Financial due diligence is one of the most critical aspects of closing deals in the world of M&As. It’s the process through which potential investors, buyers, or partners thoroughly analyze a target company’s financials to determine its financial health and performance.

The findings of financial due diligence are then merged with those of other due diligence areas — like legal, operational, and technical— and used to determine whether or not a proposed deal should proceed.

In this article, we’ll tell you five top ways to make the financial due diligence phase of your next M&A more efficient.

1. Start Early

A common mistake many companies make is waiting until after they’ve sent a letter of intent to start looking into the target’s financials.

A much better approach is to start financial due diligence as soon as you develop an interest in a particular target company or asset. Use publicly available information to gain some early insights into its financial health and performance. This proactive approach provides numerous advantages. 

First, it can help you spot major financial discrepancies or inconsistencies early on. You can then determine the best course of action.  

For example, if you still believe in the target’s potential, you can start devising strategies to address your concerns. Alternatively, you can abandon the deal and redirect your efforts toward more promising opportunities.

Starting financial due diligence early can also arm you with a foundational understanding of the target’s finances — that you can use to tailor your approach when you make first contact. And once official discussions start, you can use the knowledge you already have to back up your positions or arguments.

2. Engage Industry Experts

Engaging experts from the industry in which your target operates is another great way to improve the efficiency of the due diligence process. 

Experts possess an in-depth understanding of the market and industry, allowing them to provide nuanced insights that your in-house analyst team might miss. They can help identify potential red flags or uncover hidden opportunities that might not be immediately apparent.

Industry experts also have an unbiased perspective. Since they’re not emotionally or financially tied to the deal, their evaluations are objective, which makes for a more transparent and genuine assessment. They can help you avoid costly missteps that might result from cognitive biases.

Another big plus of industry experts is their network. They can tap into industry contacts for additional insights, benchmarking, or validation, leading to a more comprehensive and contextual analysis of the target.

3. Look Beyond the Numbers

Financial due diligence aims to offer a comprehensive understanding of a business’s financial health, risks, and opportunities. But while raw financial figures can reveal a lot about a company, they don’t always tell the whole story.

Revenues, expenses, and profits can provide an overview of what has happened, but not necessarily why or whether this is sustainable. Not to mention, some companies can sometimes manipulate their financials to portray a more favorable position, i.e., window dressing.

To get a fully accurate picture of your target’s financial health and future potential, make sure to look beyond the numbers. 

For example, study the competitive landscape, market trends, and customer satisfaction. A detailed examination of these elements can provide useful context for some of the target’s financial figures, including helping you determine if these are sustainable.

4. Set a Clearly Defined Scope of Work

Before you begin the financial due diligence process, define the scope of the project. Write down the items or elements you’ll examine, how you’ll examine them, and the overall objectives you hope to achieve. 

A well-defined scope of work provides direction and can prevent you from straying into areas that aren’t important to the deal you’re pursuing. It can also help you:

• Allocate resources more efficiently.
• Ensure the right team is assembled.
• Ensure that tasks are appropriately delegated according to team members’ strengths and expertise.

One of the key items in your scope of work should be a financial due diligence checklist. This refers to a comprehensive list of items and information that you’ll use to assess the target’s financial health and performance.

Here are some of the most important items to include in your financial due diligence checklist:

1. Income statements 
2. Balance sheet 
3. Cash flow statements 
4. Tax records (including returns and audits)
5. Operating margin
6. Gross margin
7. Profit margin
8. Debt to equity ratio
9. Interest coverage
10. Asset turnover
11. Return on equity
12. Return on assets

An important note: It’s essential to try to strike a balance when setting the financial due diligence scope of work. While it should be specific enough to provide direction, it shouldn’t be so rigid that it prevents the exploration of unforeseen areas or elements that may emerge during the actual financial due diligence process.

5. Choose the Right Virtual Data Room

A virtual data room (VDR) is a digital vault where all stakeholders in an M&A deal, including the buyer, seller, financial experts, and legal professionals, can store and share sensitive documents and data.

A top-tier VDR streamlines and makes the financial due diligence process more efficient by offering a centralized location for all essential financial documents. This eliminates the need for repeated requests for documents from different parties — everything can be housed within the VDR for fast and convenient access.

A VDR can also help ensure the security of information and data during this phase of an M&A. Financial due diligence usually involves the exchange of sensitive and confidential documents. Any security breaches could lead to significant financial and reputational damages for all parties involved.

Leading providers of VDRs, like CapLinked, usually include robust security features, such as advanced encryption, to protect all sensitive information and data from illegal or unauthorized access. 

In fact, if you’re looking for a reputable VDR provider to partner with in your next M&A deal, look no further than CapLinked.

CapLinked’s virtual data rooms come with a user-friendly interface, military-grade security, and a suite of premium features — like customizable permissions, collaboration tools, and document and version management — which are designed to facilitate a smooth, fast, and efficient financial due diligence process. 

Want to find out more? Request a quote today.

Wrapping Up 

While financial due diligence is undoubtedly the most important component of due diligence, it’s the way you approach it that makes all the difference.

Use the tips we’ve outlined here to improve the efficiency of the process the next time your firm takes part in an M&A. A more efficient financial due diligence process can lead to more accurate valuations, a clearer understanding of potential risks and opportunities, and a smoother integration post-acquisition.

Sources:

Investopedia: Top 6 Websites for Finding a Company’s Financial Stats

EDUCBA: Window Dressing in Accounting

The post How to Make the M&A Financial Due Diligence Phase More Efficient appeared first on Valutico.

The Terminal Growth Rate is often used in valuation models and financial projections, but what is it and why is it important? Below we aim to provide a straightforward explanation of what the Terminal Growth Rate is and its significance in financial analysis.

What is the Terminal Growth Rate? The Terminal Growth Rate is the estimated pace at which a company is expected to continue expanding after the initial projected growth period. Also known as the long-term growth rate, it is the growth rate of a company’s free cash flows beyond a certain forecast period. Broadly speaking, it’s the rate at which you predict the company to grow in the future. In financial modeling and valuation, analysts project cash flows for a specific period, typically 5 or 10 years, and then assume a stable, perpetual growth rate for subsequent years. This stable perpetual growth rate is the Terminal Growth Rate.

That’s a short summary, but we’ll take you through the explanation step by step below.

Key Takeaways:

• The terminal growth rate is the estimated pace at which a company is expected to continue expanding after the initial projected growth period.
• It reflects the steady rate at which the company’s free cash flows are anticipated to grow beyond the period covered by the initial forecasts.
• It’s used in financial modeling and valuation to estimate the company’s long-term value. In particular, the Terminal Growth Rate is used in a DCF analysis to help calculate the Terminal Value.
• The Terminal Growth Rate and the Terminal Value are important figures in valuations, because they usually represent a significant contributor to the final valuation estimate.
• Different industries have varying Terminal Growth Rates based on growth potential and market maturity.
• There are several ways to estimate the Terminal Growth Rate, including historical growth rates, industry averages, economic projections, and qualitative factors.
• Conservative assumptions are important to avoid overestimating the company’s future growth.
• Sensitivity analysis assesses the impact of growth rate changes on valuation.

A Simple Explanation of Terminal Growth Rate

Financial specialists make predictions about a company’s cash flows for a certain period, usually the next 5 or 10 years. But after this period they need to estimate how much the company’s cash flows will keep growing beyond. This is the Terminal Growth Rate. To come up with the Terminal Growth Rate, these experts might look at the company’s historical growth rates, consider industry trends, and evaluate how the overall economy is performing.

The Terminal Growth rate is used as a crucial part of the widely used valuation technique Discounted Cash Flow analysis, to determine that Terminal Value. The Terminal Value, derived using the Terminal Growth Rate, is combined with the present value of cash flows during the forecast period to calculate the total value of the company. It’s crucial to make conservative estimates of the Terminal Growth Rate, and be cautious about being too optimistic, as even small changes in this rate can have a significant impact on the company’s value.

Explaining Free Cash Flow: Cash flow is like the lifeblood of a business (or your personal finances). It covers tracking the money that comes in and goes out. When more money flows into the business than goes out, you have positive cash flow. Free Cash Flow is a specific type of cash flow that focuses on the cash left after the company has covered all its necessary expenses and capital investments needed to maintain and grow the business. It’s the cash that a company can use for other purposes, like paying off debts, returning money to shareholders, or investing in new projects.

Terminal Growth Rate Formula

The Terminal Growth Rate is typically incorporated into the Perpetuity Formula used in DCF analysis to determine the present value of future cash flows. The formula is as follows:

Terminal Value = Cash Flow in the Last Forecast Year * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate)

The Terminal Value represents the value of the company’s cash flows beyond the forecast period, and the Discount Rate is the rate used to discount future cash flows back to their present value.

Note: It’s important to understand that this is one of the commonly used methods to calculate terminal value, especially in more simplified DCF models. However, for a nuanced valuation, particularly for capital-intensive or rapidly growing companies, the normative free cash flow method might be more appropriate. In such cases, analysts often adjust the terminal value calculation using normative free cash flow. This results in the formula:

Terminal Value = Normative Free Cash Flow * (1 + Terminal Growth Rate) / (Discount Rate – Terminal Growth Rate)

Normative Free Cash Flow=NOPAT from the previous year×(1+g)−g×Capital Expenditure from the previous year

This adjustment ensures that the terminal value calculation aligns more closely with the company’s typical operations.

