Equity valuation is an interesting, complicated & important area of interest to various stakeholders like investors, financiers, government authorities & prospective investors.
A recent spate of IPOs at steep valuations has raised eyebrows & intense discussions amongst the investment community & therefore calls for a look at the equity valuation techniques.
As finance & investment professionals, we are all familiar with the following techniques of equity/business valuations:
- Discounted Cash Flow (DCF)
- Comparable Company Analysis
- Precedent Transactions
- Others - a) Asset-based valuations, b) Dividend Discount Model (DCM), c) Market capitalization.
Discounted Cash Flow (DCF)
DCF is the most popular methodology under which the present value of a business and consequently the value of equity shares are estimated by forecasting future cash flows and discounting the cash flows to their present value using a discount rate, which is typically the cost of equity.
While this is the most popular & widely used technique, the challenge is to develop & forecast realistic cash flows covering all aspects of business. Prospective investors would ideally look at different scenarios before finalizing their investment decision - optimistic, pessimistic & realistic scenarios considering key revenue and cost drivers having a significant impact on the businesses.
Comparable Company Analysis
This is a relative valuation method that uses key financial metrics like price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S) ratios to compare with its peers, which are publicly traded. This method helps to quickly assess the company's value vis-à-vis its peers & at best helps prospective investors to make a comparison with their peers.
Precedent Transactions
This methodology results in a comparison of the prices paid for similar businesses in recent business deals, especially with respect to mergers & acquisitions. Investors have resorted to this methodology while acquiring part of the business units, like cement plant units, power plants, or even an entire running business having a track record.
Other Methodologies
A brief mention about other methodologies.
Asset-based valuation involves calculation of the fair market value of all the business assets—both tangible & intangible & subtracting the liabilities of the business.
The dividend discount model calculates the value of a stock's intrinsic value by finding the present value of all its future dividend payouts to its shareholders. This methodology basically works well with mature businesses with stable dividend records.
Market capitalization is the method that is straightforward& involves calculating the total value of the company's outstanding shares by multiplying its current market price. At best this method is used by investors to assess the market perception & ideally could be assessed based on the share price over a period of time, say the last 6 months' average.
While the above gives an insight into various techniques of valuations, let me now deal with the pricing of shares as witnessed in the primary markets, which companies tap in the form of a) Public offer (IPO) b) Offer For Sale (OFS)
As per the Securities & Exchange Board of India (SEBI), companies, inter alia, are required to adhere to the book-building process in their Initial Public Offering (IPO) of shares, where bids for shares within a price band (floor price & upper end price. band should be within a-end price; the 20 percent range) are invited from prospective investors. Without further going into the other requirements of SEBI regarding the book-building process, let me dwell on the aspect regarding the price band fixed by companies mobilizing money from investors (both retail & institutional).
Price bands of IPO/OFS are finalized by the company on the basis of the above-mentioned methodology. It's the management & company promoters that finalize the price bands of the shares and issue shares to prospective investors & furnish in the issue prospectus various information, including parameters like Price to earnings,price price to sales, and price to book, to enable investors to assess & decide their willingness to invest.
During the last few years many new-age businesses like platform companies using technology to create a digital space, high-end IT & IT-enabled services, semiconductor businesses, etc., have taken advantage of the present capital market boom supported by the robust economic growth of the Indian economy. Some of these companies are loss-making and do not have strong track records of financials to justify capital raising, and even more so at a premium to their face value. Such companies were seen to be tapping the capital market at a considerable premium, deviating significantly from the valuation norms enumerated above, which raises questions on the reasonableness of the share price offered under IPO/OFS. Promoters of these companies seem to be taking a stand that their businesses will turn around & grow exponentially in future years & pitch for a considerably high premium not backed by valuation methodologies or their past financials. In the absence of anything under Indian laws prohibiting such high premiums, it is left to investors to exercise due caution & understanding before making their investments in such a company's IPO/OFS. This is of utmost importance, especially with respect to small retail investors who have ventured into investments in stock markets with a hope to grow their investments & income to beat the inflation.
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