Tag Archives: Public Companies

Business and Company Valuation; Discounted Cash Flow and Multiples

Business and Company Valuation

“What is a business worth?” Although it seems simple, determining the value of any business requires experience, sound judgment from market and industry experience and at least some understanding of financial analysis.

Underpining everything that is outlined below however (much of which I sourced from wstselfstudy.com), I am certainly a part of the Warren Buffet school of thought that outlines that it is important to be able to understand a business before you decide it is the business for you.

What a company is worth is commonly different between buyers and depends on several factors including:

  • Assumptions regarding the growth and profitability prospects of the business,
  • An Assessment of future market conditions and demand,
  • Assumptions based on the competition in the market,
  • Varying appetites for assuming risk (the discount rate on expected future cash flows)
  • What unique synergies may be brought to the business after the purchase.

The purpose of this article is to provide an overview of the basic valuation techniques used by financial analysts to answer the question in the context of a merger or acquisition.

Basic Valuation Methodologies

There are several basic analytical tools that are commonly used by financial analysts to determine the value of a company or business. These methods are based on financial theory and market reality but it must be remembered that these tools are only indicators and should not be viewed as a final definitive statement of value, but rather, as a starting point to estimate value.

The Wall Street Self Study course notes that different people will have different ideas on value of an entity depending on factors such as:

  • Public status of the seller and buyer
  • Nature of potential buyers (strategic vs. financial)
  • Nature of the deal (“beauty contest” or privately negotiated)
  • Market conditions (bull or bear market, industry specific issues)
  • Tax position of buyer and seller

Each methodology is fairly simple in theory but can become extremely complex. They include:

“DCF” – Discounted Cash Flow Analysis

The free cash flows to a company are discounted over projection period. This method is especially relevant where there aren’t any comparable companies allowing the use of the multiples methods below or for smaller companies.

In a DCF analysis, free cash flows are modeled over a projection horizon and then discounted to reflect thier present value in today’s dollars (i.e less). In addition to these cash flows, a value must be determined for the cash flows generated beyond the projection horizon, commonly called the “terminal value”. Thus, DCF accounts for time value of money and relative risk of investment, but is highly sensitive to the discount rate.

The DCF approach is among the most scientific and theoretically precise valuation methodologies because it relates specifically to the profitability and growth of the business being valued. Due to its dependency on the discount rate and a number of long term future assumptions, it must be remembered that it needs to be used in association with other methods.

Analysis of Selected Publicly Trading Companies or Selected Acquisitions using Multiples

A part of most valuation methodologies is the idea of a ‘multiple’. A multiple is simply a ratio of value to a financial statement statistic such as Revenue, EBITDA, EBIT and the Price / Earnings (PE) ratio (Check here for Company Valuation Definitions of these ratios). Each of these multiples are common in different industries for different reasons. In general, the higher the multiple, the higher the value given to the future earnings or cash flow of a company; in other words, the higher the multiple, the more a buyer will pay for the company.

An an examples, If a company’s LTM EBITDA was $50 million and similar companies were trading at a 7X EBITDA multiple, the company would have an implied value of $50 million X 7 or $350 million based on an LTM or trailing basis.

The following is a brief overviewe of the two common methods that are used in selecting appropriately similar company multiples:

Trading Comparables (“Trading Comps”) Analysis

Trading Comps is the term for multiples analysis of publicly traded companies and then making comparisons with other similar or comparable companies.

This method is most relevant for valuing public companies with publicly traded competitiors. A major disadvantage of this valuation method is that often, it is difficult to determine the appropraite competitor and number of variables can get in the way.

Deal Comparables (Deal Comps”) Analysis

Deal Comps or analysis of selected acquisitions are very similar to trading comps except that deal comps compare actual completed transactions instead of publicly traded companies as the domain of comparable companies.

This approach is very relevant in the absence of public traded competitors but information can be very scarce and unreliable depending on company and the particular industry.

Other Methods

The following are other methods that I will not go deeper into in this article:

Asset Valuation – Involves analysis of tangible asset

Break up Analysis – Involves sum of parts analysis based on different business lines

LBO Valuation – Involves financial engineering based on leverage or use of debt

The Disadvantages of a Company Going Public or ‘Floating’

Following on from my post about the advantages of company going public, The following article discusses the disadvantages of a company going public through an IPO; as outlined in IPO and Equity Offerings by Ross Gedes.

The disadvantages brought about through the flotation of a company in an IPO are typically perceived differently by different companies with different focuses and requirements.

There are the costs involved that include both the direct costs, in time and money, of the flotation process as well as the opportunity costs of underpricing the offering and subsequently the costs of increased disclosure to public shareholders.

The disadvantages of private company going public are:

  1. Increased disclosure,
  2. Costs of IPOs,
  3. Potential loss of control,
  4. Separation of ownership and control,
  5. Perceptions of short-termism (Wall street),
  6. Meeting investor expectations.

Increased disclosure

When a company moves from private ownership to public, it vastly increases the number of people who have access to its financial records. This can be a huge shock to the existing owners, not just the reporting of the company’s results, but the disclosure of management salaries and perks that often piques the interest of newspaper editors on a slow day.

