Valuation Manual

Online version of the Valuation Manual

1. Introduction to Valuation Methodology

Over time, many valuation methods have been used in different circumstances and with varying degrees of success. At present, a limited number of methodologies are generally accepted and are commonly considered as the best approaches to estimate enterprise value. For the most part, these are listed in the International Valuation Standards.

These widely used methods vary in terms of their sophistication and goals, with their corresponding advantages and disadvantages. While it is debatably easier and generally faster to calculate a Valuation Multiple, the calculation of a Discounted Cash Flow requires the establishment of well-founded hypotheses and extensive knowledge of the business, as well as the use of a considerable amount of time for its preparation. On the other hand, Valuation Multiples can easily be influenced by the market conditions from time to time (although this effect can be mitigated by corrective adjustments), whereas Discounted Cash Flows are less dependent on daily or temporary market trends and seek to estimate the company’s "fundamental" or "intrinsic" value, which tends to remain stable over time.

All valuation methods have pros and cons for their application. They have to be used with caution as each one will be most suitable in particular circumstances (availability of information about the company and the market, time limits, budget available, etc.). In any case, it must be remembered that the best thing is not to rely on a single valuation method. In order to obtain a more realistic and accurate estimate of a company’s value, e-Valuation recommends the comparison of the results of at least two methods that are complementary to each other.

The following sections of this manual will set out, in simple, practical terms, the approaches most universally used to value companies, namely:

• Discounted Cash Flows

The Discounted Cash Flows method identifies the absolute value of a business, so it is not necessary to compare it with similar companies and it allows all the success factors to be taken into account explicitly. Therefore, while this method is much more sophisticated than Valuation Multiples, it is also more complicated to apply as many factors must be considered explicitly and the result obtained is highly sensitive to certain variables applied such as the discount rates or the long-term growth assumptions.

• Listed Company Valuation Multiples

The Valuation Multiples method provides a figure that is considered to relate the company’s value (sales, earnings, etc.) to the market value of its shares (the price) or its enterprise value (the value of the business as the sum of the market values for various demands in terms of its earnings and cash flows). These are not measures of absolute value, but they do allow a relative value to be established. The multiples method is sometimes criticized for not taking explicit account of various profitability indicators considered for any business: required performance, growth, return on invested capital (ROIC), etc. Nonetheless, other points of view could also be discussed as the greatest benefit of multiples lies in the fact that all the success factors are incorporated into a single figure, thus allowing more effective and judicious analyses.

• Comparable Transaction Multiples

The logic behind this method is the same as for the listed company valuation multiples method, with the difference that the data used for comparisons come from financial transactions for the sale and purchase of privately-owned firms.

• Ratios of Industry Success Factors

This valuation methodology is also similar to that for comparable multiples, with the difference that the benchmark data used are not based on financial variables (Profit and Loss Statement, Balance Sheet, Cash Flow Statement), but on other trade and business indexes that are strongly linked to the enterprise value.

For the sake of mere illustration, here are other valuation methodologies that are occasionally used (for very specific cases or for verification or complementary purposes) and some others that used to be popular in the past:

In recent years, new valuation methods have emerged in an attempt to respond to the disadvantages inevitably presented by each of the methods mentioned above. These have generally been put forward by consulting firms or investment banks whose analysts use them to value large companies. Among these, we can mention:

• EVA (Economic Value Added)
• EB (Economic Benefit)
• MVA (Market Value Added)
• CVA (Cash Value Added)
• CFROI (Cash Flow Return On Investment)
• TSR (Total Shareholder Return)

2. Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method is extensively used to estimate a company’s value. It is a dynamic method that takes into consideration the value of money over time and allows assessing the specific impact of many variables on future yields and behavior. DCF valuations may be very sensitive to small changes in any of the initial data, so they provide thorough analysts with a very powerful tool. Although it can be argued that the method is complicated and subjective, we do not feel these reasons to be sufficient to reject it as the same could be said of many valuation techniques.

An identical reasoning could be applied to the sensitivity of DCF regarding long-term growth hypotheses: while this figure may also affect other valuation methods, the effect on DCF can be mitigated by using a nil or very low long-term value-added growth rate, as well as performing a rigorous study of the value that really remains in the business at the end of the period forecasted.

The simplified formulation of this method can be expressed as the summation of updated cash flows from the explicit forecast period plus the residual value, also updated:

FCFF = Free Cash Flow for the FirmTD = Discount rateVR = Residual Value

Thus, the method consists of four basic elements:

1- Free Cash Flow for the Firm (FCFF)

2- Discount rate / Cost of Capital (TD)

3- Time Horizon (n)

4- Residual (VT) or Terminal Value

2.1. Methodology

We describe below in summary what this method consists of and how to apply it, explaining each of its basic components.

