03
Nov
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Valuation Drivers
Valuation of a business enterprise reflects the expectation on future potential and performance of the business. Valuation Drivers are factors which significantly affect the value of the business enterprise. There are many factors affecting the value of the business including both qualitative and quantitative factors. Many of these factors may not be controllable at enterprise level such as the market environment, industry wide scenario like technological changes, economic activity like the current covid crisis, government initiatives and regulations, etc. Qualitative factors such as the human capital, management effectiveness, marketing and branding, products and services are important factors which affect the financial performance of the enterprise which in turn affects the value of the firm.
In this article we discuss the valuation drivers in the financial performance which can significantly affect the value of the enterprise.
1. Leverage Ratio or Debt to Equity Ratio – This is one of the key valuation drivers. This can affect the valuation in the following ways
It increases the discount rate – The discount rate is increased on account of higher beta as the unlevered beta of the industry is re-levered to arrive at an expected beta of the company. Higher leverage ratio means higher levered beta which results in higher discount rate.
If the leverage is too high, it also increases the survival risk of the company which again raises the discount rate. A higher discount rate implies lower valuation.
A high amount of debt also reduces the equity value as it is reduced from the Enterprise Value (The value which is arrived at after discounting the Free Cash Flows to Firm and the Terminal Value) to arrive at the Equity Value of the company.
Hence a high leverage can impact the value of the company negatively and vice versa.
2. Working Capital Investments and Cash Conversion Cycle Management – Another important valuation driver is the Working Capital Investments or Cash Conversion Cycle management which is quite often neglected. Cash Conversion Cycle is the sum of Receivable Days Outstanding and the Inventory Holding Days and reduced by Payable Days outstanding. A company with higher cash conversion cycle will imply high investments in its working capital (Receivables and Inventory). A high investment in working capital will result in increase in working capital requirements as the business grows which will reduce the free cash flows available for the company.
Hence, a company should evaluate its receivables days outstanding and inventory holding days very carefully and focus on reducing these to minimum which will help increase the value of the company.
3. Capex and Investment in Fixed Assets – A company with higher investments in fixed assets such as a manufacturing concern, will have lower cash flows than a trading concern with minimal assets, provided all other things being constant.
Future Capex requirements may include both maintenance capex and incremental capex. A company should carefully evaluate what would be the maintenance capex required to maintain the efficiency and utility of its existing plant and machinery and other productive fixed asset.
If the company includes incremental capex in its projections, then it is important to match the explicit forecast period with the expected gestation period of the new investment so that the results of the new investments are also included in your cash flow projections along with the cash outflow for investment itself.
Generally, higher the capex, lower the cash flows and lower the valuation.
4. Revenue Growth and EBITDA Margin – These are kind of self explanatory metrics. EBITDA is considered as a proxy for the operating cash flows generated by a company. These basically imply the financial performance of the business and this is primarily what drives the valuation of the business. Higher the revenue growth and EBITDA, higher the cash flows and higher the valuation.
5. Explicit Forecast Period and Terminal Growth Factor – Usually the explicit forecast period should be equivalent to a period of an expected high growth period.
The various factors for taking an explicit forecast period include factors like investment gestation period, high growth period, etc. The length of the explicit forecast period should be based on the factor for which the period is being considered. E.g if the explicit period is taken assuming high growth then the explicit period should be equivalent to the high growth period of the company. The sustainable growth or the terminal growth should be considered post the explicit period.
6. Investments – Sometimes, the value of investments the company has significantly affects the overall value of the company. Investments are usually the excess cash which the company has either not yet invested in the operations of the company or has not returned to the shareholders. Higher the investments, higher will be the value of the company.
However, it is also to be seen that If the investment amount is significant and the return on investments is lower than the return it can generate from its operations, then it signals that the management is not efficiently utilizing its surplus funds which can put a drag on the projected financials and hence bring the value down.
A business enterprise should start working on managing these factors and turning them favourable to enhance its value at least couple of years prior to a potential transaction. While some of these valuation drivers may be controllable but it may not have a high impact while others may not be controllable but have a high impact on valuation. As a business owner, the focus of the management should be on controllable high impact valuation drivers.
At FinVal, we help enterprises increase their intrinsic value by providing them guidance and hand holding them on identifying the high impact controllable valuation drivers, comparing them against industry standards and help in building strategy on improving these factors.