Calculating the Terminal Growth Rate:

There are various methods to estimate the Terminal Growth Rate. One approach is to use the industry average growth rate or the country’s economic growth rate, depending on the company’s market and geographical location.

Another approach is the historical growth rate analysis. This method involves analyzing a company’s historical growth rate over an extended period, typically five to ten years, and using it as a proxy for the Terminal Growth Rate.

Analysts may also consider macroeconomic factors, industry trends, and management forecasts to arrive at a reasonable estimate.

When estimating the Terminal Growth Rate, it’s not only beneficial but imperative to align it with broader economic forecasts, especially for companies closely tied to overall economic conditions. For instance, if an emerging industry has seen high growth rates recently, projecting a Terminal Growth Rate higher than the broader economy can result in unrealistic valuations. Over an extended period, this would mean the company would outgrow the economy itself, a scenario that’s logically implausible.

Where is the Terminal Growth Rate Used?

Beyond valuations, the Terminal Growth Rate is used in various areas within the realm of finance and business decision-making. Some of the key uses include:

Investment Decisions:

Investors use the Terminal Growth Rate to evaluate the long-term growth potential of a company before making investment decisions. A higher Terminal Growth Rate may signal a more attractive investment opportunity.

Strategic Planning:

Companies incorporate the Terminal Growth Rate in their strategic planning to set realistic long-term financial goals and assess the sustainability of their competitive advantage.

Budgeting and Financial Forecasting:

The Terminal Growth Rate assists companies in projecting future cash flows and making financial forecasts for budgeting purposes.

Dividend Policy:

For mature companies with stable cash flows, the Terminal Growth Rate helps determine an appropriate dividend policy. The rate at which dividends can grow sustainably is linked to the Terminal Growth Rate.

Mergers and Acquisitions:

In merger and acquisition analyses, the Terminal Growth Rate plays a role in estimating the future cash flows and potential synergies of the combined entity.

Cost of Equity and Capital:

The Terminal Growth Rate is used to calculate the cost of equity in the Dividend Discount Model (DDM) and the cost of capital in the Weighted Average Cost of Capital (WACC) formula.

Credit Risk Assessment:

Credit rating agencies and lenders may consider the Terminal Growth Rate when assessing a company’s long-term creditworthiness and ability to meet debt obligations.

Scenario Analysis:

The Terminal Growth Rate is used in scenario analysis to explore different growth rate assumptions and their impact on a company’s value and performance.

Assumptions of the Terminal Growth Rate:

Several key assumptions underlie the Terminal Growth Rate calculation. These include the assumption that the company will achieve steady and sustainable growth beyond the forecast period, that it will maintain its competitive advantage, and that market conditions will remain relatively stable.

Steady and Sustainable Growth:

The Terminal Growth Rate assumes that the company will experience consistent and sustainable growth beyond the forecast period. This implies that the company will continue to expand and generate increasing cash flows without any significant disruptions or adverse events.

Competitive Advantage:

The assumption of a Terminal Growth Rate is predicated on the company maintaining its competitive advantage over time. This competitive edge can stem from unique products, innovative technologies, strong brand recognition, or effective cost leadership. If the company loses its competitive edge, the Terminal Growth Rate may not be applicable, and growth prospects could change.

Stable Market Conditions:

The calculation of the Terminal Growth Rate assumes that the market and economic conditions will remain relatively stable over the long term. Economic volatility, changes in consumer preferences, technological shifts, or disruptive market forces could impact a company’s ability to sustain growth.

General Consideration for the Terminal Growth Rate:

Conservative Assumptions:

When estimating the Terminal Growth Rate, it is essential to be conservative and avoid overly optimistic projections. Small changes in the Terminal Growth Rate can significantly impact a company’s valuation.

Sensitivity Analysis:

Due to the significance of the Terminal Growth Rate in valuation models, analysts often perform sensitivity analysis to assess the impact of varying growth rate assumptions on the overall valuation.

Industry-Specific Considerations:

Different industries may have varying Terminal Growth Rates due to their growth potential, market maturity, and risk profiles. Industries experiencing rapid technological advancements, like the technology sector, may have higher growth rates, while mature industries may have lower growth rates.

Growth Potential:

Industries with high growth potential, such as technology, renewable energy, or healthcare, may experience higher Terminal Growth Rates due to emerging opportunities and increasing demand for their products or services.

Market Maturity:

Mature industries, like utilities or traditional consumer goods, tend to have lower Terminal Growth Rates. These industries often experience slower growth as they reach saturation points in the market.

Risk Profiles:

Industries with higher perceived risks, such as biotechnology or startups in competitive markets, may have lower Terminal Growth Rates as investors demand higher returns to compensate for uncertainty.

Execution Failures in Growth Projections:

While it’s essential to project growth based on past successes and industry standards, it’s equally crucial to factor in potential execution failures. Such failures could be due to a variety of reasons including, but not limited to, market changes, internal challenges, or external pressures. Relying solely on historical growth without accounting for possible failures might lead to an overly optimistic Terminal Value. It’s pertinent to adjust the Terminal Growth Rate or the Terminal Value directly to encapsulate potential failures.

In certain cases, especially for rapidly growing or capital-intensive companies, the cash flow from the final projected year might not be representative of ‘normal’ operations. In such situations, analysts adjust the terminal value calculation using normative free cash flow.

How to Find the Terminal Growth Rate:

Estimating the Terminal Growth Rate involves careful analysis and consideration of various factors. Common methods include:

Historical Growth Rates:

Analysts may examine the company’s historical growth rates over a significant period to identify trends and extrapolate a reasonable Terminal Growth Rate. However, relying solely on historical data may not fully capture future prospects.

Industry Averages:

Comparing a company’s growth prospects with industry averages can help gauge its competitiveness and potential long-term performance.

Economic Growth Projections:

Analysts may consider macroeconomic indicators and economic forecasts to estimate the Terminal Growth Rate, particularly when the company’s performance is closely linked to broader economic conditions.

Qualitative Factors and Management Forecasts:

Incorporating qualitative factors, like management’s strategic plans or market outlook, can provide valuable insights into the company’s long-term growth potential.

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• Valutico launches a new «Notes» feature to document decisions and assumptions in valuations.
• The feature empowers users to justify and communicate valuation inputs to third parties effectively.
• Users can take comprehensive notes, facilitating internal reflection and collaboration with colleagues.
• The new feature now means Valutico provides users both “numbers” and “narratives” to add important depth to each valuation.

Valutico is excited to introduce its latest feature, «Notes,» designed to address the critical need for documenting decisions and assumptions in valuations. The new functionality aims to empower users to justify and communicate their valuation inputs effectively to third parties, such as clients, courts, and potential buyers.

Justifying Valuation Inputs Made Easy

Valuation processes often rely on standardized methodologies, but the decisions and assumptions underlying these valuations are highly subjective. When presenting a valuation to external parties, users frequently face the challenge of justifying specific decisions or assumptions made throughout the process. This could include explaining the selection of peers, rationale behind forecasts, or adjustments made during the quality assurance phase.

To overcome this challenge, Valutico’s new feature enables users to document decisions and assumptions directly within the platform. Users can take comprehensive notes to remind themselves of the reasoning behind specific choices or areas that require further analysis. This documentation not only facilitates internal reflection but also serves as a valuable resource for discussing decisions and assumptions with colleagues working on the valuation.

«We recognize the importance of providing our users with the tools they need to justify their valuations and enhance trust in their work,» said Paul Resch, CEO at Valutico. «Our new feature allows users to document decisions and assumptions comprehensively, empowering them to demonstrate their expertise, professionalism, and preparation.»

Seamless Integration For an End-to-End Valuation Workflow

The new functionality caters to a diverse range of users who require robust documentation capabilities. Notetaking facilitates collaboration and discussion among team members, providing a platform to explain and share rationales. But users can also leverage the solution to present well-structured and professional justifications for their valuations to clients or other stakeholders, even when they don’t have access to the underlying spreadsheet-based model.

Currently, users resort to workarounds such as maintaining separate documents for note-taking. Valutico’s new feature eliminates the need for third-party tools and consolidates all documentation within the platform, aligning with the company’s commitment to an end-to-end valuation workflow.

By introducing this feature, Valutico aims to improve user experiences and enhance trust in valuations. Users will also be able to export the comprehensive documentation as part of their reports as part of a planned update in an upcoming phase, which will foster transparent communication with third parties and showcase the thought process behind their valuation inputs.

Key New Note Features

Core Features of Valutico’s New Note Taking Product Feature:

Comprehensive Note-Taking:
Users can take notes at various stages of the valuation process, including the qualitative assessment, peer choice, valuation methodology selection, and parameter adjustments.

Documentation of Decisions and Assumptions:
The feature allows users to document the rationale behind specific decisions and assumptions made in the valuation. This documentation helps justify inputs to third parties, such as clients, courts, and potential buyers.

Collaboration and Discussion:
For internal users, the feature facilitates collaboration and discussion among team members. Users can explain their rationales and share notes with colleagues, enhancing teamwork and understanding.

Seamless Integration within Valutico:
The note-taking feature eliminates the need for third-party tools or Excel spreadsheets. Users can keep all their documentation within the Valutico platform, aligning with the platform’s end-to-end valuation workflow.

Filter by Stage:
Users can filter for specific notes within valuations, making it easy to find relevant information when reviewing or sharing valuations. The ability to add, remove, and edit notes ensures that users always have an updated set of notes.

To explore this new feature further, we invite you to book a demo and connect with one of our Valutico experts.