2.1.1. Free Cash Flow for the Firm

The Free Cash Flow for the Firm (FCFF) represents the funds available for all the parties providing corporate funding (shareholders and banks or other financial creditors). These funds may therefore be used to:

• pay interest and repay the principal of loans
• increase the cash balance or other investments
• pay dividends or redeem shares

Simply speaking, it is calculated as follows:

EBIT (Earnings Before Interest and Tax)
- Tax on EBIT
= NOPLAT (Net Operating Profit Less Adjusted Taxes)
+ Amortizations and other accounting entries
= Gross Cash Flow
- CAPEX(Inversiones en Capital Fijo)
- Accounting variations in operational provisions
= Free Cash Flow for the Firm

Once the Free Cash Flow for the Firm has been calculated, in order to calculate the total value, it is necessary to take into account possible assets not reflected in the same, such as investee companies or other investments, that need to be added or adjusted to estimate the Total Enterprise Value (EV). In the same way, potential hidden liabilities that have a good chance of emerging must also be deducted.

When preparing forecasts for a DCF valuation, special attention must be paid to the following points:

• The projected growth opportunities must be realistic and take into account potential future competitive advantages.
• The growth hypotheses must be consistent with the planned investment.
• The projected rate of return must be realistic in comparison with past results and the forecasts of other analysts (or else forecasts must be made excluding inflation).
• The projected inflation rate must be in line with market expectations.
• The ratios and margins applied in the forecast period must be consistent with historical figures or with the strategic changes or investments to be effected.

The estimation of future cash flows is generally done for the 5 10 years following the present moment, depending on the information available, the industry in question and the company. In cyclic industries, for example, we will have to consider which moment of the cycle we are in and try to cover a complete cycle or else make sure that our last explicit cash flow occurs in a central moment of the cycle.

The accuracy of projections depends, to a large extent, on the quality of past strategic and sectorial data used for their preparation. In order to reduce the uncertainty implied in the estimation of future cash flows, the factors that will have the greatest impact on the company’s profitability (and so on its cash flows) must be studied in depth and be well understood by the analyst.

An analysis of the sensitivity of these (success) factors allows an assessment of their impact on the enterprise value. Another useful tool for producing forecasts is the preparation of multiple scenarios reflecting the different market expectations or the company’s possible strategic options. Each scenario is evaluated using the DCF method (not necessarily with the same discount rate for all the scenarios) and any differences in value can be analyzed. The advantage of this technique when evaluating the possible impact of a change in the market circumstances lies in the fact that:

• The effect of the differences in cash flows from one scenario to another can be analyzed over different years.
• Any systematic error in the forecasts of cash flows and/or discount rates will be neutralized once the percentage differences between the DCF valuations are calculated for each scenario.

2.1.2. Cost of Capital

Once the Free Cash Flows expected for each year have been calculated, their present value must be estimated. The rate used to update or discount future cash flows (bring them to present value) lies in the cost of capital (the demands of the parties supplying the company’s funds). If the discount rate is not determined precisely, the present value of future cash flows will be too high or too low and, as a result, so will the valuation.

In the case of Free Cash Flows, the cost of capital comprises two main items:

• the cost of the capital furnished by shareholders or partners in the firm, i.e. the return they require for their funds, and
• the cost of the capital furnished by the company’s financial creditors, i.e. the return (interest rate) required by the banks and other financial lenders.

E = Market value of the equity Ke= Cost of Equity = Return expected by shareholders
D = Market value of the debt Kd = Cost of Debt Before Tax = Return expected by creditors, adjusted for the effect of the debt on taxation

The cost of the debt (Kd) is the mean weighted interest rate that the company must pay for the loans and credits received. It is possible to calculate the cost of each component of external resources separately, although in practice a general mean of the cost of the debt is used. This cost must reflect the current interest rates on the interbank market (Rf) and their spread (Rpd, differential in basis points) reflecting the company’s credit risk.

Kd = Rf + Rpd

The cost of equity (Ke) consists in the total return expected by the participants in the company’s share capital. The greater the risk presented by the company, the higher the expected return. The method most commonly used to calculate the cost of equity is the Capital Asset Pricing Model (CAPM).

Ke = Rf + Rp * b

Rf = Risk-free rate

The current yield of public Treasury bonds is generally used to calculate this rate. This formula has been questioned at times as long-term bonds are not truly risk-free. Those who use this argument resort to the yield from short-term government securities. The disadvantage of this lies in the fact that short-term interest rates, unlike long-term returns, do not reflect the expectations on future changes in interest rates. For the same reasons, there are various arguments that defend the use of the interest rate for long-term bonds. In practice, the risk-free rate is generally accepted to be the return on 10 year Treasury bonds. The market for this kind of security is generally liquid and the yield is therefore reliable.