Companies are required by stock exchanges, securities commissions and regulators to disclose information on a regular basis so that investors and potential investors can make buy, sell or hold decisions. A much greater amount of information is required at the time of the IPO and is included in the offering prospectus.

Disclosure requirements vary by country. Those countries with the largest stock markets, relative to the economy, typically have the highest disclosure requirements (e.g. Australia, Canada, UK, USA).

The development of efficient capital markets in Central and Eastern Europe has been hindered partially by the reticence of corporate executives to disclose information about their firm’s operations and performance.

It’s not all bad though. Botosan (1997) has found that increased disclosure on the part of the company can reduce its cost of equity. By reducing its cost of equity, a company is able to invest in more projects, raise capital more cheaply, and enhance its valuation.

Costs of IPOs

Initial public offerings aren’t cheap. Investment bankers take commissions of between 2 and 7 per cent of the total amount raised; lawyers and accountants bill by the hour, and many hours are required. The ancillary costs, such as public relations, printing, corporate advertising and others can add several hundred thousand more dollars, euros or pounds.

In addition to the upfront costs of the IPO, there are the costs of maintaining a quote on the stock exchange (stock exchange fees, management time, more extensive audits and reporting, reconciliation of accounts to US GAAP if listed on a US exchange, etc.).

However, the direct costs of an IPO can pale beside the indirect cost of underpricing. Because no cash is coming directly out of the issuer’s pocket, underpricing can sometimes be ignored as a cost. It should not be. IPOs around the world are under priced compared with their short-term performance. On average, an IPO will close at a price that is 15 to 20 per cent above its issue price, although this varies by market and industry and over time. This means that selling shareholders and the company are leaving significant sums of money on the table when they go public.

The amount of money left on the table is calculated by subtracting the offer price from the first day closing price and multiplying by the number of shares offered. For example, many analysts believe Google left too much money on the table in its 2004 IPO.

Potential restrictions on management action

In many private companies, the managers are the owners. Therefore there are few restrictions on management action other than statutory and legal regulations and common sense. However, this is not a problem as the linkage of ownership and control should lead to little divergence of opinion about the appropriate course of action for the company.

In public companies, the managers are the agents of the shareholders – they should be acting on behalf of the shareholders and in the shareholders’ best interests. In order to ensure that they do, public companies have boards of directors who are meant to oversee management’s actions on behalf of shareholders. In some circumstances a strong board of directors may limit the actions of management.

Potential loss of control

Not all IPOs are for more than 50 per cent of the issuer’s voting shares, in fact, the average is around 30 per cent. So although control is not lost through the IPO, if the company requires further equity to fuel its growth, existing shareholders will suffer dilution. For the majority of companies, control will pass to public shareholders at some point in time.

‘This risk [passing of control] can be minimized by limiting the number of shares sold to the public, seeking to ensure a broad distribution of shares to the public, creating tiered classes of stock with differential voting rights, entering into voting agreements among pre-IPO shareholders, adopting supermajority provisions or staggering the terms of the directors. Creating a dual class voting structure can depress the price of the shares with less voting power. While some structures may prove more effective than others, there is no guarantee that a public company will not be threatened by a hostile acquiror.’ (Greenstein et al., 2000: 7)

Perceptions of short-termism

One of the most common complaints of corporate management is that Wall Street or the City are too ‘short-termist’. Short ‘termism’ outlines that investors and analysts focus exclusively on the current quarter/reporting period, without giving due consideration to the long-term impact of the company’s decisions. Shareholders generally judge management’s performance in terms of profits and stock price.

Significant pressure exists to increase profits each period and to meet analysts’ expectations and this pressure may cause management to emphasize near-term strategies instead of longer-term goals (Garner, Owen and Conway, 1994).

In order to meet investors’ quarterly or semi-annual earnings expectations, a company may be forced off the long-term strategy that was in place prior to the IPO. Managers may feel compelled to follow strategies that support the share price in the short term, rather than over a long time horizon.

I have watched several interviews with Warren Buffet where he has stated that he predominately wishes for long term investors in his company Berkshire Hathaway to avoid the Wall Street phenomenon of short termism. The corollary of this wish is a somewhat reduced daily liquidity of the stock, but if the company is returning above average dividends over time as a result of better decisions being made, this is less of an issue.

Dealing with institutional investors

Along with the above complaint about short-termism, many chief executives, often those heading a company with badly performing stock prices, complain that the stock market doesn’t understand entrepreneurs, and that entrepreneurial decision making and creativity are stifled by the men in blue pinstripe suits.

Additionally, dealing with shareholders, financial analysts and the press is time consuming. The CEO and CFO/Finance Director should expect to expend, on average, at least one day per month meeting with and discussing the company’s strategy, performance and operations. Those companies that do not establish good relationships with the financial community can find themselves without friends in times of need, such as when faced with a hostile take-over.

