Two of the primary methodologies for valuation are the Income Approach and the Relative Valuation Approach. Knowing when to use the right methodology depends on numerous factors including the type of company, the industry it operates in, the financial performance, purpose of the valuation and the company’s strategy going forward, just to name a few. Within each primary methodology are different approaches to be used depending on these specific criteria being met and knowing which methodology to implement requires the right understanding and experience. While there are fundamental aspects, such as earnings proficiency and performance integral to all the methodologies, there is also an extensive number of technical adjustments and subjectivity required.
The Income Approach
The Income Approach involves discounting the future cash flows of the business at an appropriate discount rate to derive the present value. Within the Income Approach, two commonly implemented methodologies are the Free Cash Flow (FCF) and Dividend Discount Model (DDM) methodologies.
Free Cash Flow Methodology
FCF is more suitable when:
- the investor takes a control perspective;
- the company is in a growth phase of its lifecycle;
- free cash flows align with profitability within a reasonable forecast period;
- the company does not pay dividends; and
- the company pays dividends but the dividends paid differ significantly from the company’s capacity to pay dividends.
Dividend Discount Model Methodology
A DDM is suitable where:
- the investor takes a minority perspective;
- the company is dividend-paying; and
- a dividend policy has been established that bears an understandable and consistent relationship to the company’s profitability.
Critical to each is the ability and experience to fully understand the asset, analyse historical and forecast information and test the growth assumptions and reasonability to ensure the cash flows to be discounted are sensical. An analysis of the capital expenditure and working capital is also required to ensure that sufficient levels of reinvestment are made into the business which align with the business achieving its growth targets. Due to the sensitivity of most valuations to the discount rate it is equally important to substantiate the accuracy of the assumptions and adjustments used in this rate.
Relative Valuation Approach
Relative Valuation Approaches consist of comparing the price of the business to the underlying values of similar companies in the market. Commonly implemented methodologies include a Price/Earnings multiple and an Enterprise Value/EBITDA multiple methodology. In both instances a market based multiple is applied to the relevant metric to ascertain the value. In the case of the Enterprise/EBITDA valuation further adjustments relating to shareholder loans, borrowings and cash are made. A key contributor to the valuation is that the earnings metric used is based on sustainable earnings which the company envisions achieving going forward. Again, it becomes crucial to make the right adjustments to ensure that a normalised sustainable figure is used to provide a more accurate estimation of value. As part of our process, we also integrate our technical knowledge with our vast research capabilities and utilise our bespoke database of previous valuations performed to ensure the relative valuation makes sense.
How can we guide you?
Regardless of the valuation methodology, it is vital to think critically about the business to be valued and use in depth research resources. Most fundamentally perhaps is the need to rely on experienced advisors/experts for support and rely on their technical expertise to ensure the more detailed intricacies are accounted for. With a combined 50+ years of valuation experience, JSE and TRP accreditation and countless independent valuations performed across all sectors the Merchantec Capital team is ready to assist you.