Rp = Capital Risk Premium

This comprises a measurement of the future risks calculated as the expected future market return minus the risk-free rate. It is the most difficult component to calculate in the cost of equity. The estimates of this premium normally vary from values close to zero up to 8% (or even higher values for Internet and new technology companies), but the most typical values tend to be around 2% 5% depending on the market. The highest estimates normally stem from historical observations of bond yields. The lowest estimates tend to be subjective judgments on the future returns expected by investors or are the fruit of a dividend update model where the premium comes from a discount rate equal to the present value of the future dividends at the current market level.

b= Beta Factor of the Capital

This is a pure risk measure generally used in the CAMP model to estimate the contribution of a value in a diversified portfolio. The risk inherent to a business can be divided into two factors in order to obtain a calculation of a better and more consistent b allowing comparisons between companies and markets.

• A firm’s systematic risk is the inherent risk in light of its industry and business characteristics, regardless of its capital structure.
• Its financial risk is a risk factor that results from the firm’s level of leverage. In order to make the b’s comparable between companies, we first have to eliminate the effect of leverage, so as to include it again later at a level equivalent to that of the comparable companies.

The beta of a share (i) is equal to the covariance between its yield and the yield from the market, divided by the volatility (measured in terms of the standard deviation) of the market yield. A beta value equal to 1 means that, if the market goes up by 5%, then the price of the company’s shares will also go up by 5%. A beta value equal to 2 implies that, if the market goes up by 5%, then the stock price will increase by 10%.

In practice, betas are generally based on the relative volatility of historical returns, although this may not accurately represent the current risk if there have been changes in the structure of the company’s liabilities. Critics of beta argue that past volatilities cannot provide a measure of future risk in a constantly changing environment.

2.1.3. Time Horizon

With regard to time horizons, two different periods of time are normally considered, although the first is sometimes, in turn, sub-divided in two. The first period is the explicitly projected period for which specific cash flows have been calculated. Ideally, it must be sufficiently long for the investments to stabilize. In practice, the period explicitly projected tends to be five to ten years. The second period of time is supposed to be unlimited and starts at the end of the period explicitly projected (reflected by the terminal or residual value). It is used to determine the residual value of the business where, in many cases, the largest part of the value is concentrated. Albeit debatable, except for companies with low growth rates, it would occasionally be much better to put more effort into the calculation of the residual value than in trying to forecast five or ten years of cash flows.

2.1.4. Residual Value

The terminal value of a business comprises its value after the explicitly projected period. In practice, the residual value is frequently calculated a) using the Gordon growth model or b) using a residual multiple.

a) The Gordon growth model: This model is based on the assumption that the growth of future free cash flows will be constant. Thus, it is necessary to estimate the growth rate the business will experience after the explicitly projected period. Any error in the estimation of the growth rate may have a substantial impact on the residual value, especially in high-growth companies. Unfortunately, growth rates are always difficult to calculate over the longer term and, therefore, so are free cash flows. Under stable conditions, the growth rate will be given by the rate of new net investments, which will be similar, or close, to the company’s market growth rate.

This way of calculating residual value comprises two stages: first a perpetual income is calculated using the growth values discussed above and then these are brought to present value.

VR = Residual value

FCFF = Free Cash Flow for the firm in the last year estimated

g = Mean growth rate for future cash flows

n = Number of years in the Second time period

WACC= Weighted Average Cost of Capital

b) Residual Multiple: The multiple must reflect the unique features of the firm in year n + 1 and could be any multiple based on the Enterprise Value. This approach can be based on multiples using current or future prices. Generally speaking, multiples on financial variables such as EBITDA or Earnings Before Interest, Tax, Depreciation and Amortization, net profit, or a more stable (conservative?) value such as book value, etc. are used.

2.2. Problems of applying DCF to some industries

Applying the traditional two-stage model (explicitly projected period plus the value in perpetuity or residual value) explained above to high-growth companies (new technologies, biotechnology, etc.) entails several difficulties that have to be considered. Often:

• These firms are in industries where there are no comparable listed companies or where there are other companies in the same life cycle phase as the company under evaluation.
• These companies enjoy very high growth rates, negative earnings or even negative operating earnings.
• These companies have a short track record and, in many cases, only limited and uncertain information is available (subject to major differences in interpretation).
• Their future results are enormously uncertain: if they succeed, their success could be spectacular, but if they do not, all is lost.

These aspects mean that valuations of companies in these or similar sectors are much more complex than in traditional ones. Some of the most significant problems are discussed in the next paragraph.