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Comparable company analysis (CCA) is a popular approach to valuing a company, especially in accounting, M&A, investment banking and corporate finance fields. It involves comparing a company’s financial metrics to those of its peer companies to determine its valuation. However, while a CCA can provide a useful snapshot of a company’s value, it has both pros and cons.

What are the pros and cons of the comparable company analysis approach to valuation? On the positive side, CCA is relatively easy to perform and can provide a quick estimate of a company’s price. It is also widely used in the industry, which makes it a useful benchmark for comparison purposes. CCA can also be used in conjunction with other valuation methods to provide a more comprehensive analysis of a company’s value. However, on the negative side, CCA requires a set of comparable companies for analysis, which can be difficult to find for companies in niche industries. It also does not consider company-specific or non-financial factors that may impact a company’s valuation. Additionally, CCA can be impacted by market volatility and may not reflect changing market conditions or differences in accounting practices between companies.

Do you want to find comparable companies for your analysis? Valutico has more than 3TB of market-leading comparable company data covering almost every country. Get in touch to learn how Valutico can help you value companies faster.

Key takeaways:

1. CCA is a widely used and easy-to-perform method of valuation.
2. CCA requires a set of comparable companies for analysis, which can be difficult to find for companies in niche industries.
3. CCA only considers financial metrics and does not account for company-specific or non-financial factors that may impact a company’s valuation.
4. CCA can be impacted by market volatility and may not reflect changing market conditions or differences in accounting practices between companies.
5. CCA can be used in conjunction with other valuation methods to provide a more comprehensive analysis of a company’s value.

Comparable Company Analysis – What’s Good? The Pros to CCA Explained

1. Widely used: Comparable Company Analysis (CCA) is a widely used valuation method in investment banking, private equity, and other financial industries. This makes it a common language and framework for analyzing companies.
   Example: If an investment banker is evaluating a company for an initial public offering (IPO), they are likely to use CCA to value the company.
2. Uses publicly available information: CCA uses publicly available information such as financial statements, stock prices, and other market data to compare a company to its peers. This makes it more accessible and easier to use than other valuation methods that require proprietary information.
   Example: An analyst can easily gather the necessary data to perform a CCA by reviewing the SEC filings of the companies they are analyzing.
3. Relatively simple: CCA is a relatively simple and straightforward method of valuation. It involves comparing the financial metrics of a company to those of its peers, making it easy to understand and use for analysts and investors. It’s also useful for CEOs and CFOs of SMEs that aren’t familiar with the process of Discounted Cash Flow.
   Example: A private equity firm can use CCA to compare the valuation of a potential acquisition target to similar companies in the industry.
4. Provides a range of values: CCA provides a range of values for a company, based on the values of its comparable peers. This range can help analysts and investors better understand the potential value of the company being analyzed.
   Example: A portfolio manager can use CCA to determine the range of values for a company in order to decide whether to invest in it or not.
5. Can be used for multiple industries: CCA can be used to value companies in a wide variety of industries, making it a flexible valuation method for analysts and investors.
   Example: An analyst can use CCA to compare the valuations of companies in the technology industry, the healthcare industry, and the retail industry.
6. Can be used in conjunction with other valuation methods: CCA can be used in conjunction with other valuation methods such as discounted cash flow (DCF) analysis or precedent transactions analysis (PTA) to provide a more comprehensive valuation of a company.
   Example: An investment banker can use CCA to determine a range of values for a company and then use DCF analysis to provide a more detailed valuation based on projected future cash flows.

Comparable Company Analysis – What’s Bad? The Cons to CCA Explained

1. Limited comparables: CCA requires a set of comparable companies for analysis, and finding appropriate comparables can be difficult, especially for companies in niche industries.
   Example: An analyst may struggle to find appropriate comparables for a company in the emerging blockchain industry.
2. Can be impacted by market volatility: CCA can be impacted by market volatility, as the values of comparable companies can fluctuate rapidly, leading to an unreliable valuation.
   Example: A company may be undervalued compared to its peers due to short-term market fluctuations, even if it has strong long-term prospects.
3. May not reflect changing market conditions: CCA may not reflect changing market conditions or future growth or trends that impact a company’s valuation over time.
   Example: A company in the technology industry may be undervalued compared to its peers if CCA only considers historical financial metrics and does not reflect changing trends in the industry.
4. Assumes comparable companies are truly comparable: CCA assumes that the comparable companies are truly comparable in terms of size, industry, and other relevant factors, which may not always be the case, therefore the price may not reflect the value accurately.
   Example: Two companies in the same industry may have vastly different business models and growth prospects, making them difficult to compare using CCA.
5. Limited to public information: CCA is limited to publicly available information and may not reflect private information that could impact a company’s valuation.
   Example: A company may have a strong pipeline of proprietary technology that is not reflected in its publicly available financial statements.
6. Relies on market perception: CCA relies on the market’s perception of a company’s value and may not reflect its true intrinsic value, therefore the price outcome may be inaccurate.
   Example: A company may be undervalued compared to its peers if the market perceives it to be in a declining industry, even if it has strong long-term prospects.

In conclusion, the comparable company analysis approach to valuation has both pros and cons that should be considered before using it as the sole method of valuation. While CCA is easy to perform and widely used in the industry, it requires a set of comparable companies for analysis and does not account for company-specific or non-financial factors that may impact a company’s valuation. 

However, CCA can still be a useful tool when used in conjunction with other valuation methods. To access the best comparable company data available and gain a more comprehensive analysis of a company’s value, it is recommended to book a demo with Valutico valuation software specialists. Valutico can provide a personalized demo to showcase the range of data and insights their platform can offer for your specific business needs.

The post Comparable Company Analysis – Pros and Cons appeared first on Valutico.

• Valutico’s latest launch, ValutECO, empowers finance professionals to conduct valuations based on ESG criteria
• Companies with higher ESG scores can receive higher company valuations
• ValutECO is launched in an alpha trial phase to invite feedback

Leading the way in sustainable finance, Valutico has launched ValutECO, an advanced tool that assesses the value of companies based on their environmental impact. With this groundbreaking announcement, the valuation platform Valutico has made a significant step into integrating sustainability into the widespread practice of valuing businesses.

Valutico’s newly launched tool, currently in an ‘alpha’ trial phase, allows accountants, M&A consultants, investment managers, private equity professionals, and those in corporate finance to consider the impact of Environmental, Social and Governance (ESG) factors on a company’s value. By addressing the potential links between ESG and financial performance, ValutECO is leading the way towards incorporating sustainability into financial theory and practice.

ValutECO Explained

With ValutECO, financial professionals use a streamlined ESG assessment, specifically designed with small and medium-sized enterprises (SMEs) in mind and simplified to facilitate easier reporting. Analysts can identify priority areas for improvement, such as reducing greenhouse gas emissions, managing water usage, and increasing recycling rates. 

Valutico’s pioneering new tool integrates ESG scores into the ‘Cost of Capital’ component of a Discounted Cash Flow (DCF) valuation. This revolutionary feature allows companies with positive ESG scores to be valued higher, making them more attractive to potential buyers and investors seeking sustainability and long-term growth.

ValutECO was developed following a grant by Wirtschaftsagentur Wien, and follows research into the impacts of ESG criteria on the valuations of businesses across multiple industries, alongside validation that the condensed ESG assessment reflects more exhaustive assessments on the market. 

Impact on Sustainability

The widespread adoption of a tool like ValutECO has the potential to be a game-changer for sustainability in industries all around the world. It would financially incentivize companies to prioritize sustainability and embed environmental factors as a key component of their everyday operations. This would result in one way in which companies’ impact on the planet becomes a crucial aspect of buying, selling, and investing decisions.

Valutico acknowledge that the integration of ESG into financial analyses is an ongoing conversation requiring further academic study, but they’re optimistic that their new tool ValutECO will contribute to steering the conversation in the direction of a more sustainable future.

Valutico’s CEO, Paul Resch states:

«Leading the way in integrating sustainability into financial practices is a significant accomplishment for Valutico. We recognize the importance of ValutECO as an initial step towards achieving this goal, and we’re grateful for the grant provided by Wirtschaftsagentur Wien that made this possible. We’re looking forward to receiving feedback from financial professionals on how this innovative tool can enable sustainable growth and we’re excited for what lies ahead.»

Alpha Phase: Valutico appreciate that a universally accepted standard for ESG scoring, nor ESG valuation analysis, currently exist. As such, ValutECO has been launched as a working and viable early-stage tool, and further development is anticipated following user feedback, and ongoing research. 

The post ValutECO is the New Groundbreaking ESG Tool for Sustainable Business Valuations appeared first on Valutico.

What is ValutECO?

A tool that allows financial professionals to incorporate Environmental, Social and Governance (ESG) aspects in the valuation of a company.

How does ValutECO work?

Users complete a streamlined ESG assessment of the target company to arrive at an ESG score. The ESG score feeds into our proprietary algorithm to derive an appropriate adjustment to the Cost of Equity and Cost of Debt, which impacts the final valuation.

Who is ValutECO for?

All finance professionals who value companies, such as accountants, auditors, tax advisors, M&A professionals, investment managers, corporate finance advisors, and banks who want to consider ESG factors as part of their decision-making process, especially as an input to the valuation.

How are the Cost of Capital adjustments calculated?

