This blog is an extension of our previous blog on “The Mathematical Complexity Involved in Deriving Terminal Value”.
DCF is an elaborate valuation methodology. At the end of the day, it has more assumptions than data. If you look at the assumption sheet of any decently designed financial model leading to valuation, its assumption sheet will have the highest number of rows populated.
Further DCF valuation is a time-consuming exercise and at times, any effort put into this may be spread over weeks.
In life, we all must have come across various situations where we did not have the luxury of time to build a DCF model every time we spotted an opportunity. Even if we have the required time, we may not have enough data/ guidance to design a detailed valuation model. At times, you might have been pressed by your clients, senior management, colleagues or others to give a quick view of the valuation of a company. There comes to our rescue another methodology of valuation called “Relative Valuation”. Relative valuation is quick and makes lesser assumptions.
Under relative valuation, we derive the value of a company with relation to the values of listed companies whose stocks are already being traded in markets. It’s a value derived in relation to an already existing value, hence it’s also called relative valuation.
Relative valuation assumes that the total value of a company is the function of just some key financial or operational parameters and the corresponding multiple ones. Sales, EBITDA and PAT are three such ever green parameters. Then there are some industry specific parameters such as:
Exhibit 1: Industry Specific Relative Valuation Multiples
In the simplest of its form, a multiple say P/E, can be interpreted as price market being willing to pay for every 1 unit of earnings generated by the Company. The EV/Sales, EV/EBITDA and P/E multiples are functions of:
1. Growth rates
2. Efficiency reflected by EBITDA margins, PAT margins, etc.
Relative valuation is thus highly dependent upon the quality of the peer set we choose for the company. Ideally, the peer set should comprise of those companies which have similar risk return profiles as that of the company you are undertaking valuation for. Only when the risk profile is similar, this peer set can act as a benchmark for valuation of the company under consideration. It is therefore extremely important that you apply the right criteria for selection of the peer set.
All the risks associated with a company can be broadly classified into three types:
Exhibit 2: Risks associated with a Company
These three put together measure the overall ability of a company to generate PAT (earnings) that truly belong to the shareholder.
If we choose a listed company in a way such that it has got all the above three risks same as that of our unlisted company, beta (measure of risk profile) of the listed company will be an appropriate beta for our company. Additionally, this listed company will also be the right benchmark for relative valuation of our company. Let’s now follow the steps below:
1. Equating the Business Risk:
- Select all the companies listed in the sector your company belongs to.
- Filter out those having similar revenue size, similar growth rates in sales in the past, operating in similar geographies with similar products and/ or services portfolio as your company.
- While filtering, ensure the similarity of factors contributing to the revenue in listed companies and your company.
- By doing so, we now have a set of companies having the same business risks as your company.
2. Equating the Operating Risks:
From this filtered list, further select those companies that have near about:
- Same EBITDA margin
- Same EBITD magnitude and
- Similar historical EBITDA trends as your company.
In this step, you have theoretically made the operating risks of the companies same as that of your company.
The peer set that you now have can be used as a benchmark for relative valuation and beta of your own company. However, before you can use the beta of the peer set as a benchmark, two more steps are involved:
- Financing risk has been quantified using the equation below:
Unlevered Beta measures all the risks except the financing risk. By unlevering the beta you have stripped the stock of any financing risk. As leverage increases riskiness of the equity also increases. For the set of companies identified in step 2 unlever the beta using the equation above.
- Take the average of unlevered beta and re-lever this using the debt to equity ratio of your own company or industry average. You now have a levered beta for your company. Since your company is smaller and unlisted, you may add another 10% to the calculated beta to make it appropriate for your company.
4. If you have understood clearly the concept and what we have just done, it won’t be difficult for you to realize that
- Unlevered beta of the peer set should theoretically be identical and practically be very close.
- What we have essentially done is made the unquantifiable risks across listed companies and our company identical and adjusted the quantifiable risk to make beta suitable for use.
5. Theoretically, this is what you should do but in real life it may happen that you don’t get a peer set if you apply the selection criteria so strictly. You may have to relax them. This will certainly introduce error but probably that’s the best you can do and hence be willing to live with that error.