- Develop a
valuation model that accurately reflects
the underlying elements of the business.
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- Strong competitive
advantage drives sustainability of
earnings.
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- Capital flows
towards companies with sustainable
earnings.
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- Valuation
methodology will be influenced by
stage of investment
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- Check the
valuation range against valuations
of comparable companies.
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Valuation influences many management decisions.
These decisions may involve valuing your own business
for the purposes of capital raising, or for the purposes
of determining value for an unexpected bid from one of your
competitors.
Valuation decisions are also important for your own acquisitions,
joint ventures, strategic investments or new business opportunities.
The key issue for management is to develop a model that
accurately reflects the underlying elements of their business.
To do this, management needs to create robust financial
projections, select appropriate valuation methodologies,
determine the parameters (like discount rates or other variables)
and then compare valuation ranges with similar companies.
Once the valuation range has been determined, the CEO/founder
will be in a much stronger position to negotiate with potential
investors.
Investors or potential acquirers will develop their own
forecasts and create their own valuation models. Investors
are always seeking “undervalued” companies where
they believe they can do things differently and improve
earnings.
Investors focus on the earnings potential of the business,
the management capabilities and the company’s competitive
advantage.
It is therefore important to develop some robust financial
projections.
Financial Projections
The financial projections will determine whether your business
is an attractive and sustainable investment proposition.
See the “Preparing Financial
Projections” article at this Website for further
information.
Projections need to be prepared for a period of up to
10 years. Since the assumptions may change, due to industry
factors, power of competitors, suppliers or buyers, it may
be appropriate to divide the projections into two periods:
first 5 years and second 5 years.
The key issue is whether the earnings over the invested
capital will exceed, or fall short of your cost of capital.
The cost of capital is calculated by adding the cost of
equity and the after tax cost of debt in their respective
proportions. Although the cost of capital calculation has
been simplified, it is actually known as the weighted average
cost of capital. If for example, the return on invested
capital is less than the cost of capital, the company is
unlikely to generate sufficient cash to stay in business.
The time to break-even is a critical consideration.
If the return on investment is in line with the cost of
capital, then the company is at least profitable, although
it may not be generating the level of returns required by
investors.
Like the earlier example, the company may not yet be sustainable
and have some difficulty attracting investors.
Investors, on the other hand, may be more interested if
the returns on investment exceed the cost of capital. VC
managers seek to achieve returns (IRR) of 25% and above
on their investments.
Sustainability is a key issue and is driven by strong competitive
advantage. Capital will always flow towards sustainable
companies with improving earnings.
Some time ago, the buy/hold/sell recommendations of various
brokers for listed IT companies were reviewed. It was evident
that the companies with strong earnings rates, expressed
as EBITDA to Sales above 20%, had “buy” recommendations.
Earnings sustainability is just one factor the brokers look
at, but it is a very important one.
Valuation Methodology
Once the financial projections have been developed and
different scenarios considered, it is necessary to consider
the most appropriate valuation methodology.
This methodology may be influenced by the stage of the
investment (seed, start-up, early or late expansion, bridge
funding), the proposed form of exit (IPO or trade sale),
or company specific factors (revenue growth, margins, return
on investment rates).
Generally, there are two main valuation approaches:
- Capitalisation of earnings, or
- Discounted cash flows.
Capitalisation
of Earnings
The capitalisation of future earnings approach is based
on using an appropriate multiple and applying that to the
projected earnings.
This approach is fairly widely used in both the public
and unlisted markets and is easy to understand. It does
however have some difficulties with the calculation of “maintainable”
earnings and the selection of appropriate multiples. Is
it a price earnings multiple, or an EBIT or EBITDA multiple
or a cash flow multiple?
For example, if the price earnings multiple is used, the
calculation is the price earnings multiple by the net profit
after tax figure. If the company is trading at a price earnings
multiple of 10 and has a net profit after tax of $5 million,
the implied valuation of the business is $50 million, assuming
no debt.
This valuation method is generally not suitable for companies
in the seed, start-up, or early stages of development. It
is also inappropriate for “turnarounds” or loss
making companies.
The selection of the multiple and earnings estimates will
be of significant interest to the potential investor. If
the multiple increases and the earnings grow, there is a
double whammy effect. Two separate factors are working together
to provide an uplift in the valuation.
VC managers are keenly aware of this dynamic. Essentially,
they want to buy low (with low multiples) and add value
(by boosting earnings) on the way through.
Discounted Cash Flows
The discounted cash flow approach is generally used to value
companies, acquisitions, or investment opportunities where
cash flows (amount and timing) are available. This approach
also caters for companies in the early stages of their development,
companies with lumpy cash flows or companies seeking to
break-even in the near future.
The financial projections flow into the discounted cash
flow model. The issues for this approach relate to the selection
of the discount rate and the calculation of the “terminal
value” at the end of the forecast period.
Depending on the stage of the investment (seed, start-up,
early or late expansion, or bridge), different discount
rates will apply to reflect the riskiness of the business.
A liquidity premium is also included in the discount rate
to reflect the illiquid nature of unlisted companies.
The terminal value, depending on the future earnings potential
of the business may represent a significant part of the
valuation. The valuation reflects two components: valuation
of earnings from current activities, and the valuation of
earnings from future activities.
The terminal value is usually calculated at the end of the
forecast period by using the capitalisation of earnings
approach and then the amount is discounted back.
Valuation Comparisons
Having applied the valuation methodology to your forecast
numbers and derived a valuation range, it is advisable to
check the numbers against the valuations of comparable companies
with similar economic characteristics (size, growth rates,
profitability, capital intensity, and risk).
If you want to make better decisions in your business,
an appreciation of its value is essential.
It involves time developing the projections and establishing
a valuation model, however it prepares the CEO/founder for
the capital raising process or sale negotiations.
It also provides a process for evaluating future acquisitions
or other investments.
Being aware of the company’s value should also extend
to being aware of the dilutionary impact of future capital
raisings. See the “Valuation
Assuming Future Dilution” article at this Website
for more information.
Peter T Gow is the Managing Director of Creative
Capital Pty Limited. He founded Creative Capital to accelerate
the learning skills of entrepreneurial CEO's and develop
their expertise in capital management, business and strategic
planning, cash flow management and market research and analysis.
Peter has over 12 years of experience in working with growth
companies and has been involved in the completion of over
30 financings in the software, manufacturing and medical
areas. His expertise covers company evaluation, strategy
and market analysis, capital raising, transaction structuring,
documentation and completion. Peter has also set up several
venture capital funds for a major financial institution
and appraised a range of venture capital managers.
Creative Capital Pty Limited
Peter T Gow
61 412 235 455
petergow@creativecapital.com.au
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