Valutico developed a proprietary Cost of Capital adjustment algorithm, based on the ESG scores of listed companies, obtained from S&P Capital IQ. We performed a detailed linear regression analysis, considering the betas and credit spread of listed companies, regressed against their ESG scores, for the universe of listed companies globally. The ESG score of the target company is then fed through the algorithm to arrive at Cost of Capital discount or premium, which in turn will affect the Discounted Cash Flow valuation result.

The higher the ESG score, the higher the Cost of Capital discount, which results in a lower overall Cost of Capital and thus a higher valuation. For very low ESG scores, the algorithm will apply a Cost of Capital premium, increasing the overall Cost of Capital and thus decreasing the valuation.

As a general rule of thumb, ValutECO will generally apply a ~0.08% discount to the Cost of Equity and a ~0.09% discount to the Cost of Debt for every 10 point improvement in a company’s ESG score.

Similarly to the Qualitative Assessment, it is up to the discretion of the user as to whether they wish to use these specific discounts or premiums in their final valuation. The ESG industry is relatively nascent and thus, as a new tool, this approach is not yet a widely adopted standard across the industry.

ValutECO is still in Alpha Phase – what does this mean?

Valutico appreciates that neither a universally accepted standard for ESG scoring, nor a universally accepted standard for ESG valuation analysis, currently exist. As such, we are launching ValutECO as a viable tool at an early stage of development, to solicit feedback, work closely with users to understand their needs in this area and develop ValutECO into a tool that could be more widely adopted. Notably, this means ValutECO can be considered as still under development and subject to change at any time.

Do I need a Valutico subscription to use ValutECO?

Yes, in order to access ValutECO you need a subscription to the Valutico valuation platform.

I do not have a subscription to ValutECO, how do I use ValutECO?

You will need access to Valutico to use ValutECO. Within the platform it features as an optional step. Users can also utilise the ESG assessment component by itself, without applying any ESG adjustment , in case they wish to conduct their standard valuation but still discuss ESG issues with their clients separately. If you are a Valutico user, read the next FAQ response for more information.

I am a Valutico user, how do I use ValutECO?

If you’re a Valutico user, reach out to customer service and they can provide you access. ValutECO’s launch add-on price point is established at between $200 – $500, with 100% of sales being donated to the World Land Trust Charity, patroned by David Attenborough. Valutico extends a cordial invitation to contribute beyond the stipulated amount.

Once you have access to ValutECO, a new step will be added to the valuation workflow. Upon entering this step, you have the choice to start or skip the ESG assessment. In the former case, you will conduct a short 29-question ESG assessment, which provides an overall ESG score, as well as dimension scores for E, S and G. Your overall ESG score has an impact on the Cost of Capital, which impacts the discount rate applied to all DCF-based valuation approaches. You may also choose to conduct the ValutECO assessment for informational purposes, but not apply any Cost of Capital adjustments. In order to do so, simply deactivate the toggle on the ValutECO result screen, or in the parameters on the valuation screen.

Where do I see the impact in Valutico’s valuation platform?

If activated, the Cost of Equity and Cost of Debt adjustments will be shown in the Discount Rate table on the Valuation screen, per the screenshot below:

How can we advise clients of the impact of the ESG report?

There are at least two ways you might want to use this tool with clients:

1. Demonstrate their ESG score, in order to discuss which aspects across Environmental, Social and Governance dimensions they should be aware of, in order to future-proof the value of their business
2. Indicate the difference between a valuation that incorporates the ESG score into the valuation, versus one that does not. This might be a positive or negative impact, showing the effect of certain ESG aspects on the value of the business

Is the streamlined ESG survey consistent with longer-format ESG surveys?

Yes, the condensed ESG survey is broadly consistent with the S&P Capital IQ ESG scoring mechanism, but is focused on SMEs as opposed to large, listed companies.

When would you recommend using ValutECO?

We built the ValutECO methodology with private SMEs in mind, for which complex probability-weighted ESG cashflow scenarios might pose an insurmountable or expensive challenge. We want to lower the barrier to ESG adoption for these types of companies. The questionnaire is purposely kept as broadly applicable as possible.

Some notable use cases for ValutECO include:

• Sell-side M&A: showcase the positive impact of a good ESG performance and justify an elevated valuation
• Private Equity: showcase the positive impact of a good ESG performance and justify an elevated valuation; satisfy ESG requirements by your LPs
• Sustainability / Management consulting: help clients understand ESG is not just a soft factor, but translates into tangible value

When would you recommend NOT using ValutECO?

Users should not use the Cost of Capital adjustments generated by ValutECO if their forecasts already include ESG impacts, in order to avoid double-counting.

The post ValutECO – FAQs appeared first on Valutico.

In this article, we’ll explain what the Weighted Average Cost of Capital (WACC) is, by breaking it down into its components, and highlighting its role in valuing a company through the Discounted Cash Flow method (DCF).

What is the Weighted Average Cost of Capital (WACC)? Determining a company’s «Cost of Capital» is vital in corporate finance and valuation, and the Weighted Average Cost of Capital (WACC) provides a specific way of doing so. WACC considers the costs associated with different components of a firm’s capital structure, such as debt, equity, and preferred stock, and weighs them according to their proportion. These costs are then combined into a «weighted average» which represents the overall cost of financing a business. WACC is a valuable tool in discounted cash flow analysis for finding the value of a company.

First we provide a quick WACC overview, then we explain step-by-step how the WACC works.  

QUICK OVERVIEW

• The Weighted Average Cost of Capital (WACC) is a popular way to measure Cost of Capital, often used in a Discounted Cash Flow analysis to help value a business.
• The WACC calculates the Cost of Capital by weighing the distinct costs, including Debt and Equity, according to the proportion that each is held, combining them all in a weighted average.
• The resulting WACC represents the average cost of all the types of capital a company uses to finance its operations.
• The WACC is used as the discount rate in a DCF analysis.
• The higher the WACC, the higher the discount rate, and so the lower the value of the business.
• WACCs in certain industries may be higher or lower in general, depending on the risk associated with that industry. Riskier industries, may have a higher Cost of Capital.

What is the WACC? A Short Summary

The Weighted Average Cost of Capital (WACC) is an important tool for business valuation. It is a metric used to calculate the Cost of Capital for a company based on its specific financing mix (debt, equity and/or preference shares). The Cost of Capital is then used to discount future expected cash flows to arrive at a present value – the valuation of the business using the Discounted Cash Flow method, a leading valuation technique.

The WACC formula derives the current cost of each form of finance, starting with the risk-free rate, the expected return on equity, and the costs associated with debt financing. To calculate the WACC, you must first determine each source’s «costs,» which are expressed as percentages. You then weigh each source by its relative importance in terms of debt or equity.

In order to understand this, it may help to know the following: 

What is the Cost of Capital?

The Cost of Capital is how much it costs to obtain debt and equity capital, which is used to finance the operations of a business, including business growth. This is an important metric in business and finance. Businesses that are considered less predictable or more risky may have to face higher costs to obtain capital, as the providers of capital consider themselves taking onboard extra risk of losing their money, and want to be rewarded for their exposure to this risk. 

Why is Cost of Capital Important for Business Planning?

Broadly speaking, the company’s Cost of Capital shows how much money new endeavors must generate to offset these upfront costs, in order for the business to generate money. 

Cost of Capital is important in business planning as it represents the minimum return a company must earn on its investments in order to satisfy its creditors and equity investors. This helps the company determine the feasibility of new projects and investments, set a proper pricing strategy, and make informed decisions on allocating resources. By considering the Cost of Capital, a company can ensure it is using its funds in the most efficient manner and maximizing returns for its stakeholders.

Cost of Capital vs. WACC

The cost of capital is the total cost of debt and equity that a company incurs to run its operations. This method doesn’t consider the relative proportion of each source of financing. WACC, on the other hand, goes a step further by considering the proportion of each financing source used by the company.

How is the WACC Used?

The Weighted Average Cost of Capital, and its related concept, Cost of Capital, are used when making important financial decisions, including for mergers and acquisitions, investment decisions, as well as evaluating a company’s financial performance and stability.

How Do You Calculate WACC?

To calculate WACC, one must first find the cost of debt and then determine the required rate of return for equity.

In order to calculate WACC, we use the following equation:

WACC = (E/V x Re) + ((D/V x Rd) x (1-T)).

In this equation, «E» stands for «Equity», «V» stands for «Value», «Re» stands for «Required Rate of return for Equity», «D» stands for «Debt», «Rd» stands for «Cost of Debt», and «T» stands for «Tax Rate».

The cost of debt, or Rd, is the rate at which a company can borrow money from its creditors. This rate is typically determined by the length and size of the loan, as well as credit ratings associated with the company.

The required rate of return for equity (Re) is generally calculated using the Capital Asset Pricing Model (CAPM). This model takes into account a variety of factors, such as risk-free rate, beta, and expected market returns.

Finally, tax rate (T) represents taxes associated with interest payments on debt or dividends on equity.

WACC – Key Components

WACC is calculated using a variety of factors, including these main factors. 

Cost of equity (or «discount rate»), which considers the expected rate of return given current market conditions and the risk associated with investing in the company. 

• Beta factor:
  The beta factor is part of the Weighted Average Cost of Capital (WACC). It is a measure of the volatility of a stock in relation to the market as a whole. The beta factor is used to calculate the cost of equity in the WACC formula and is a measure of a stock’s systematic risk, or the risk associated with the overall market. A beta of 1.0 indicates that the stock moves in line with the market, while a beta greater than 1.0 indicates a stock that is more volatile than the market. A beta of less than 1.0 indicates a stock that is less volatile than the market. The higher the beta, the higher the required return for the stock, and the higher the cost of equity in the WACC formula.

