“Old ways do not always open new doors.” The field of business valuation is constantly changing and one cannot remain complacent. As theories and techniques modernize and evolve, we must adopt new methodologies and open new doors. At Pike + Zijlmans, we apply the latest developments and trends to each client’s situation.
When explaining the basics of business valuation, I previously referred to three pillars: cash flow, growth, and risk. After listening to a CNBC interview with Dr. Aswath Damodaran, acclaimed Professor of Finance at New York University Stern School of Business, author, and valuation expert, I realized that there was a fallacy in my thinking.
Dr. Damodaran raised some challenging points concerning valuation multiples. Citing examples in the tech industry, he concluded that a large portion of value is locked up in cash for some companies. After dividing market capitalization by earnings, it might appear in some cases that a company’s market capitalization is, for example, 35 times its latest earnings (PE ratio). However, these businesses may have, for example, 25% of their market capitalization locked up in cash, which is less risky than other investment opportunities and therefore earns a much lower return.
The graphic below shows an example of this where cash and short-term securities comprise a substantial portion of market capitalization for some technology companies, in some cases over 100%.
In situations where certain types of assets are abnormally high or low for a given company relative to industry standards, it might not be appropriate to apply one measure of risk across the entire value of the business. To normalize the risk and make it more comparable with other companies for pricing purposes, it is suggested to remove excess assets (such as cash) from the equation, assess them separately, and then add that value back after calculating equity value.
Based on the above revelations, my basic formula for explaining business valuation changed from three pillars to four: cash flow, growth, risk, and excess (nonoperational) assets. Cash flow refers to the distributable cash that a company generates at valuation date. The value of the company is based on future cash flow, or how this distributable cash can grow into the future. This is the growth pillar. Risk refers to the probability of achieving the aforementioned future cash flows. Finally, excess assets refer to assets, such as excess cash, that can be stripped out of the company without affecting its operations.
There are three general approaches to valuing a company – asset approach, income approach and market approach. The asset approach builds up a valuation based on the replacement or reproduction costs of assets and/or liabilities. The income approach (i.e. discounted cash flow, dividend discount model, etc) converts a stream of future cash flows to present value based on a discount rate, which quantifies the risk of achieving the future cash flow stream.
The asset approach does not consider future cash flows; therefore, our four pillars do not apply. Our four pillars are modelled explicitly in the income approach.
The market approach (i.e. price to earnings, enterprise value to EBITDA, etc) multiplies a point-in-time financial result by a valuation multiple. In market approach valuation methods, cash flow and excess assets are modelled explicitly, whereas growth and risk are embedded in the valuation multiple. Some market approach valuation methods lead directly to equity value such as Price to Earnings and Price to Book. Valuers sometimes do not add excess assets separately to the resulting equity value. When comparable companies exhibit substantially different levels of excess assets, adjustments should be applied to first remove excess assets from the valuations multiples and then add them to equity value. I provide a step process further below for applying market approach valuation methods with excess asset adjustments.
One could determine an appropriate pricing multiple from comparable companies using the following steps: 1) gather a peer group of similar companies; 2) identify other excess or non-operational assets and liabilities (in addition to excess cash) of the peer group companies; 3) remove the excess cash and other excess and non-operational assets or liabilities from each peer group company; and 4) divide market capitalization by earnings. After applying the pricing multiple to the appropriate earnings figure, excess and non-operational assets and liabilities of the subject company should be added to the resulting valuation.
While this change in methodology is not applicable to every situation, the new perspective reminds us that we must look at each valuation on a case-by-case basis. Pike + Zijlmans best serves our clients by offering a wide variety of services and taking a tailor-made approach to our business. This means keeping abreast with changes in our field and acting as innovators in business valuations.
For more information about business valuation concepts, please contact Andrew Pike of Pike + Zijlmans at firstname.lastname@example.org or at +31 70 221 0058.