Companies in new technology sectors normally have very high growth rates combined with a negative cash flow in the initial phases of their life cycle. The problem with a projected DCF period of 5 or 10 years lies in the fact that it usually doesn’t capture all the growth, as this can continue beyond the explicitly projected period. As a result, it is necessary to calculate a perpetual growth rate consisting in an approximate mean of ongoing fast growth and the actual long-term growth, a value very difficult to estimate.

Another problem related to this is the homogeneity of Internet companies in presenting negative results, meaning that the resulting residual value the projections depend on can only be more negative. It is hard to estimate historical growth when earnings are negative and, even if obtained, it may be meaningless.

Nonetheless, this is not the only problem for the calculation of residual value: there is also the problem of determining the company’s cash flow in the last year of the explicitly projected period. Due to high growth rates, the company might not yet have attained maturity by this point and so the bases for the cash-flow projection would be inappropriate.

The lack of historical data therefore aggravates the valuation problems. In addition, the beta values used for the calculation of the cost of equity (see section on CAMP) are largely based on long-term historical estimates. If there are no comparable listed companies with enough track record, it is impossible to infer this risk parameter from comparable companies. Another difficulty that arises is when calculating taxes, which gets even more complicated as businesses with losses can defer tax payments and offset losses against future earnings.

Some proposed solutions:

Companies with negative earnings

In the case of negative earnings, these can be adjusted if the losses come from non-core or non-operational activities of the firm. This implies that negative results are not caused by the company’s normal activity and it is necessary to estimate the earnings in a "normal" year. One method to estimate a "normal" year might be to use the mean returns from previous years or the returns of comparable companies, especially when adjustment is not possible.

If negative earnings are not caused by the firm’s normal activity, or if the company is going through a cyclical recession, then earnings can be adjusted more easily. On the other hand, if the cause coincides with structural problems, indebtedness, a start-up phase or long-term operational issues, then it might be safer to base the projections on revenue and calculate the sustainable margin.

If negative earnings are not caused by the firm’s normal activity, or if the company is going through a cyclical recession, then earnings can be adjusted more easily. On the other hand, if the cause coincides with structural problems, indebtedness, a start-up phase or long-term operational issues, then it might be safer to base the projections on revenue and calculate the sustainable margin.

Companies with no track record

In the case of businesses with no track record or when it is not possible to identify similar companies, there may be an option, albeit disputed, to replace one source of information for the other. When we are looking at comparable companies, there is no value whatsoever in having two main elements for the comparison: similarity in type, size, margins, geographical presence, etc. of the business and the current stage in the company’s life cycle, with special attention being paid to growth expectations.

Some parameters

Below is a list of parameters that are important when considering valuations of companies with negative earnings, no track record and/or without comparable companies.

1. Updated information - Use figures from the Profit and Loss Statement for the last twelve months and “fresh” estimates for items on the balance sheet that are not frequently updated. The goal is to obtain a better estimate of the value, instead of simply referring to the earnings or figures from the previous fiscal year (if available).

2. Expected revenue and growth margins – The elements normally taken into account to estimate the expected growth in revenue are:

• Consistency with the company’s historical achievements, if there are any to compare with (it might be possible to look for those of companies with a comparable track record).
• Consistency with the expectations for growth and margins in the industry in general (or related industries or those with growth patterns or expectations similar at present or in the past).
• Changes in the number and quality of competitors and the firm’s competitive advantages (current and future). The fact that there is no competition does not mean there won’t be tomorrow. When will it arrive, if it can?

3. Need for re-investment – The growth of operating revenue is something that reflects the amount of ongoing investment made by the firm in itself and how well this re-investment is carried out. However, this is not applicable to the re-investment requirements of start-ups. There are three ways to cope with this:

• Assume that the company’s existing re-investments grow at the same rate as its revenue.
• Assume that the company’s needs for re-investment will approach the mean value for the industry.
• Examine the ratio of marginal sales to company capital. The higher the result, the lower the amount of re-investment and the higher the enterprise value.

4. Risk parameters and discount rates – Risk parameters can be estimated through a firm’s financial characteristics – the volatility of its earnings, its size, the nature of its cash flow and financial leverage. These risk parameters will vary gradually over the period being estimated and, as the company achieves the proposed sustainable margin, they will have to come closer to those of the mean for comparable companies.

5. Valuation of the company and its stock - Most of a young, high-growth company’s value will generally be found in the residual value, unless a very long explicit period is being estimated. In order to calculate the terminal or residual value, it is necessary to estimate re-investment in perpetuity (Stable Growth Rate / Return on Capital) and ensure that this is consistent with the forecast growth rates.

2.3. Conclusion: advantages and disadvantages of DCF valuations

The DCF method may be difficult to apply in very early phases of a fast-growing, developing company’s life cycle and this may lead to assigning it a lower weighting in the analysis than other valuation methods. Having said that, other techniques also present disadvantages when it comes to valuing businesses, such as biotechnology or new technology companies.