Cost of debt is typically determined by interest rates on loans or other financing instruments. 

Sometimes, other factors are considered, such as:

Preferred stock that a company may have issued, which pays out dividends at predetermined rates regardless of how well a business is performing. 

Weighted average shares outstanding which reflects how many shares are currently outstanding for each type of security held by investors. 

Valuing a Business – WACC in a DCF

Weighted Average Cost of Capital (WACC) is an important concept when it comes to valuation. WACC is essential in a Discounted Cash Flow (DCF) analysis, as it serves as the «discount rate». A DCF requires projecting future cash flows and then discounting them back to their present-day values using the WACC rate as the «discount rate». The sum of all projected future cash flows (discounted by the WACC) gives an estimate of the «fair value» for a company.

What Does a High WACC Mean?

WACC is calculated as a weighted average of all sources of capital, including debt and equity, used to finance investments. A high WACC indicates that financing costs are higher and reduces the valuation of any given project through discounted cash flow analysis. It also means that investors may be less willing to allocate funds to such projects due to the high cost associated with them. In conclusion, a high WACC can have serious implications on an organization’s ability to obtain funding and accurately evaluate potential investments or projects.  Understanding the impact of WACC is key when considering a company’s overall financial health and future prospects.

What Does a Low WACC Mean?

A low WACC is beneficial to any company and its stakeholders. It represents the rate of return that a company must pay for all its financial sources such as debt and equity. A lower WACC means that there is less risk associated with the financing and so the expected return on investment (ROI) will be higher. This makes it more likely for shareholders or other financiers to invest in a company as they have confidence in their returns.

Having a low WACC can also have implications when it comes to valuation. Low Cost of Capital lowers the discount rate used in discounted cash flow models meaning there is an increased value for future cash flows leading to higher valuations for firms with lower Cost of Capital. A low WACC is important for any company’s financial performance and is something that should be monitored closely. Companies should strive to maintain a low Cost of Capital in order to attract investment, reduce the risk associated with their financing and significantly increase their valuation.

Do Different Industries Typically Have Different WACCs?

The industry in which a firm operates can have a significant effect on its WACC. Industries with higher levels of risk often require companies to take on more debt or pay higher interest rates when borrowing money, resulting in a higher WACC. On the other hand, firms operating in less risky industries may have access to lower cost financing options and consequently have a lower WACC.

For example, some of the industries with the highest WACCs include telecommunications, technology, utilities, media, pharmaceuticals, and oil & gas. These industries tend to require significant investments in research and development in order to remain competitive and therefore demand higher returns for investors. On the other hand, industries such as retail, transportation services, leisure/hospitality and banking typically have lower WACCs due to their relatively predictable business operations and low levels of risk.

Ultimately, it is important for companies to understand their individual WACC as well as how it compares to those in their industry in order to gain insight into their financial health and potential value. By analyzing the WACC, firms can gain a better understanding of their overall financial position and make more informed decisions when it comes to investing in growth and other opportunities.

Making Investment Decisions Based on the WACC

The WACC is expressed as a percentage, like interest of return on an investment. If a company has a WACC of 8%, this would mean that company should make investments that give a higher return than 8%, in order to grow. Any investments that give a lower return than 8%, may mean that it is therefore costing the company more money to finance its operations, than it is making from the operations themselves. 

The Weighted Average Cost of Capital helps investors make informed decisions about where to allocate their resources for maximum return on investment. 

Investing in a Company: WACC is used for this purpose as it takes into account both debt and equity financing costs and in this way provides a measure of required return for investors in order for them to be willing to invest in a company. This is because  higher WACC means that the Cost of Capital is higher and the investor will demand a higher return on their investment to compensate for the increased risk. Thus, knowing the WACC of a company can help investors make more informed decisions when investing in that company.

WACC Example

For example, say a company has total equity of $400 million with a cost of 12% and total debt of $600 million at a 6% cost. The WACC can be calculated by weighting these components appropriately:

WACC = (.4 x .12) + (.6 x .06) = 9.0%

This tells us that the company must earn an expected return of at least 9% on any new investments in order to create value from its capital structure. This is a critical metric for investors to analyze when assessing a company’s discounted cash flow or overall valuation.

What are the Limitations of WACC?

 Although WACC is a valuable tool for valuing companies, it has some drawbacks. The calculation of several elements in the WACC can be subjective and subject to different interpretations, leading to varying results among analysts. For instance, the effective tax rate or risk-free rate may be calculated differently or based on proprietary methods.

Therefore, it is crucial to use the WACC in conjunction with other financial instruments when assessing valuations. While it is useful in determining the minimum acceptable return on investment, other factors such as market conditions, competition, and company-specific risks should also be taken into account. With a platform like Valutico, a broader range of tools can be used to perform a more thorough and detailed analysis of companies.

The post Weighted Average Cost of Capital Explained – Formula and Meaning appeared first on Valutico.

Valuing a business using ‘multiples’ is a common method for determining how much a business is worth. Below, we outline what this method is, the different ways it works as well as key considerations when using this approach to value a company.

What is valuation using multiples? Valuations using multiples is one of the three main approaches to valuing a business, sometimes referred to as the ‘market-based approach’. The method assumes that similar companies (or assets) should be valued similarly, so it uses financial data from other companies to help determine a company’s value. A financial ratio (or ‘multiple’) observed from these peer companies is applied to the company that is being valued. By applying this multiple from similar companies, the value of the new company is estimated. This is a simple and practical method widely used by valuation practitioners. The challenging aspect is finding the appropriate comparison company multiples to use.

First we provide a quick overview of key takeaway points, then we explain step-by-step how the method works. 

QUICK OVERVIEW

• Valuation using multiples is one of the three main ways to value a business, sometimes referred to as the ‘market-based approach’
• It’s used widely by valuation practitioners, who will take a ratio either from comparable companies, or comparable transactions, to help value their target company
• It is often divided into two main approaches – Comparable Company Analysis (CCA) and Comparable Transaction Analysis (CTA)
• CCA compares using companies, whereas CTA uses transactions
• The ratio used might be EV/EBITDA, EV/Sales, P/E or another, depending on the valuation performed and the type of business being valued
• The ratio is then used in a simple multiplication calculation, to determine the value of the company in question
• The multiple being used is taken either from a company whose price is listed on a public exchange, or from an M&A transaction where the comparable company was the target of an acquisition
• These multiples/ratios can be time-consuming to find, and the selection of correct peer companies or appropriate transactions can have a large impact on the final valuation result
• Practitioners will often search online or subscribe to a database in order to access these multiples
• Valutico is one software platform where it’s possible to access these multiples (book a demo to learn more)

Major Assumptions of the Multiples Approach

This method assumes that one good way to value a company is to compare it with the value of similar companies. The major assumptions being that similar assets – or companies – will sell at similar prices, and that it is valid to make such a comparison between companies.  

The method relies on using a financial metric known as a ‘multiple’ (a ratio), as a comparison point. So another major assumption when adopting this method, is that the type of ratio chosen as the comparison point, such as P/E or EV/EBITDA should be similar across similar firms. 

Two Different Methods of Valuation Using Multiples

Broadly, there are two different common ways to value using multiples. 

The first is comparable company analysis (CCA), also known as “comps”. The second is precedent transaction analysis, known as “precedents” and also called a comparable transaction analysis (CTA).

To conduct a comparable company analysis, a company is compared with its peers on the basis of these aforementioned multiples. The data for these multiples can be taken from publicly available sources as all of these measures can be calculated from the financial reports of the publicly traded companies. 

On the other hand, it is more difficult to conduct a precedent transaction analysis as there is not much public data available for past transactions. However, to conduct such an analysis you have to search for transactions with similar businesses like the one you are analyzing. After that one can apply the above mentioned multiples to the target company.  

Pros

• Can be used for a quick estimation of a company’s value
• Simple approach to value a company. Good to get a first impression
• When using the comparable company analysis, data can be easily derived from the annual reports of companies
• Easily defended as multiples are observed in the public domain

Cons

• Not all of the necessary data is publicly available when conducting a precedent transaction analysis
• Only applicable between companies of the same industry, which will sometimes make it hard to find the right peers and can therefore distort the result of the valuation
• Multiples are oriented to the past and can therefore only reflect the future with difficulty
• Comparing SMEs with large, publicly listed companies can be difficult and determining the correct discount to apply is very subjective

Comparable Company Analysis Formula

A valuation using multiples is based on the following simple calculation: 

A financial (and in some cases even non-financial) metric is taken from the company that you are valuing. 

This is shown in the center of the equation below. A multiple based on this metric, is taken from a set of other similar companies (far right). The original metric from the target company is multiplied by this multiple, to determine the value of the company. 

That simple equation is how the value is determined.

In practice, however, this multiple (far right) might be the average (or median), taken from multiple similar companies in the industry.

Sometimes in very rough calculations it might just be the average for the industry. It’s rare that one would select one comparable company for this methodology, unless that company is identical in almost every respect. 

Example:

Here’s an example of a particular metric you might use:

In order to determine the Enterprise Value of the business, you find the EBITDA from the business you’re valuing, and then multiply this by the EBITDA multiple observed from the other comparable companies. This EBITDA multiple is the EV/EBITDA ratio. From this we determine the Enterprise Value of the business. 

