody’s rating, which also involves some subjectivity) and the average equity volatility. It can be challenging to verify all the data that goes into computing the beta and market premium; consequently, most valuers use it as is. Due to the time, effort, and skills required to compute beta and market risk premium, most valuers tend to use the betaand market risk premium provided by Aswath Damodaran. Damodaran updates the data periodically. He also provides the raw data that he uses in the computation of beta; it includes listed companies from US, Japan, and Europe, as well as listed firms from emerging markets such as China, Kenya, India, and Israel among other markets; most countries with vibrant stock markets are well represented in the dataset. The above notwithstanding, the selection of companies and sector segmentation also requires some subjective assessment. There are other approaches, but Damodaran is one of the key approaches.
Despite the above challenges, CAPM continues to be used widely and is acceptable by many investment professionals.
So how do investors do it?
On the investor side and especially for private equity-type investors, the methodology used to arrive at the discount factor is the target rate of return or expected Internal rate of return (IRR). The target rate of return is the minimum return an investor will seek for assuming the risk of investing in a security or company. A lesser TRR generally means that there is lower risk.
The TRR may not be derived mathematically but is advised by the riskiness of the investment, inflation, required rates of returns by investors to the fund, target payouts by investors etc. Surveys of investors show different target returns, but a 30% IRR target is not uncommon, especially for non-impact investors in the continent. The number goes higher for early-stage funders and lower for funders of more established businesses that are less risky.
While there are clear company valuation methodologies, conducting company valuations is not merely applying the formulas to get a value. It entails understanding the reason for the valuation, the subject company and sector and market of operations. It also requires the valuer to select the most suitable valuation approach together with other valuation drivers such as the discount rate. This process requires the valuer to apply their expertise and judgment to ensure that the valuation generated represents the company’s fair value.
The discount factor is a key driver of valuation and, as highlighted, is derived from a mix of objective calculation methodologies and subjective considerations. When valuing a company, use the different approaches to ensure that your valuation is hinged on theoretical considerations and market expectations.
If this is not something you do on a day to day, it is advisable to use a financial consultant.
At InVhestia, we offer valuation services, among other offerings, for businesses and projects. Talk to us about your valuation needs.
By Keziah Njeri, Associate Principal InVhestia Africa Limited