The DCF approach must not be ruled out in any way and, as the short-term forecasts start to show more predictable cash flows and allow estimation of reliable long-term projections, this method will gradually gain in importance and weighting in the valuation. The fact that a methodology is hard to apply should never imply that its use is not advisable.

Below is an outline of the major advantages and disadvantages of the use of DCF.

Advantages

• DCF is a sophisticated valuation method that takes into consideration key business variables such as cash flows, growth and risk. With precise hypotheses, a DCF would give better estimations than any relative valuation. Even (especially) in the case of newly-created companies with high growth and uncertainty, this characteristic is a point in favor of this methodology.
• DCF estimates the “intrinsic” value of the business in absolute terms. Therefore, the changing attitude of the market does not affect the resulting valuation as strongly as in the case of relative valuations, thus achieving, in principle, more accurate estimations in the longer term.
• Based on cash flows and present market value, DCF can be used to calculate the implicit discount rate of a business.
• DCF provides tools to mitigate the effect, also present in other valuation methods, of sensitivity to long-term growth assumptions by allowing the use of long-term added-value growth assumptions equal to zero.
• Using the DCF methodology, it is possible to carry out an analysis of multiple scenarios to be able to study the impact of non-systematic, company-specific factors on enterprise value. Without doubt, this is one of the most powerful analytical tools.
• The company is forced to give an explicit prediction of its cash-flow profile, so as to identify and manage all aspects of the business and the strategic factors that will need to be dealt with in future.

Disadvantages

• Due to the sophistication of the DCF method already mentioned, many more case analyses have to be performed (in comparison with relative valuation multiples) in order to obtain an accurate valuation. This increases the uncertainty, particularly in the case of companies with negative earnings, without a track record or with no comparable peers. Nonetheless, the use of multiples also requires implicit considerations of the same factors and their application may be impossible in those cases.
• The numerous hypotheses lying behind a DCF valuation make it difficult to produce and need time to be spent defending or at least discussing them with the company’s management or third parties.
• Whereas we mentioned earlier that one of DCF’s advantages was that it estimates the firm’s “intrinsic” value and so ignores current market attitudes, it is also true that, by valuing a company with a specific stock transaction in mind, the market price tends to be more important. Relative valuations normally produce values closer to the market price than those made using the discounted cash flows method.
• The magnitudes and timeline of the cash flows, as well as the discount rate, are subject to sudden variation. A small error in the predictions of cash-flow attributes or the discount rate would have a considerable effect on the resulting value.
• In many cases, around 80% of the value is found after the explicit period projected and has to be calculated using residual value techniques. As explained above, these techniques normally result in gross approximations to the value, and have to be treated as such.

3. The Multiples Method

3.1 Introduction

The Valuation Multiples method relates a business’s value figure with i) the value of the share or ii) the full business value of the company. Valuation multiples are not a measure of absolute value, but allow comparisons of relative value between similar or comparable companies.

This method actually operates under the hypothesis that markets are efficient and that the value of companies whose stock is listed on the exchange is constantly available and is a reasonable or “fair” value. It is not a method based solely on historical data, but also on predictions about the near future. Technically speaking, the method itself is not as rigorous as the Discounted Cash Flows method, since it frequently requires accounting adjustments and no two companies are exactly alike.

However, its best virtue, its simplicity, makes this method universally accepted and used by most market analysts and financial service providers. It is also frequently used to contrast results obtained through other methodologies. In this section, we will generally refer to multiples of listed companies, although practically everything said here can be applied in exactly the same way to the multiples resulting from transactions affecting privately-held firms.

3.2 Methodology

The procedure followed to apply a Valuation by Multiples can be split up into three steps:

Step 1: Identification and selection of comparable companies

In this first step, those companies belonging to the same market segment and/or sharing business characteristics in common with the company under valuation are identified and selected. It is essential to analyze their business models and financial structures, as well as their strategies and potential for future growth in order to be able to reach the conclusion that they are truly comparable. Although it is virtually impossible to find two perfectly comparable businesses, it is possible to attain a reasonable degree of comparability.

First of all, it is necessary to determine the selection criteria, considering the following aspects, among others:

Market sector and size of the company’s geographical market

Market share

Company structure

Diversification of its products/services

Growth expectations

Margins, profitability, investments required, etc.

Next, based on the criteria mentioned above, the comparable companies are selected. When there are no comparable companies in a given market sector, it may be possible to use companies presenting similar figures (margins, growth, size) for a relative valuation, even though they do not belong to the same market sector.

