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8) Business valuation: when to invest or divest your money
The following short section will introduce you to the simplest notions of business valuation, so that you will be able to develop an idea of how to value a business properly, and thus of when to invest your money and when to divest it. Since it is not our purpose to delve into the technical details of financial engineering, we will focus our attention only to the two most used methods in practice: the DCF method (Discounted Cash Flows Method) and the Peers Multiples method. For more details on the topic of business valuation, you can consult specialized books on the topic and discuss these notions on the forums.
A. The DCF method
The DCF method is what can be called an “intrinsic method” because it relies directly on the anticipated results of your company (as opposed with “comparison methods” which value a company by comparing it with other comparable firms).
Before explaining the mechanisms of this method, we need to introduce the notion of Free Cash Flow after tax (FCF after tax). We call free cash flow after tax the quantity: EBITDA – EBIT*(1-T_C) – Change in Working Capital for the period – Capex, which represents the cash flows generated by the firm and available to shareholders and debtholders (since taxes and investments have already been taken into account).
According to the DCF method, the enterprise value will be given by the sum of these free cash flows discounted at the WACC (let’s denote it by k) of the company:
Enterprise value = sum(FCF_i/(1+k)^i), where the sum is taken over the Free Cash Flows FCF_i (the Free Cash Flow of year i), where i goes from 0 to infinity (in theory only, because in practice you won’t be able to forecast free cash flows until infinity).
Note that by enterprise value we mean the market value of (Shareholder’s Equity + Debt), since the free cash flows belong to the shareholders and the debtors. In order to infer the market value of equity, you will thus need to subtract back the market value of debt (which can be assumed to be equal to its book value if the company is not financially distressed; indeed, in case of bankruptcy, debt will be repaid first and shareholders will be paid last. Therefore, debtors are in a safer position, the market value of debt is less volatile than that of equity and can be approximated by the book value of debt if the company is not financially distressed. If the company is financially distressed, i.e. if its risks of bankruptcy are too high, then the market value of debt will be smaller than its book value, reflecting the fact that very likely debtors won’t be able to recover the principal of their loans).
Practically, you will not be able to project the Free Cash Flows up to infinity, and what you will want to do is project them over the next n years (n will depend upon the visibility you can have over your business operations) and then use a terminal value for the enterprise after n years. But how will that terminal value be determined ? What you can do is take the projected cash flow from the end of year n and assume that it will keep growing at a rate of g forever; mathematically, this yields:
Enterprise value =
sum(FCF_i/(1+k)^i), i=0..n) + sum(FCF_n*(1+g)^i/(1+k)^(n+i), i=n+1..infinity) =
sum(FCF_i/(1+k)^i), i=0..n) + [FCF_n/(1+k)^n] x 1/(1-(1+g)/(1+k)) =
sum(FCF_i/(1+k)^i), i=0..n) + FCF_n / [(1+k)^(n-1) x (k – g)]
(Note that we simply summed a geometric series in order to derive the explicit formula for the sum giving the terminal value)
The market value of equity should therefore be given by:
sum(FCF_i/(1+k)^i), i=0..n) + FCF_n / [(1+k)^(n-1) x (k – g)] – (Market value of debt at t=0).
In the above, you probably identified that the terminal value of our company (i.e., its value at the end of year n) is given by: FCF_n / [(1+k)^(n-1) x (k – g)]. There exist other methods to determine such terminal value. For instance, you could decide that such a residual value would be a certain multiple of year n’s EBITDA, etc … What truly matters, eventually, is to end up with a terminal value which gives you the best approximation of reality.