The Underlying Logic of Valuation Using Multiples

The core way the approach works is to look at the financial performance of other similar companies, but not actually compare directly with say the main metric like sales, or EBITDA, but use the ‘ratio’ from those figures as the comparison point. 

It is assumed that similar companies should be able to apply these ratios from one to another and return a valid valuation estimate, because they are similar enough in operations and business environment that it would be valid to do so.

Partly because this approach is simple and therefore practical, it is widely used by valuation practitioners. The challenging aspect is simply finding the correct comparison company multiples to use. 

Choosing the Multiple

Multiples are taken from a range of different financial metrics, like EV/Sales or EV/EBITDA, and then applied to that related metric (e.g. Sales, or EBITDA) of the company you’re valuing by multiplication as shown above. 

So, in the case of using EV/EBITDA, you would need to know the (median) EV/EBITDA multiple from similar companies, or the industry. In this simple example, you take that multiple (ratio) and then multiply it by your company’s EBITDA, to give you the EV or Enterprise Value. 

Trading, Transaction and Experience Multiples

Broadly speaking, valuation multiples are used in two different methodologies as explained above, either in a trading comparable analysis (i.e. observed from companies listed on the stock exchange), or a transaction comparable analysis (i.e. observed from M&A deals). However, practitioners also sometimes make use of multiples known as ‘experience’ multiples. The differences between these three are expanded upon below. 

Trading Multiples (a.k.a. ‘Comparable Company Analysis’, ‘CCA’, ‘Comps’)

• Comparable data is based on market prices of comparable, listed companies (a so called ‘peer group’)
• This valuation method reflects investor sentiment in sectors and markets
• Assumption: Share prices are an accurate reflection of fair market value
• Adjustments are often necessary (i.e. discount for lack of liquidity and/or marketability)

Transaction Multiples (a.k.a. ‘Comparable Transaction Analysis’, ‘CTA’, ‘Precedent Transaction Analysis’, ‘PTA’, ‘Precedents’)

• Comparable data is based on purchase prices in transactions with similar companies
• Strategic premiums, control premium, etc. are included in the transaction values

Experience Multiples

• Based on
  • Industry estimates
  • Surveys of market participants
• In practice, there is acceptance of such multiples in many industries
• Often used for very small businesses and early stage companies
• Examples: 
  • “Pharmacies are valued at 0.8x – 1.2x annual revenue“
  • “Wind farms are valued at €0.8m – €1.2m per MW installed capacity“
  • “SaaS start-ups are valued at 10x Sales”

Equity Vs. Enterprise Multiples – Which To Use?

The ratio is either related to the Equity Value or ratios related to the Enterprise Value. 

An example of an equity multiple:

Price / Earnings

An example of an enterprise multiple:

EV/Sales, EV/EBITDA, EV/EBIT and practically all non-financial multiples (e.g. EV/ARR, EV/barrel, EV/MW, EV/Click, etc)

The decision as to whether to use an equity multiple or enterprise multiple is based on the metric we deem most appropriate, as well as the availability of data. The higher up in the P&L statement the metric is that is selected, the more assumptions are made on the similarity of operations of the respective companies. 

For example, if we use the EV/Sales multiple (with Sales being the first item on the P&L), we disregard the operating (profit margins), capital (debt and interest) and asset structures (depreciation & amortization) of the companies. This is useful if we have limited information or are comfortable that the companies operate on a similar basis, but may become problematic if there are material differences in the way the companies operate.

On the other hand, if we use the P/E multiple (with Earnings being the last line item on the P&L), we have already taken the operating, capital and asset structures of the respective companies into consideration. We are thus comparing the prices per each unit of actual earnings.

Note that, because the impact of debt (in the form of interest), falls below EBIT on the P&L, typically any metric below that would be an equity metric and any metric above that would be an enterprise metric. This is because Enterprise Value consists of Debt + Equity but Equity Value only consists of Equity.

Common Types of Enterprise Valuation Multiples

Here are some common enterprise valuation multiples:

EV/Sales – This is the ratio of Enterprise Value to the sales of a company.

EV/EBITDA – Shows the ratio of Enterprise Value to the EBITDA of a company. It is often used as it eases the comparability between companies from the same industry (without having to worry about asset or capital structure). 

EV/EBIT – Indicates the ratio of the Enterprise Value and the EBIT of a company. This is a very similar multiple to the EV/EBITDA excludes D&A (thus the asset structure).

EV/EBITDAR – The only difference between EBITDA and EBITDAR is that the latter also includes rental costs. Including this makes it easier to value companies which have nonrecurring or variable rent, like restaurants and casinos. 

EV/Invested Capital – This multiple shows the proportion of Enterprise Value to the Invested Capital of a company. This expresses the Enterprise Value as a proportion of capital invested by debt and equity holders. 

Common Types of Equity Valuation Multiples

Here are some common equity valuation multiples:

Price/Earnings (“P/E”): The price earnings ratio is the ratio of the price to the earnings of a company. It shows the amount an investor is willing to pay for one dollar of net earnings. 

Price/Book: This multiple compares the price to the book value of a firm.

Dividend Yield (Dividend/Price): The dividend yield is used to compare the returns from owning shares (without taking share price appreciation or depreciation into account) with cash dividend returns.

Which Year to Use?

When the comparable companies approach is used, it is critically important to use the same P&L metric for the comparable company(ies) and the target company. For example, if I use the P/E multiple, I should use the Earnings of the comparable companies for the same year (say 2021) as for my target company.

Typically, one would initially use the last actual year as that is based on facts with no assumptions or estimates. One can, however, also conduct valuation exercises for several years for each multiple, i.e. using an EV/EBITDA approach for 2021, 2022 and 2023 (provided we have forecast EBITDA figures for our comparable companies and our target company).

Comparisons Are Often Using Companies in the Same Industry

Usually, it is very important to only compare companies from the same industry when conducting a valuation with multiples. The main reason is that trading multiples are different in various industries because of various factors that might be specific to an industry, such as market size, market growth, capital intensity, leverage, etc. It is therefore common to see industry-specific statements such as “US tech firms are trading at 20x earnings”, or “Construction companies are trading at 2x book value.” 

Valuation with EBITDA multiples

Valuation with EBITDA multiples is often chosen because it disregards the effects of differences between companies’ debt costs (interest), taxes and depreciation & amortization on the valuation. As these are excluded from the valuation, the approach assumes that these comparable companies have similar operating characteristics (such as sales growth, margins and return metrics). 

The post Valuation Using Multiples—What Is It and How Does It Work? Core Ideas Explained appeared first on Valutico.

This complete guide to the discounted cash flow (DCF) method is broken down into small and simple steps to help you understand the main ideas. 

We’ll walk you through what a discounted cash flow analysis is, what it is used for, as well as what all the distinct terms mean, and provide step-by-step instructions on how to calculate company value, and share price, using the DCF method. 

If you want to read to a step-by-step example of a DCF, skip to the end of the article here.

If you want to understand the pro’s and con’s, skip down to here.

If you want to understand the basic logic first, keep reading.

What is the Discounted Cash Flow Method?

What is the discounted cash flow method? The discounted cash flow (DCF) method is one of the three main methods for calculating a company’s value. It’s also used for calculating a company’s share price, the value of investments, projects, and for budgeting. The DCF method takes the value of the company to be equal to all future cash flows of that business, discounted to a present value by using an appropriate discount rate. This is because of the time value of money principle, whereby future money is worth less than money today. That’s why it’s called a ‘discounted’ cash flow.

Context of DCF: There are three main approaches to calculating a company’s value. The first is 1. the intrinsic or income-based approach, also known as an entity approach, then there is also 2.  the asset-based approach also known as the cost-based approach, and finally 3. the multiple based or ‘comps’ (comparable company analysis) approach. A DCF analysis is the main income-based approach—an approach based on the company’s own cash flows. 

The DCF Formula

We’ll explain what all these terms mean, as well as the logic behind the method, below. 

DCF = discounted cash flow

CF_i = cash flow period i

r = interest rate (or discount rate)

{n} = time in years before the future cash flow occurs

In essence, this equation simply adds up all future business cash flows, but discounts each one. 

A discount rate, or discount ‘factor’, is calculated and applied to each year’s cash flow, in order to arrive at the present value. 

Understanding the Logic Behind a DCF

Why is it Called ‘Discounted’ Cash Flow?

Let’s imagine you’re valuing a company that’s going to operate for 3 years and then stop operating. 

How much is it worth?

You could say it’s worth whatever cash flows it produces, each year, for these 3 years. 

Like this:

$10 million + $10 million + $10 million.

No points for working out that this company is worth $30 million. But here’s the big problem with this basic approach:

Is that predicted $10 million of cash flow in the future, really equal to $10 million in your pocket today?

The answer is no, it’s not.

What’s worth more to you out of $10 today or $10 in three years’ time?

Your answer is probably the money right now, and so you can see money today is worth more than money in the future. This actually has a name—it’s called the Time Value of Money (TVM) principle, and there are several reasons for this to be the case:

Uncertainty—future money is not guaranteed. 

Inflation—you will be able to buy less with that $10 in 3 years.

Investing—you can invest that $10 today, earn, say, 10% interest per year, and in 3 years it will be worth $13.31.

So, to be more accurate in using cash flows to value a business, you’re going to need to discount the money to be received in the future. In particular, reduce this figure of future cash flow, to bring it in line with what that amount of future money could be said to be worth today. Only at this point do you add up all the ‘discounted’ cash flows, to get your company value. It should now–we hope–be obvious why it’s called a discounted cash flow analysis. 

