Valuation Methods and Techniques

The time when a value was simply determined based on intrinsic value with an adjustment for hidden reserves or a multiple of the average profit over the past three to five years is now behind us. A brief overview of the available valuation methods.

Intrinsic value, earnings-based value…

A disadvantage of these convention-based methods is that the value of the enterprise depends on the chosen valuation framework, even though the value is primarily determined by the future cash flows to be earned.

… or economic value?

Modern methods focusing on future cash flows, such as ‘discounted cash flow’ and ‘adjusted present value,’ have emerged and are now well-established. They have become commonly used; however, even in the hands of well-intentioned but less experienced advisors, these methods can lead to outcomes that do not accurately reflect the value of a company. The methodology is patient and can easily be misused: ‘garbage in’ results in ‘garbage out.’ The quality of the data used also contributes to the quality of the valuation.

Valuation is a specialized field. It is not just about applying the methodology, but also about having knowledge of the company being valued.

Elements of Economic Value

The value of a company depends on its ability to achieve a future return on invested capital that is higher than the cost of that same capital. This implies that the following elements are important:

Future cash flows (investing money with the aim of higher future monetary returns).
Time preference (generally preferring consumption now over in the future, expecting compensation for deferring consumption).
Risk (deferring consumption carries risk if money is invested in risky projects or assets).

Enterprise Value
The value of the enterprise is the sum of the future cash flows discounted at an appropriate cost of capital. The cost of capital represents the ‘opportunity cost of capital,’ or the expected return that an investor foregoes by investing in a project with a risk profile similar to the unchosen alternative. The cash flows to be discounted and the relevant cost of capital depend on the chosen cash flow method.

CASE: EXPERT IN BANKRUPTCY PROCEEDINGS
In 2014, ValuePro assessed the value of a minority stake in a procurement consortium. These shares were part of the bankrupt estate, and the valuation was carried out at the request of the curator. Thanks to the arguments presented in the valuation report, the curator was able to negotiate a price in the discussions that was several times higher than the initial offer.

Discounted cashflow (DCF)Adjusted Present Value (APV)

In the discounted cash flow (DCF) method, the free cash flows, which refer to the operational cash flows (distinguished from financing cash flows) that can be extracted from the business without compromising its future earning capacity, are discounted using a weighted average cost of capital (WACC) that is based on the market value of equity and interest-bearing debt.

In the adjusted present value (APV) method, the free cash flows are discounted using the cost of equity, as if the company were 100% financed with equity. The benefit of financing with interest-bearing debt, known as the ‘tax shield,’ resulting from the tax deductibility of the compensation to debt providers (interest), is separately discounted. This allows the APV method to provide insight into the extent to which value creation occurs by substituting equity financing with interest-bearing debt. The outcomes of DCF and APV, when applied correctly, are equal to each other.

Input for Valuation Methods

Applying cash flow-based valuation methods correctly requires knowledge and expertise. This applies not only to the chosen method but also to other aspects crucial for conducting a proper valuation. The quality of the valuation depends on the input used. Equally important are:

Valuation date and date of valuation;
Subject of valuation;
The appraiser;
Purpose of the valuation;
Assumptions and premises to be used;
Knowledge of the entity being valued and the industry it operates in.

Valuation Date and Date of Valuation
Valuation is time-sensitive. Therefore, it’s important to know the specific date when the value of the entity was determined (valuation date) and the date when the valuation activities were concluded (date of valuation). For example, an assignment to determine the value of an entity as of October 31, 2013 (valuation date) might have been completed on March 1, 2014 (date of valuation). Information related to the period between the valuation date (October 31, 2013) and the date of valuation (March 1, 2014) might be included in the valuation (depending on the assumptions used), while information beyond the date of valuation would not be considered.

Subject of Valuation
It is essential to clearly define the subject of valuation. Is it specific assets (project, patent, or customer base), liabilities (provisions, interest-bearing debts), entities (corporations or partnerships), or the business of the entity(ies)?

The Appraiser
Once the subject of valuation is determined, it is important to identify for whom the valuation is being conducted. Value is subjective, meaning an object inherently has no value (intrinsically), but it gains value because a subject assigns it value based on its specific circumstances (which are time and place-bound). This implies that knowing who the appraiser is becomes crucial for valuation. Is the valuation being performed from the standpoint of the seller, the one continuing the business, an arbitrary third party, a strategic buyer, or a financial buyer? Different perspectives may lead to different notions of value.

Purpose of Valuation
To conduct a meaningful valuation, the purpose of the valuation must be clearly defined: ‘different values for different purposes.’ For example, the valuation of an amusement park for property tax assessment will be based on different criteria than a valuation for the purpose of selling the same amusement park. A valuation conducted for a shareholder dispute will involve different considerations than a valuation intended to provide a price indication for acquisition negotiations.

Assumptions and Premises to be Used

Valuation is future-oriented. Since nobody can predict the future, it is crucial to substantiate or justify expectations about cash flows and risks as best as possible. Helpful in this process can be, in addition to management’s own expectations, publications on industry outlooks or more general (macroeconomic) forecasts. Facts and circumstances that one could have been aware of as of the valuation date and expectations that one could reasonably have had by that date are utilized.

Knowledge of the Entity Being Valued and its Industry

Last but not least, the entity being valued itself. The numbers of the entity and the story behind them should provide insight into how it generates its revenue and what its future expectations are regarding investments to be made, financing methods, and the results to be achieved. Insight should be gained into the following aspects:

1. Typology of the business;
2. Strategy / business plan;
3. Business model;
4. SWOT analysis;
5. Financing method;
6. The extent to which the entity has been able to meet expectations (as set out in forecasts/budgets) in the past.

Research into each of these aspects will lead to a substantiation of the expected cash flows, relevant cost of capital, and financing included in the valuation.

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Valuation Methods and Techniques

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