Valuation of Services Company
Authored by Muskan Jain
Keyword: Valuation of a company, DCF, income.
A valuation of a company's real life is a dynamic and comprehensive exercise that needs several variables and considerations to be made. A company's valuation requires a solid understanding of both how value was generated before the valuation date and how it will continue to be produced in the future. The basis of business valuation is the ability to understand how a business cultivates ideas or concepts and deploys its invested capital, aimed at driving returns over its capital cost.
The value creation process does not follow a single path, but rather several paths that differ in its life cycle by sector and the role of the organisation. Whether we are conducting a valuation analysis for financial statements, accounting, M&A, strategic planning, company transformation, or dispute and litigation purposes, recognising this method is at the core of our comprehensive valuation experience.
Business valuation has been defined by many as both art and science. A variety of approaches or methods refer to the scientific and analytical component, not only to the topic of the valuation itself, but also to the production of certain inputs (e.g. capital costs, discounts and premiums) into the calculation. The expense, market or income (DCF) approaches are the most widely used valuation methods. Although the cost approach can be used on occasion, the most widely used in business analysis are by far the sales and demand approaches.
The approach to revenue measures value on the basis of the present value of the business enterprise's future cash flows; whereas the approach to the market relies on the application to the subject company of market multiples of comparable companies or comparable transactions. The art of valuation lies in the capacity, through professional judgement, to efficiently apply these methods. Over years of experience across the range of business life cycles, markets, territories, and valuation purposes, this form of perspective is gained and also calls for a thorough understanding of the criteria and demands of regulators and other stakeholders.
During this era of Startup India and Make in India every two out of every three Indians less than 35 years of age are rushing into an entrepreneur and becoming their own boss. A huge inflow of projects is sure to come with over 700 higher education institutions and 200 million enrolled students. However, a key step in a company's growth is that of being able to determine its viability and its earnings potential, whether it is to enter a sector in the market or to acquire an established company with the use of Valuation. Economic growth results in the need for business valuation.The true valuation is based on many varying factors, such as the economic condition of the region, market attractiveness, the growth strategy of the business, the human resources, the nature and the way in which assets owned.
Methods of Valuation
Valuation of a company in the most basic form is a description of the equity and of the debt it borrows. If, however, a more detailed analysis or a special judgement is appropriate, evaluators can use a combination of approaches and techniques, which depend on suitability of the sector or size of a company's operations. Some of the following methods are developed:
1. Valuation Multiples
2. Net Asset Value (NAV)
3. Discounted Cash Flow (DCF)
4. Economic Value Added
5. Market Value Added
6. Average Fair Value
· Valuation multiples
Multiples are financial measuring instruments, which measure one financial factor as a ratio of the other to improve the comparability of different companies. Multiples are the proportion of one financial metric (i.e. share price) to a separate financial statistic (i.e. income per share). It is a simple way of measuring the worth of a business and comparing it to other firms. Let's look at the different types of multiples used to valuate businesses:
a) Equity Multiples
b) Enterprises multiples
· Net Asset Value ( NAV)
The net asset value reflects a certain mutual fund's market value per share. The liabilities of the total asset value are determined by deducting the number of shares. The market value of a portfolio must be collected and divided by the total current unit number of the funds in order to calculate the price of each investment. The unit costs of mutual funds most of the time start on Rs.10 and rise with the increase of the assets. The more famous the mutual fund is according to this law, the higher its NAV. In open end funds the net value of an asset is most widely used. Interest and shares are not exchanged among shareholders with these investments. By having a reference value, NAV helps to decide which assets to remove or retain in its investment portfolio.
The net value of an asset = (Total asset – total liabilities)/ total outstanding shares
· Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a method of valuing an investment value based on future cash flow. DCF analysis measures using a discount rate, the present value of potential projected cash flows. A present value estimation is then used to determine a future investment. The Business is deemed valuable to invest if the benefit measured by DCF is greater than the current cost of investment.
· Economic Value Added
The calculation based on the residual income methodology, Economic Value Added (EVA) or Economic Benefit, serves as an indicator of the profitability of projects undertaken. Its basic principle is that when additional wealth is generated for shareholders, real profitability exists and that ventures can produce returns above their capital cost.
EVA = Net Operating Profit after Tax - (Capital Invested × WACC)
· Market Value Added (MVA)
MVA is a critical concept for investors to evaluate how well their capital is used by the business. MVA’s status can improve or weaken the current path either positively or negatively. If negative, the organisation may decide to change course in favour of an approach that is more value-based. A negative MVA often suggests to investors that it does not efficiently or effectively utilise its resources. It's not therefore a good investment.
MVA = Market Value of Shares – Book Value of Shareholders’ Equity
· Average Fair Value
This methodology is adopted after almost every avenue is finished and is not very detailed as such. Where a reliable calculation can not be based on one method alone due to the lack of data or to the absence of comparable firms, more than one method is averaged, which is called an Average Fair Valuation.
Although there are several industry-wide agreed valuation approaches, it's not an exact science, it's an art. A set of assumptions and estimations are filled with the entire method. In addition, the methods of valuation are easily exploited depending on the time frame within which the analysis is carried out.
No single method of valuation can provide a full proof method for the company's potential success, as there are many other macro variables involved, all of which are difficult to account for. Although the availability of accurate details in the case of public corporations makes the study more rational, there are still risks that it would be biased. Therefore, no single method of Valuation can act as a panacea and the only aid these approaches can do is to analyze complicated data and include some patterns for more insightful decision making. As they indicate, the rest is subject to business risks.