Following the Fundamental Steps in a DCF

As just explained, in a DCF analysis, you discount the future cash flows in order to value a company more accurately.

So, by how much do you discount them? Well, by a certain discount factor. You then apply this discount factor to each year’s cash flow. 

This discount factor is the main method underlying a DCF. Once you apply these discount factors, in essence, you then simply add all the years together–with the factors applied–to give you the value of the business. 

The discount factor for each year is calculated as follows:

1 / (1 + r) ^ n

r = discount rate

n = number of discount years

Looking at it differently, this calculation provides you with a discount factor that tells you how much you’d have to invest today, in order to get to that figure of $10 million in year 1, $10 million in year 2, in year 3, and so on. 

Remember, present money can earn interest and be worth more in the future. That is the fundamental principle underlying this method. 

Adding A Row for the Discount Factor

Here we will add on a row in our table to illustrate.

You don’t need to worry exactly how the formula itself works too much to perform the method. 

The important figure there is r, which we’re using as the discount rate in this whole equation. In the full DCF, it will often be the WACC, which we’ll come to later. But here, we use what interest we could get from an alternative investment in the market, called the Market Rate. This is the rate of return you’d get if you invested your money today instead. 

In our example, it’s 10%. 

With that r figure plugged into the above formula, you find the discount rate appropriate for each year, as so.

Every year you discount it by a different factor. The further in the future, the more you discount it and thus the lower the discount factor. 

Then you simply multiply the cash flow each year by this discount factor. 

This provides you with your discounted cash flow figure. 

You get:

Then if you add them all together, instead of getting $30 million… you get: 

$9 million + $8.3 million + $7.5 million = 

$24.8 million

This is quite a bit less than the original $30 million figure, so you can see the real impact of the TVM principle and its impact on the DCF approach right there. This value is widely referred to as the “Net Present Value” (NPV). 

Congratulations, you have now seen, quite simply, the logic behind a discounted cash flow method. Does this make sense? We hope the underlying logic is fairly clear…

But, you may have spot something that’s not particularly realistic. Businesses often don’t stop operating after year 3. In fact, we don’t actually know how many years they’ll operate for. So, how do we account for the value of the cash flows across all these possible years in the future (which may be forever)?

Well, the short answer is after that forecast period where we estimate each year’s cash flows then discount them, we add a single number at the end to account for all the theoretical years in the future, called the Terminal Value (TV). We’ll explain how this works next. 

But first, a quick aside, which you can feel free to skip if you want to jump ahead:

Explaining The Terminal Value

What happens after year 3 of our projected forecast?

How many years does the company last and what is the total and, more importantly, the Present Value, of these cash flows across these future years?

We need to know this sum total number so we can add it to the other three years of cash flows, to get the full value of the company’s entire life. 

Well, the DCF method uses a number called the Terminal Value to represent this assumed sum total. This Terminal Value is the number the DCF method uses to represent what the business is worth beyond your initial 3, 5, 10-year (etc.) forecast. It’s a very important number in a DCF analysis because it represents a large chunk of the total valuation amount.

“How do I calculate the Terminal Value?” you may ask. Well, once more you can rely on a widely used formula. 

FCFn x (1 + g) / (d – g)

And you need three numbers to do this. 

• FCFn is the free cash flow in year n,  being the last forecast period
• g is the terminal growth rate.
• d is the discount rate (which is usually the weighted average cost of capital (WACC), r in our previous example)

This formula is known as the Gordon Growth formula.

What Happens When We Add the Terminal Value?

Let’s do a quick example to illustrate the portion of the final valuation that is represented by the Terminal Value.

Let’s say the discount rate, using the WACC, is 12% (so, this is a risky business – the higher the WACC, the riskier the business as investors expect to be compensated for taking on additional risk).

The terminal growth rate is 1.7%. 

(The growth rate always has to be lower than the growth rate of the economy, otherwise given enough time the company will grow larger than the economy, which doesn’t quite make sense).

If we plug these values into the above formula, this Terminal Value calculation gives $98.7 million. But remember—you still have to apply the discount factor at the end of the forecast period. Using the WACC of 12% in year 3 provides a discount factor of 0.75 which produces a Net Present Value of the Terminal Value of:

$74 million. 

Can you remember how much our 3-year business was worth before this step? It was worth $24.8 million. So the Terminal Value here is three times as large! 

Incidentally, adding them together gives the total value, which would then be $98.8 million. You can see why the Terminal Value is so important to the valuation as a whole! 

Two Methods to Calculate the Terminal Value

As mentioned, the Terminal Value is highly important to a DCF valuation because it takes up a large chunk of the whole valuation. 

There are two main methods to calculate what the business is worth after the years of your forecast cash flow. That is–of course–two ways to calculate the Terminal Value. 

As it turns out, one major way is to assume the company will exist forever. 

This is the perpetual growth method, also known as the Gordon Growth Method, which is the one used in the example immediately above and is particularly favored by academics. 

The second approach is by assuming the business is sold at that point. 

This approach then becomes technically a multiple-based approach, because of the way it works. Practitioners assume the business is sold as a multiple of some financial metric like EBITDA, based on what they can see today for other businesses that were sold, and what these comparable trading multiples are. 

Some practitioners will use an average of both methods. 

How to Determine the Correct Discount Rate to use?

In this article, we have referred to the discount rate to be used to discount the future cash flows as the Market Rate (r) or generally as the discount rate (d). 

The principle behind determining the correct discount rate to use is that the discount rate needs to adequately reflect the riskiness of the business being valued. 

In most DCF analysis, practitioners make use of the Capital Asset Pricing Model (CAPM) to calculate a discount rate that reflects the riskiness of the business being valued. The details of how the CAPM works is beyond the scope of this article but in short, the formula is as follows:

Ce = Rf + B x (Rm – Rf) + Cp

Ce = Cost of Equity

Rf = Risk-free Rate

B = Beta

(Rm – Rf) = Equity Market Risk Premium

Cp = Cost of Equity Premium

If the WACC is used to discount the cash flows (more on this below), then it is calculated as follows:

WACC = Ce x [E/(D+E)] + Cd x (1-t) x [D/(D+E)]

Ce = Cost of Equity

E = Equity 

D = Debt

Cd = Cost of Debt

t = Tax Rate

How to Value Stocks Using DCF?

Valuing stocks using DCF is pretty much the same method when valuing a company but you just take one extra step. 

Once you have added all your future discounted cash flows together, you get the value of the business today. Then you simply divide this figure by the number of shares. So if we take our example from before and we know they’ve issued 10,000,000 shares. We divide the value of the company by 10,000,000, so we get $9.88 per share. This gives us our own unique determination of what the share price should be. 

The 5 Major Steps to Calculate a DCF

Really, conducting a DCF is just like following a recipe. 

There are some simple steps to take, and these are often done in MS Excel. Or, if you have a tool like Valutico, then you just need to enter some key figures and the software does all the work.

But if you want to be able to go through the steps yourself, let’s do that now. 

Here is a recommended order of steps to follow: 

Step 1. Forecast cash flow. (‘free cash flow’)

Step 2. Calculate the discount rate. Often, the Weighted Average Cost of Capital (WACC) is used*. 

Step 3. Calculate the Terminal Value. 

Step 4. Discount the cash flow. Discount the Terminal Value. 

Step 5. Add up all the figures you have to arrive at the Net Present Value. Depending on the exact methodology and discount rate used, this could be the Enterprise Value or Equity Value.

*the WACC is one popular discounted cash flow method (DCF WACC). However there are other methods. 

Why Would You Use a DCF Model?

DCF is widely used in valuing companies, and it is used widely in valuing stocks as well. But it can be used in several ways, including to:

• Value a business you want to sell, or for a business you want to purchase.
• Value a company’s stock price to compare it to the actual stock price, as one piece of information to help you decide whether to invest.
• Value a project.
• Assess the impact of an initiative, like a cost-saving programme or entering a new market.
• Use for internal financial planning and accounting (FP&A) purposes, such as budgeting, and forecasting.
• Allow a company to raise money.

Problems with a Discounted Cash Flow Analysis

No approach to valuing a company or stocks is completely perfect. 

Just remember, when valuing you are making educated guesses about the future. 

If you get these educated guesses wildly incorrect, then your valuation will likely also be off. 

But let’s take a closer look at some of the drawbacks specific to the DCF approach. 

Garbage in. Garbage out. 

Cash flow: A lot hinges on getting these cash flow projections correct. It might be quite straightforward to project cash flow for year 1, but when you get to year 2, and especially years 3, 4, 5 and beyond, in many industries this becomes almost impossible to predict with a high degree of certainty. Some industries like oil and gas might lend themselves to you having a longer forecast period of say 10 years, but even these industries are subject to the unknown future. When you’re trying to predict cash flow for many businesses in 5 years’ time it can be particularly difficult, and becomes closer to complete guess-work. 

Moreover, year 4 cash flows are determined by year 3 cash flows, as that is the way the business works. Year 5 by the year before, and so on. If you make a mistake in the early years, this deviation can be magnified in the future. Small variations early on are magnified later. 

Strengths of a Discounted Cash Flow Analysis

The DCF approach is widely used and considered a strong approach for valuing a company or stocks. Many would call it the leading approach. Here are some of the main reasons:

• It is a so-called ‘intrinsic’ approach based on data that directly reflects the company’s actual financial performance. 
• It allows the practitioner to consider multiple distinct financial performance scenarios, whereby they can compare different possible futures based on making different assumptions. 
• Relying on cash flow data, it incorporates a wide range of important financial metrics, such as net income, working capital, and capital expenditure. 

