ASHUTOSH KHARANGATE explains the different methods of valuing one’s business
Several times, an owner of a business is faced with this question. What is the value of my business? It may just be a question s/he ponders on, or it may be situational. The situation could be that he wants to add another partner or help the exit of one, s/he may want to allot shares to some old employees or the most common reason could be that s/he is having a merger or acquisition or investment opportunity. In the above cases s/he would need to value the business.
There are several methods of valuation. The most common ones are Discounted Cash Flow (DCF) or in simpler words the future value of business, multiple method and net asset value method. The method/s to be adopted depend on the purpose of valuation, the nature of business and the stage of the business.
In case the business is looking for expansion and is seeking investment or is contemplating a Mergers and Acquisitions (M&A) transaction for future growth, DCF method is recommended. In this case the owner makes a future prediction of profitability. The business owner puts together a profit and loss account for the next 3 to 5 years depending on the nature of the business.
For dynamic businesses like IT, a shorter period and for more predictable business a longer projection is done. From the Profit after Tax (PAT) of each year of the projections, Free Cash Flow (FCF) is derived. FCF = PAT +Depreciation – Capital expenditure – Working capital blockage. This FCF is then discounted to today’s value by applying a discount rate. The discount rate is usually the average cost of your funds borrowed. So, let’s say the total investment into your business is Rs. 1 lakh and 50% each is equity and debt. Let’s assume your debt borrowing is at 10% rate. With equity expectations, we take a few percentage
points over what the stock market gives us. The average of the two is the discount rate that you will take. Weighted Average Cost of Capital (WACC) = cost of debt multiplied by share of debt + cost of equity multiplied by share of equity. In this case 50%*10% + 50%*20% = 15%. There is also an element of perpetuity value, which is based on the assumption that a business is never ending. So, beyond the 5 year period a perpetuity value is attached. This is usually done only for more predictable businesses.
The combined value of such discounted values over 3 or 5 years and at times added to the perpetuity value is the value of your business. This is called Enterprise Value. When you reduce your total debt from this value you get your equity value; when you divide this by your number of shares your get per share value. If you need to decide how much stake to offer to a new person or to make an exit, you can consider this per share value. Based on circumstances, you may offer a discount etc. If it is for an M&A or investment, the amount of funds the M&A transaction is getting you, divided by the equity value is the amount of stake you would need to sacrifice. So, for instance, to make the above projections happen you need INR 50 lakhs. The enterprise value post your calculations is INR 5 crores. You would need to share 10% of your equity, 50 lakhs / 5 crores.
Multiple method is generally used to back the DCF. In this case, we use the valuation of listed companies or companies in our sector of which deals have happened in the recent past and use their benchmarks. For e.g. a listed company in our sector is valued at INR 5 crore. We compare this to the revenue, EBITDA and PAT of its latest financial year to arrive at multiples. If revenue is INR 5 crores, it means the company is trading at 1 times multiple (5crores / 5 crores). We do this for Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) and PAT. For a company where a deal has happened, we compare it for the year in which the deal has happened. We may want to discount these multiples before using them against our revenue, EBITDA and PAT as our company shall be much smaller than these. Generally, we discount by 20-30%.
The last method is Net Asset Value (NAV). This is used when business is asset heavy. Also, when the owner wishes to exit and may want the as on date valuation. All assets – fixed, movable and current are valued at realisable values and from them the debt to be paid is reduced. This gives us the NAV.
Many times, owners get confused by asking for the value of fixed assets separate from business. We need to understand the assets used in the business are to generate the business value. Hence, we could use either of the methods based on the reasons and what makes more sense to us
