Valuation is a complex art of balancing variables and thought out fit assessment
2017 was a harbinger of times to come. During the last year, thousands of stake sales which occurred across the world. But how different is a valuation for a stake sale? What does one need to do differently?
What differs?
Valuing a running business for investment is slightly different from valuing a business for a stake sale. The fundamental difference being an understanding of partnership in the future as against liquidating a position today. While an investment transaction may be quite satisfied in a multiple or DCF valuation, a stake sale/ secondary transaction requires establishment of a reasonable price for a transaction. While reasonableness is a factor of the high price of ownership or auction fever (Research published in the Journal of Consumer Research) and buyer-seller expectation management, practitioners deploy more than one method to ensure that reasonableness can be as less subjective as possible.
Disclaimer: These views were published in the Professional Insights Handbook for valuers by the Valuation Standards Board.
Picking the right methods, the magic sauce
Valuations are only part science. While the tools are scientific, they are always based on certain assumptions and representations of the management and the ability of a valuer to be able to identify non-financial metrics and laterally relate them to the value of a business. Each valuation method employed may provide a completely different range of valuation numbers. Cherry picking the right valuation methodologies that showcase the relative value of a business requires:
1/ Picking the right methodology
MPM (market price method)/ CCM (Comparable Companies Multiple Method) and subset CTMM (Comparable Transaction Multiples Method) & CEM (Comparable Exit Multiples Method) / DCF (Discounted Cash Flows)/ TV (Terminal Value)
2/ Choosing the right multiples
indicative of the value of the business
indicative of the value of intangibles
indicative of the ability of the business to generate super-profits
3/ Choosing the right combination of methods
4/ Adjusting with factors to factor asset specifics
5/ Applying the right weights
A combination of these factors and selection of the right factors is akin to a custom made recipe, bringing in the art element in valuation.
1/ Picking the right methodology
Owing to the nature of a valuation exercise itself, different methods of valuation may yield different results for the value which may not be in similar ranges unless the business has reached a mature stage in business. Comparability with the public companies on all parameters, stage in the life-cycle and uniqueness of the business can throw up deviations which require use of multiple methods. We can delve separately on how to pick the right methodology in another article dedicated to the purpose. For the limited purpose of this article, we should move on.
2/ Choosing the right multiples
Let us take 2 examples of unlisted securities based on my practice which are secondary stake sale transactions I have advised on in various capacities. Again, this may vary significantly from the nature of the business and the stage of the entity.
Example 1, Table 1:
A 6YO ERP company being acquired by a Strategic Investor where the objective was to enter into the Indian market by capitalizing on their market reach
for CCM method
Example 2, Table 2:
A 10YO IT services company being acquired by a Strategic Investor where the objective was to consolidate and achieve cost and talent efficiency
for CCM method
*CGU means Cash Generating Unit
It may be observed from the examples above, within the same industry, you could have completely different method under the same methodology being deployed in arriving at the value of the asset. In many cases, there may be a non-financial metric involved as well (such as gross profit per full-time employee in business services or EV (Economic Value) per sft. of completed development in real estate).
Once the right multiples have been agreed upon, the next step is opting for the right methodologies to be employed.
3/ Choosing the right multiples
This is where practice takes a slight deviation from text books. Typically, a valuer may choose to employ more than one method for the valuation in the interest of fairness for all the parties and to reduce the skewness of variability between one method and the other. An example of this is the First Chicago Method/ Venture Capital Method, elements of a discounted cash flow as well as multiples are employed is in vogue in the North American markets.
Example 2, Table 3:
Let’s take the example of the case of the company in Example 2 above, DCF, CTMM, CMM & CEM were employed together to generate a weighted average valuation which provides the best of all worlds.
4/ Adjusting with factors to factor asset specifics
Now that the methods that need to employed have generate their expectation of a value, you would need to adjust it (discount/ premium) to factor in for the specifics of the transaction.
These adjustments may include:
A control premium to factor in the benefits of controlling the business operations, directly or indirectly or the opposite, discount for lack of control
A discount for lack of marketability of the unlisted securities or illiquidity risk
A discount for size of the business as it may have not reached the stage where the business risk/ organizational is relatively low or small stock risk
A discount for secondary transaction as the transaction is between shareholders only and do not mean providing the company with growth capital, as in most other cases that warrant a valuation
Any other specific adjustments such as synergy gains, cost of post transaction integration, etc.
Example 2, Table 4:
Continuing from Example 2, Table 3 above, there were specific adjustments to be done in each method.
5/ Applying the right weights
Once the EVs have been generated with the above exercise comes the trickier part that requires experience and detailed knowledge of the transaction. The most subjective among the steps, each valuer needs to create their own calculator for why and when to apply a specific weight. This checklist-based approach can help justify and ensure that subjectivity can be reduced with an internal policy.
Example 2, Table 5:
Continuing from Example 2, Table 4 above, the weights assigned for the valuation based on the checklist of factors prepared and identified were:
6/ Multiply
The easiest part of the exercise is now deriving the weighted average enterprise value ensuring as less subjectivity as possible.
Lasting note
The fundamental premise of any valuation exercise is to arrive at a reasonable, less subjective financial number for a non-financial asset (a running business made of real people, tangible assets and intangible relationships they have accumulated). When any business approaches a valuer, it is the implicit responsibility of the valuer to be able to gauge, understand and translate this to financial terms in a manner that ensures that due credit is given to what makes the business as well as the transaction unique. This is the reason that valuation is still for the most part, an art that is mastered with years of experience and deliberation. The introduction of standards is a bold step in the right direction to avoid subjectivity and educate the fraternity to be able to deal with the dynamic world of transactions and collaborations.
Disclaimer: The views and opinions expressed in this article are those of the author and based on his experience and not necessarily those of the Institute or any other regulatory body. Examples of analysis performed, methodologies and approaches described within this article are only examples which have been truncated with a lot of specifics omitted for brevity for this article. They should and must not be utilized ‘as-is’ in the real-world without having sufficient guidance or experience or otherwise consulting a professional valuer.
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