What are the Different DCF Methods?

This article has outlined the simple form of a DCF analysis. However, there are multiple versions that differ in how they are calculated and when they should be applied:

• DCF WACC (simplified)—largely what this article has been describing, your basic DCF which calculates Free Cash Flow to the Firm and discounts these cash flows using the WACC as the discount whilst keeping a constant capital structure (D/E ratio) throughout the forecast period. 
• DCF WACC—similar to the above except that it calculates a different WACC in each forecast period based on a changing capital structure (D/E) and thus a changing beta in each period.
• Flow to Equity – this calculates the Free Cash Flow to Equity and discounts these cash flows using the Cost of Equity.

Note that in theory the above three approaches should deliver an identical valuation result thus the choice of what method to use is simply down to the level of information at hand and personal preference.

A DCF Example – Each Step in a DCF Calculation in Order

In practice, you can calculate a DCF using MS Excel. However, if you do multiple valuations throughout the year, or valuations you want to update regularly, then a tool like Valutico makes things significantly easier. 

To understand the steps, let’s go through each in turn with our DCF example. 

Step 1. Cash Flow

You need the ‘unlevered’ cash flow*. To calculate this free cash flow (FCF), you need to add up the following figures (you do not add the tax rate, that is shown below as it’s used to calculate the tax amount). 

The CapEx, tax, and in this case non-cash working capital, are negative. 

Add these to get the free cash flow for that single year (or particular period, like 6 months). Step 1 done. 

*You can also do a different ‘levered’ cash flow method (Free Cash Flow to Equity), which ‘in theory’ at least should provide the same outcome, but unlevered is the more commonly used. Unlevered is the operating cash flows (Free Cash Flow To Firm), whereas levered is the cash flows available to shareholders once other claims (i.e. debt) has been paid. 

Step 2. Discount Rate

Now, we need to calculate the discount rate. We will use the CoE and WACC formulas described above. Therefore, we can put in the following values:

We had to calculate the Cost of Equity using the CAPM method as previously described. Now, we’ve got that, we can move onto two core components of the WACC equation, to finally give the WACC. 

This is:

Finally, we have our discount rate.

Step 3. Terminal Value.

Now, we need the Terminal Value. 

There are two methods, and one option is to combine them both and use the average. 

First, the perpetuity growth method (or Gordon Growth model).

And then, the exit multiple. 

The perpetuity growth formula is:

Free Cash Flow on last year + 1 / (discount rate – growth rate)

So we need:

The WACC we need because it’s our discount rate in this equation.

But we also need the free cash flow from the last year. 

So here is the EBITDA and FCF year on year for our entire 5-year forecast period:

Then taking these we get the following:

Step 4. Putting it all together.

Now that we have the WACC and the Terminal Value, we can do the discounting.

Both the free cash flows, and the Terminal Value need to be discounted.

Then we sum these, and get the Enterprise value (EV). 

Let’s go. 

Remember, the discount factor equation is:

Discount factor = 1 / (1 + r)^n

In this case, we have chosen to use WACC for r. 

So we get the following:

And this enterprise value is the value of the business. 

Congratulations, if you worked along, you have now valued a business using the DCF method.

If you perform multiple valuations per year, and valuations are a significant part of the work you do, then using a tool that automates most of the process can make your life much easier. Try booking a demo, if this applies to you. Otherwise, we hope the explanation above has helped you wrap your head around what a DCF analysis is, and how to use one.

The post Discounted Cash Flow Analysis—Your Complete Guide with Examples appeared first on Valutico.

It’s easy to get tripped up by assumptions when valuing a business, especially if you’re in a hurry to produce results. That’s why performing the right sense-checks can help you determine accurate valuations. 

Our experts came together to discuss what they believe are the most useful sense-checks to help ensure accurate company valuations.

We hope you find these useful, and check back in soon for more content like this as we’ll be exploring additional ways to improve your valuations.

1. Avoid a hockey stick forecast

Your growth forecast shouldn’t look like a hockey stick… generally speaking. Ensuring that your financial forecast makes sense is top of our list of checks. 

We’re dealing here with one of the primary valuation methodologies—the Discounted Cash Flow (DCF) method. Hockey stick-like growth in your DCF projections may indicate these projections are not realistic.

A useful tip is to check for consistency between the forecast margins and historical margins—EBITDA margin, EBIT margin, and Net Income margin. By checking that the forecasts actually reasonably match up to what was achieved in the past, you can at least assure that your forecasts are structurally similar to the real-world conditions that the business currently faces.

There needs to be a really good reason for such a large increase in margins… and usually the reason isn’t quite good enough.

2. Perpetual growth rate too high

Again, in a DCF analysis – the one we mentioned above and favoured by academics and practitioners alike – when you project the future cash flows and discount them to determine what the business is worth, one of the most sensitive inputs to your overall valuation result is the final year—the so-called ‘terminal year’.

That is the year that represents all future years extending out into perpetuity (all theoretical future years of the company).

Because that figure contributes such a substantial portion of the overall valuation – it is often more than all the other years combined – you need to very carefully check the assumptions behind it (it can often be more than 70% of the final valuation result!)

One critical component of the terminal value is the perpetual growth rate.

The perpetual growth rate is an assumption of the annual growth rate until the end of time. 

The most widely accepted assumption for the perpetual growth rate is that company’s country’s long-term inflation target, provided it does not exceed the country’s historical GDP growth rate. This is because otherwise, logically, as the company grows it will eventually grow bigger than the entire economy of its country, which obviously doesn’t make much sense. 

So there’s a narrow margin within which your perpetual growth rate lies and makes sense, but small differences can have a big impact.

The rationale for using the long-term inflation target is that it assumes that the business has reached such a mature state that it is no longer increasing market share or expanding in any other way, but simply increasing sales prices (and free cash flow) in line with all other prices in the economy (i.e. inflation). For the UK, for example, the long-term inflation target is 2% whereas for South Africa it is 5%.

You can find the long term inflation rate on websites like TradingEconomics.com.

3. Compare operating metrics with peer companies

Well-loved by practitioners, a common way to value businesses quickly is through the ‘comps’ approach, wherein you compare the target company to other similar businesses, either in terms of what the similar business (or part of it) recently sold for (transaction approach), or how much similar peer companies are valued at as a whole, according to its market cap (i.e. the value of all its shares added up).

Selection of your so-called “peer group” in this type of valuation is thus very important and requires a lot of thought.

One critical check that is often overlooked, is to benchmark the operating metrics (such as sales growth, EBITDA or EBIT margins) of the peer companies, against the company you are performing the valuation on.

It’s usually a good assumption that companies that operate in similar industries, exposed to similar industry risks, should have similar operating metrics.

If some of the peers have wildly different operating metrics, then you should probably question whether these companies should be included, or at least try to understand why.

4. Don’t include too many transactions

Another way to value a company is through comparing how much similar companies sold for (wholly or in part) in the past, and using that as a comparison basis.

But finding comparable transactions can be more difficult than simply finding appropriate peers.

Our team has observed that there can be a tendency to try to find as many transactions as you get peers, or a similar number. But this is often a mistake, and something that you should watch out for.

It’s a mistake because you can end up with outliers—transactions that are not a good fit for your company, as a comparison point.

Basically, you want to focus on the quality of your comparable transactions, rather than the quantity.

It’s far better to have one or two really appropriate transactions, than 15 or 20 transactions that aren’t that relevant.

One thing that signals that a transaction is not an appropriate comparison is when a very small percentage was acquired. This typically happens as a follow up to an earlier transaction or in case of an investment rather than an acquisition. Transaction multiples are most useful for transactions involving a controlling stake being acquired (i.e. at least 50%) as that is typical of a private transaction. 

5. Check for discrepancy between valuation methods

In an ideal world, the different valuation methods should give similar results… in theory…although in practice this doesn’t always happen. 

If there are major differences between estimations from different valuation methodologies, it may mean that some assumptions need adjusting.

For example, if the DCF is delivering a valuation that is 2x or 3x that of the comparable company approach, this could indicate that the discount rate used may be too low, or the discount applied to the observed multiples may be too high.

One very important check at the end of your valuation process is to see that the various methodologies speak to each other. A football field chart such as the one shown below is very useful for such a check: 

If  there are vastly different results you might want to double-check your key assumptions to find out what has gone wrong, or make sure you understand the reason for the difference.

Ultimately, of course, you are not using every valuation method, just the ones that fit the purpose for that type of company and your particular scenario. But it’s important to understand why differences have arrived between the pertinent methods so you can ensure your final results are valid.

Valuing a business is a precise exercise that warrants lots of checking and double-checking of assumptions. We hope you found our experts’ most recent guidance on this topic useful and that it allows you to conclude your business valuations with the confidence that the results make sense.

If you want to learn more about valuations, we offer a valuation course. Please get in touch to request a brochure – we’ll email it to you straight away.

Or if you already perform valuations regularly and you don’t yet have a subscription to Valutico, obviously we strongly recommend you book a demo to see how we can help you drastically improve the speed at which you deliver accurate, defensible valuations.

Of course, if you just want a one-off valuation, then we also can help with that.

The post 5 Simple Sense-Checks That Vastly Improve Your Business Valuation (According to The Experts) appeared first on Valutico.