‘The performance expectations of Wall Street can only be described as brutal. Miss your earnings forecasts, especially in the first year after your IPO, and you could see a catastrophic decline in the price of your stock of 50 percent or better. Once a young management team has discredited itself with Wall Street, there may be no recovery.’ (American Lawyer Media, ‘The Survival Guide to IPOs’, p. 15)

Whilst many believe the advantages of company going public outweigh the disadvantages, every year dozens of companies voluntarily leave the stock market in what is called a ‘public to private transaction’. These transactions are typically management buy-outs and leveraged buy-outs of the public shareholders and come after extended periods of a depressed share price.

The Advantages of a Company Going Public or ‘Floating’

Whilst reading IPO and Equity Offerings by Ross Gedes, I came across the following advantages of going public. These will be compared with the disadvantages of a company going public in a later post.

The advantages of going public that will be discussed in this article include:

  1. Liquidity and increased share price,
  2. Management and employee motivation,
  3. Enhanced image/prestige,
  4. Access to alternative sources of capital,
  5. Ancillary benefits.

Valuation and liquidity impact

Companies listed on a stock exchange are typically worth more than similar companies that are privately held. The information contained in an IPO prospectus and subsequent annual reports reduces the uncertainty around performance and hence increases the value of a business.

In addition, investors are willing to pay a premium for liquidity: the ability to easily buy or sell shares. Private companies have limited or no liquidity in most cases. The liquidity premium varies over time and economic conditions, but a reasonable estimate would be in the 30 per cent range. This means that if two identical companies exist, one listed and the other not, the listed company will typicallly be valued approximately 30 per cent more than the private company in the marketplace by investors.

Daily liquidity means that insiders know the value of their holdings more accurately, as well as facilitating further sales of shares. This leads a good proportion of private companies to at least consider going public.

Motivate management and employees

The use of incentives such as stock options and stock bonuses to attract and retain both employees and management became very popular; particularly in the USA and UK during the 1990s.

Equity-based awards and ownership tend to be spread more broadly among management and employees in public companies compared to private companies. In addition, management and employees of public companies can see the results of their efforts in the share price more immediately.

Prestige/enhanced image

A significant, but intangible, benefit of a flotation is the increased visibility of the company through its ongoing disclosures to the stock exchange or securities commission. Many analysts believe there is considerable prestige attached to managing and working for a publicly listed company.

A flotation may bring marketing benefits, by making the company seem stronger and more substantial. Press coverage of public companies is typically greater than that of privately owned firms.

These factors can lead to the recruitment and retention of higher quality employees and increased sales due to greater corporate exposure.

‘While both good and bad news must be disseminated to enable investors to make well-informed decisions, a public company that is well run and compiles a record of success can gain a first class reputation that can prove an immeasurable benefit in many ways. As a company’s name and products or services become better known, not only do investors take notice, but so do customers and suppliers, who often prefer to do business with well-known companies.’ (Garner et al., 1994: 17)

Access to alternative sources of capital

Another benefit as a result of a company going public is the ability to gain access to alternative sources of capital in the future. Public companies are often able to raise money for expansion more easily and at better rates than private companies of similar size. The public debt markets are more accessible to public companies than to companies without a listing.

Moreover, going public generally improves a company’s debt to equity ratio and may enable it to borrow on better terms in the future.

One study by Pagano et al. (1998) found that Italian companies that went public were able to borrow more cheaply after their IPO. They also found that the number of banks willing to lend to a company increases after its flotation. However, they report that a similar study conducted in Spain (Planell) uncovered no significant decrease in interest rates paid after the IPO.

Ancillary benefits of flotation

The flotation process often forces a company’s management to formulate and document a clear business strategy for the first time.

This is typically beneficial to the future success of the business and in many cases is just what a private company required to truly grow from small to medium or from medium to large in size.

Along similar lines, the anticipation of public ownership leads many companies into improving their management and financial structure. Fast growing medium-sized companies often neglect the formal structures which will help them in their attempts to become larger and more profitable companies.

If you enjoyed this article, please also have a look at my blog on the disadvantages of a company going public.

Six different types of public and proprietary companies

Corporate law

Following on from my blog on company characteristics, I thought I would write a quick blog on the different types of companies that are common today.

Companies are classified according to liability, size and where they are listed. We will discuss the first two and the resulting 6 common types of companies we arrive at.

Classification according to member liability

1 – Companies limited by shares (known as ‘limited liability’ companies)

Typically, members are usually shareholders and their liability is limited to the nominal (nominal capital is defined as the capital with which the company was incorporated) value of their shares plus any unpaid amount on their shares.

As an example, say you buy BHP shares at $10 for 100 shares, then your liability is limited so that if BHP were to be sued, it is limited to the $10 paid. This is sometimes conducted differently when you don’t fully pay for shares when the company floats. If $5 was paid and $5 was then owed on the shares, then the remaining amount must be contributed should it be called upon.

As we probably know by now, the significance is that shareholders are not liable for the full amount. This is known as the share capital method of corporate finance. Another method is by debt – going to a bank and asking for money to be lent. This is a different contractual agreement. Continue reading Six different types of public and proprietary companies