Step 2: Calculation of multiples

Once the group of comparable companies has been identified, we have to decide which multiples will provide the most accurate value measure for the companies under consideration. With this aim in mind, it is essential to understand perfectly the activities of all the businesses and to interpret their financial statements correctly. It is frequently necessary to adjust the financial information in order to obtain a fair and comparable view of the business, due to differences in the accounting policies, differences in how the business operates, the existence of non-operational assets, etc.

Valuation multiples are often criticized for not giving explicit consideration to several of a company’s profitability indices such as required performance, growth, ROIC, etc. Nonetheless, the advantage lies in the fact that all these indices are actually incorporated into a single figure that will arguably allow us to establish more effective value judgments.

Enterprise Value (EV) and Share Value

When it comes to applying a multiple, it is important to be clear whether we want to find out the value of the business as a whole (enterprise value) or the value of its shares as we will obtain one or the other depending on the multiple we use. For example, the application of a sales multiple will give us the enterprise value, whereas the price/earnings ratio (PER) reflects the value of the equity or company shares.

The use of enterprise value avoids the influence exerted by the structure of liabilities on the multiples based on share value, while facilitating a more exhaustive approach. In addition, they present a more extensive range of multiples that is easier to apply to cash flows, allowing the exclusion of assets not related to the company’s core activity. On the other hand, multiples based on stock value are more relevant in the valuation of a company’s equity as they provide a more direct approach, apart from being more familiar for most investors.

The choice of multiples applied by e Valuation in its valuations requires specific knowledge of the company under valuation, the comparable companies and the market. It might happen that the nature of the business to be valued or the availability of information may limit the number of options in an initially optimal range of multiples. For instance, when valuing an Internet business, it is not always possible to apply the widely used PER, as many of these companies have not had any earnings and will not have any for some time.

Once the comparable companies and the suitable multiples have been selected, certain adjustments might become necessary to allow comparisons between different companies with different accounting policies. For example, the results of extraordinary activities (whether profit or loss), such as the sale of a fixed asset, compensation for termination of an individual’s employment contract, or the amortization of intangible assets, will require adjustments and corrections.

Step 3: Valuation

After selection of the most appropriate value measures and their adjustment to ensure the consistency of the process, we are able to calculate the enterprise value by multiplying each multiple by the pertinent figures of the company (which may in turn need adjustment to obtain the company’s true and fair value). A company’s enterprise value is often obtained as the mean (weighted or not) of the values estimated resulting from the application of the multiples chosen earlier.

3.3 Multiples based on Share Value

Multiples based on the value of shares may refer to the share price (in which case, the figures used are measured per share) or to the company’s market capitalization. Although the calculation per share may give multiples with greater significance, multiples based on the total value (capitalization) are consistent with methods that use multiples based on Enterprise Value (EV).

Generally speaking, the use of multiples based on stock value can give fairer and more real values as their calculation is normally more objective and less inclined to errors. Nonetheless, in the case of young companies with a high growth rate and very low or nil indebtedness, both values (EV and equity) are very similar.

Price/Earnings Ratio or Earnings per Share (PER, P/E)

Earnings per share are defined as the total earnings divided by the number of ordinary shares issued and this value has to be calculated before consideration of exceptional items and the amortization of goodwill. Earnings per share (EPS) are calculated taking into account all the instruments making up the company’s capital and similar elements so as to include them in the total (diluted) number of shares.

The price per share is related to the company’s ability to pay dividends (profits). The nature of the ratio between share capital and profits is considered to be such that prices are proportional to both profits and the expected growth.

Despite the fact that this a widely used technique due to its simplicity and the widespread availability of the data needed, this method entails a risk due to accounting differences that could lead to inaccurate results. Therefore, an analysis of the adjusted earnings per share is recommended to eradicate, as far as possible, the effect of exceptional elements and to increase comparability between companies. Nonetheless, this risk has a compensation in the sense that the PER takes into account differences in each country’s tax rates as well as the capital intensity, allowing comparisons between sectors.

Price / Cash Earnings

Cash earnings are considered to be earnings plus amortizations (of both tangible and intangible fixed assets) and accounting provisions (non-cash). This result is closer to a Cash Flow than earnings, although cash earnings do not take into account asset amortization, nor the investments required in fixed assets (CAPEX). This method is less susceptible to accounting differences than the PER.

Price / Equity Cash Flow

This analysis is not very popular as Cash Flows can be represented in different ways and historic Cash Flows can be very volatile. However, if used well, it is a good value indicator.

Price / Book Value

Book value usually leads to mistaken results as it depends greatly on accounting policies of each company. However, Book Value is useful in those cases where the value of the goods is a key factor in the valuation, and provides an intuitive and relatively stable measure of the value of a company.

