Venture Capital

VALUATION OF FIRM

The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.

For example, an analyst valuing a company may look at the company's management, the composition of its capital structure, prospect of future earnings, and market value of assets.

Judging the contributions of a company's management would be more of a subjective valuation technique, while calculating intrinsic value based on future earnings would be an objective technique.

MULITPLES

Multiples are used while relative valuations are done to estimates the value of the assets by looking at the pricing of the 'comparable' assets or the firms to common variable such as earnings, cash flows, book value or sales. Multiples like P/E, P/BV, P/Sales, P/Cash flow, P/Dividends, Market Value/Replacement Value (Tobin's Q) are normally used in the market. For example industry P/E is used to value any firm in the industry, and assumes the other firms in the industry are comparable to the firm being valued and that the market, on average, prices these firms correctly. P/BV (Price/Book value) is used for firms selling at a discount on book value, relative to comparable firms, being considered undervalued. The multiple of price to sales is also used to value firms, with the average price-sales ratios of firms with similar characteristics being used for comparison. These multiples used to value and compare the firms which are comparatively undervalued or overvalued in the market.

It is assumed that the comparable multiples will help to know and identify the errors on pricing of the individual assets and the error will help to identify the stocks which will provide gains because of this error which is expected to be corrected over period of time. For example any cement company trading at a P/E of 12 while the Industry average P/E is 23 times earnings, this clearly shows that the company is undervalued and the correction towards the sector average. Accordingly overvalued stocks can be found.

Applicability of multiples and limitations

Applicability/Uses: The allure of multiples is that they are simple and easy to work with. They can be used to obtain estimates of value quickly for firms and assets, and are particularly useful when there are a large number of comparable firms being traded on financial markets and the market is, on average, pricing these firms correctly. They tend to be more difficult to use to value unique firms, with no obvious comparables, with little or no revenues and negative earnings.

Approaches: There are various approaches to value and use the multiples. The first approach relates multiples to fundamentals about the firm being valued - growth rates in earnings and cash flows, payout ratios and risk. This approach to estimating multiples is equivalent to using discounted cash flow models, requiring the same information and yielding the same results. Its primary advantage is to show the relationship between multiples and firm characteristics, and allow exploring how multiples change as these characteristics change. For instance, what will be the effect of changing profit margins on the price/sales ratio? What will happen to price-earnings ratios as growth rates decrease? What is the relationship between price-book value ratios and return on equity? The second and the most common approach to using multiples is to compare how a firm is valued with how similar firms are priced by the market, or in some cases, with how the firm was valued in prior periods, and accept the firm that are different from the firm being valued on one dimension or the other. When this is the case, either explicitly or implicitly control for differences across firms on growth, risk and cash flow measures. In practice, controlling for these variables can range from the naпve (using industry averages) to the sophisticated (multivariate regression models where the relevant variables are identified and control for differences.).

And if there is a mature firm in the industry the present multiples can be compared with that of the past multiples which will signify the growth rate of the firm over the period of time and investor expectation about its growth rate in the future.

Limitation: By the same token, they are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly similar in terms of risk and growth, the definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a group of comparable firms to confirm his or her biases about a firm's value. The other problem with using multiples based upon comparable firms is that it builds in errors (over valuation or under valuation) that the market might be making in valuing these firms. In illustration for instance, if the market has overvalued all computer software firms, using the average PE ratio of these firms to value an initial public offering will lead to an overvaluation of its stock. In contrast, discounted cash flow valuation is based upon firm-specific growth rates and cash flows, and is less likely to be influenced by market errors in valuation.

LIMITATION OF DCF MODEL

Discounted cash flow valuation is based upon expected future cash flows and discount rates. Given these informational requirements, this approach is easiest to use for assets (firms) whose cash flows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available. The further we get from this idealized setting, the more difficult discounted cash flow valuation becomes. The following list contains some scenarios where discounted cash flow valuation might run into trouble and need to be adapted.

(1) Valuation of Firms in trouble

A distressed firm generally has negative earnings and cash flows. It expects to lose money for some time in the future. For these firms, estimating future cash flows is difficult to do, since there is a strong probability of bankruptcy. For firms which are expected to fail, discounted cash flow valuation does not work very well, since we value the firm as a going concern providing positive cash flows to its investors. Even for firms that are expected to survive, cash flows will have to be estimated until they turn positive, since obtaining a present value of negative cash flows will yield a negative value for equity or the firm.

To value a firm in distress or with negative earnings we begin by looking