Every company needs to have a valuation model
Listed entities know the value of their company by reference to the share price on the stock exchange(s) that they are listed on. The directors then make decisions that will enhance the value of the shares and will avoid making any decisions that will devalue the shares in any way.
A smaller company will not be able to monitor its value or the value of its shares by reference to any publicly listed information. They could be making decisions that will adversely affect the value of their company simply by not being able to gauge the impact of the decision to its value.
There are 3 key methodologies that can be used to ascertain share or company value that are commonly used:
1. Price Earnings
2. EBITDA multiple
3. Free Cash Flow (FCF)
The first 2 methodologies are based on historic information such the signed financial statements. Often valuers use the Net Asset Value model to make sure the final value using any of the three methodologies is reasonable.
The third method is based on future projected free cash flow multiplied by a return that is ascertained from publicly available information which is then adjusted for the industry, the risks, the company’s shareholding structure and other appropriate factors. The FCF is widely accepted as the best method but needs a deep examination of the assumptions that that are used to build the model. It is fundamentally a long-term projection of the company’s cash flow and needs to be carefully thought out and the core assumptions need to be sound and not wholly aspirational.
All companies need to have a valuation done and understand how the decisions they make affect the value of the company. For example, whether a decision to defer capital expenditure will have a positive or negative outcome on the value or whether a new riskier market that you enter will adversely affect the share price.
If a company needs to be prepared for a sale, then certain behaviors and decisions need to change. In larger family businesses we often find that directors who are family tend to get paid more than what the market will bear for the job being done. These sorts of decisions need to be understood and adjusted to get a better picture of the company’s values. All major decisions should be considered in how it affects values. A hurdle rate needs to be ascertained from the valuation to apply to all future projects that will bring a higher value to the company.
It is an important consideration for companies to invest in a valuation to guide major decisions that it makes to ensure value enhancement particularly if they are considering a sale.
Suresh Naidoo
Director at Accensis.