Although the accounting value can be used to assess companies with negative earnings, it is generally not very useful for Internet companies as these often involve services or companies basing their economic activity on few, or no, fixed assets. In most cases, the book value is lower than the enterprise value.

Dividend performance

Dividends are the ultimate profit for a company’s shareholders, which should make this a widely used and representative measure. Nonetheless, dividend performance is highly dependent on the company’s dividend policy and strategies, so it is not in fact used very much.

3.4 Multiples based on Enterprise Value (EV)

These multiples combine a company’s Enterprise Value (market capitalization plus net debt / minus net cash) with a measure of the activity related to that value. For reasons of consistency, these multiples have to be based on measures related to the global business (demands by shareholders and creditors).

Multiples based on Enterprise Value (EV) provide a more comprehensive approach than those based on equity, as the first are less influenced by differences in the liability structure and other accounting differences. The multiples obtained allow better comparisons between companies.

EV / Sales

Enterprise Value / Sales is a gross measure but less susceptible to accounting differences and it therefore allows comparisons between countries. It should not be used to compare companies from different industries that have different margins. This measure is widely used for Internet and high-growth companies due to the impossibility of applying more complex multiples (partly due to the absence of earnings).

EV / EBITDA

The value of Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) has become a very popular metric among investors, as it avoids the problems associated with accounting differences in amortizations and accrued taxes. Furthermore, it allows comparisons between firms with net losses, as this measure may continue to be positive. This metric also facilitates comparisons between businesses with different levels of indebtedness, since it focuses on pre-finance figures. It is closer to a Cash Flow than other measures of earnings, but it does not reflect the adjustments for investments in working capital, nor in fixed assets. This multiple is affected by capital intensity, as a high level of intensity gives a low multiple.

EV / EBIT

Earnings Before Interest and Tax (EBIT) are easier to compare than EBITDA values in those cases where the capital intensity and/or the handling of accrued taxes differs. Nonetheless, the EBIT is affected by differences in the accounting policies for dealing with amortizations. By definition, EBIT is a metric that is further away from the calculation of the Cash Flow than EBITDA, thus making the latter more attractive for investment analyses.

EV / NOPLAT

Net Operating Profit Less Adjusted Tax (NOPLAT) is equivalent to EBIT after tax. It takes into account the differences in the tax structure and tax rates. If companies were financed only by equity, NOPLAT would be equal to earnings.

EV / OpFCF

Operating Free Cash Flow (OpFCF) is EBITDA minus i) maintenance CAPEX and ii) the increase in working capital in the maintenance phase. This measure is more significant than EBITDA, and is less affected by accounting differences than EBIT. However, it is not directly available from the companies’ financial statements and the calculation of maintenance CAPEX and the increase of working capital in the maintenance phase may be subjective. It can even be considered equivalent to a normalized EBIT or a softened Cash Flow.

EV / Free Cash Flow

This multiple is a true Cash Flow calculated as NOPLAT (thus, before taxes) plus amortizations, minus CAPEX and plus / minus changes in the working capital, but before any Cash Flow from finance. The calculation of the real Cash Flow is based on historical metrics, which may be volatile and lead to inaccuracies. Cash Flow may be negative for companies with a high level of growth, such as many Internet businesses, thus eliminating the significance of the multiple.

EV / Capital Employed

Mostly used in sectors where the value of the tangible fixed assets is a key point but it does not provide consistent information about profitability, nor cash generation.

3.5 Conclusion

Comparable multiples represent a simple valuation method with relatively little variability as they can combine different success factors in a single figure. Although other methods may be more accurate or academic, fewer inconsistencies appear when making valuations with the comparable multiples method, and much of the information needed is normally available. The biggest problem with the multiples probably lies in the fact that they are influenced by variations in accounting policies (amortizations, accrued taxes, etc.) and certain adjustments need to be applied to obtain an optimal degree of comparability between companies. This last point explains why pre-tax multiples are the preferred option when comparing companies in different countries.

On the other hand, we must not forget that, at the end of the day, multiples are each the summary of a valuation. Therefore, when we apply them what we are doing is implicitly assume the same business hypotheses and future prospects for the company we are valuing as were assumed for the company whose multiple we are using. Not knowing what these hypotheses were, as is often the case, implies a considerable disadvantage for the application of this methodology.

With regard to the choice of multiples based on enterprise value and those based on share value, while the former offer the advantage of focusing on the business as a whole and are not affected by the differences in the structure of the liabilities, the latter generally inspire greater confidence as working out the enterprise value tends to require more calculations and is therefore more subjective and error-prone. The most popular ratios among those based on enterprise value and on equity are probably the PER and the EV / EBITDA ratio, respectively. Their joint use can provide analysts with a global approach to the company, complementing cash flow studies with the relative position of earnings: i) whereas the EV/EBITDA ratio focuses more on cash flow than on earnings and avoids the issues related with accounting amortizations, ii) the PER focuses on the earnings after tax and is more comparable between industries, as they take into account the differences in capital intensity.

3.6 Problems in the application of Valuation Multiples in some industries (e.g. the New Economy)

In the case of young New Technology firms with high growth rates, it is often impossible to apply earnings-based multiples (such as PER), due to a lack of positive earnings in the first years of their operation. Sometimes, figures like the EBITDA can even be negative in the early years. For these companies, it becomes necessary to use other multiples that are always positive such as, for instance, EV/Revenue (one of the most widely used). As soon as other multiples become significant (normally EBITDA is the first to do so), they must be included in valuation analyses.

Through the use of various multiples for the valuation of a business, it is possible to obtain very different results due to the general differences in the operations and performance of companies. Thus, in order to achieve a more accurate result, e Valuation calculates a mean (weighted or not, depending on the characteristics of the industry in question) of the theoretical values obtained using selected multiples. The same process is then followed by the different methodologies used by e Valuation, contrasting fundamental valuations with market valuations so as to achieve a fairer and more balanced opinion on the company’s value.

4. Comparable Transaction Multiples

The logic behind this technique is the same as that for valuation multiples, but with the difference that the information used in the comparisons comes from private financial transactions.

This makes the process harder as it becomes more difficult to find appropriate reliable information about companies that can be, or have traditionally been, quite lacking in transparency. In addition, it is generally more complicated to obtain sufficient details of the transactions and, for various reasons (hidden agendas, special synergies, etc.), the prices involved; as a result, the multiples for companies of this type tend to be more volatile.

In contrast to the above, when enough information can be collected to prepare a set of multiples, the resulting analysis tends to be very relevant as the companies being compared are generally more similar in terms of size and characteristics than in those cases where the comparisons are established on the basis of listed companies (usually much larger in size and with a different way of working). What is more, the prices paid in private financial transactions also reflect the lack of liquidity of the financial assets issued by these firms (shares, stock certificates or equivalent) and the general difficulties to reach agreement on their value.

5. Ratios of Industry Success Factors

This relative valuation method is similar to that for comparable multiples, but with the difference that the ratios used are not based on financial variables (profit and loss statements, balance sheets, cash flow statements), but on commercial or other indicators closely linked to the enterprise value.

EV/Capacity metric

This multiple is used in industries and sectors where a capacity metric can be used to compare similar companies: for example, EV per line (telecommunications), EV per ton (paper).

Some examples of industry indicators are:

These indicators are industry-specific, unlike a good many of the financial multiples, which, if interpreted carefully, can shed a lot of light on a wide range of business categories. In terms of accessibility to these kinds of figures, they are generally available thanks to the listed companies in the same sector or reports from analysts. Multiples of this type have been greatly used for companies without any earnings as a complement for other valuation techniques, or even as the main source to estimate their value.

6. Conclusion

The text on this page is an introduction to various well established and generally accepted valuation methods that e Valuation uses for its company valuations. We have mentioned that we basically use two pillars for valuing any company. On the one hand, valuation multiples (including those derived from comparable transactions and industry success factor multiples) and, on the other hand, the Discounted Cash Flows method.

While valuation multiples are normally considered a simple and fast method often used to obtain valuations, there are also major disadvantages that have to be taken into consideration. First of all, multiples are a relative measure of a company’s value and, as a result, may be easily influenced by changing market conditions. Secondly, multiples-based valuations may also be affected by accounting policies, which may differ from one company to another or from country to country. Thirdly, valuation multiples are not such a rigorous method as Discounted Cash Flows and must, therefore, be verified and contrasted with the result obtained by this latter method, or others.

Unlike valuation multiples, an analysis made using Discounted Cash Flows tends to be less influenced by market conditions and attempts to measure the enterprise value in absolute terms. It is a dynamic, multi-period method that takes into account the value of money over time. However, for the same reasons, it is a much more time-consuming method based on sometimes questionable and uncertain assumptions.

In order to obtain reasonable forecasts of future cash flows and discount rates, conscientious analysts need a profound understanding of the company in question and the general situation of the industry involved. Furthermore, making forecasts implies an exercise in strategic review and alignment for the company. It often happens that, in the process of preparing these estimates (financial or business plan), the company’s management discover aspects or approaches to be improved or promoted (or even to be eliminated).

For all of the above reasons, we at e Valuation are in favor of applying several valuation methods and contrasting the results of each to obtain a reliable, well-justified final valuation for the company. We defend Discounted Cash Flows as the basic method for any valuation, applying comparable multiples from either listed companies or private transactions, providing that these are truly pertinent.