How to Command a Fair Valuation?
By Manish Kumar Maheshwari
Before approaching a PE fund, cos should undertake a fair valuation analysis of its biz.
It’s no secret that Promoters can command fair valuation if they do a thorough homework before approaching a private equity fund for raising capital. Here’s how - before approaching a PE fund, it‘s helpful if the promoter company does an analysis of value drivers and key success factors, objectively undertaking a fair valuation analysis of its business. While there are a number of methodologies to value a business, PE funds attach primary significance to the Comparable Market Multiples (CMM) and Discounted Cash Flows (DCF) based valuation methods.
Sample this: there’s a “Company” which is engaged in manufacturing consumer product say apparels, soaps, shampoo or any other consumer product. The Company has annual sales turnover of Rs 100 crores with Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) of Rs. 30 crores and Profit After Tax (PAT) of Rs. 15 crores. Its products have found acceptance in the market and the Company is on a strong growth trajectory. The Company believes that its sales are likely to reach Rs. 300 crores in three years time with corresponding EBITDA of Rs. 100 crores and PAT of Rs. 50 crores provided the Company can raise funds for capacity expansion and working capital requirements.
The Company computes its value as per the DCF method at Rs. 500 crores based on present value of future cash flows which is computed from projected income statement and projected balance sheet of the Company. The promoters of the Company then approach various PE funds with this valuation as basis for negotiations. PE funds will critically examine various assumptions considered by promoters while preparing projected financials and will benchmark the value with CMM method.
In CMM method, private equity funds will look at listed companies operating in the similar industry and having similar value drivers (“the comparable companies”) as the proposed investee company. Say these comparable companies are currently valued on stock markets at 14 times current PAT, then private equity funds are likely to value proposed investee company also at 14 times its current PAT i.e. 14 x Rs. 15 crores of PAT = Rs. 210 crores versus promoters expectation of Rs. 500 crores as value of the Company. The disconnect in valuation is because stock markets have taken a beating and thus the valuations of listed comparable companies across various sectors are currently on the lower side compared to few months back.
Public Vs Private Market Valuations
The private equity funds now would be reluctant to give a higher valuation to proposed investee company and would argue that they might be better off investing funds in listed companies which are available at comparatively lower valuation than proposed investee company. Private Equity funds normally consider all tangible and intangible assets of the investee company and will be willing to pay valuation premium only when there is something unique in the company versus competition which can help company gain sustainable competitive advantage.
In this scenario, the promoters have to objectively identify important value drivers/key success factors for their business and have to evaluate objectively how their business fares on these value drivers/key success factors versus comparable companies. The promoters then need to demonstrate to private equity funds how they fare better as compared to other comparable companies on the parameters. Having a strong brand, a better distribution network, a growing market share, a capable management team, a scalable business model without significant increase in capex, a strong order book position or having a cost effective technology are some such instances of value drivers / key success factors which will be considered by PE funds.
The promoters also need to analyse financials of comparable companies and explain to PE funds as to how they fare better. Eg – having higher growth rate in sales than industry average, having lower volatility in growth rate in sales than industry average, increase in profit margins over period of time than industry average, better management of working capital cycle (essentially managing debtors, creditors and inventory better than comparable companies), having optimum debt equity ratio, lower contingent liabilities, etc will also enable promoters in arguing their case for a valuation premium.
It is important to note the accounting method that is being followed. In case the promoter company is following a different accounting policy versus comparable companies due to which the EBITDA / Profit numbers are different, the promoters should highlight this during discussions with Private Equity funds and request the funds to make suitable adjustments in valuation analysis.
For a business that is in early stage, promoters should request PE funds to consider “earnout” model of valuation. The valuation of the promoter company under this model involves multiplying future profitability of the promoter company with a valuation multiple that is at a discount to the valuation multiples of comparable companies. Thus, in this method while the valuation multiple and quantum of funding is agreed today between promoters and PE funds, the valuation of the Company will be determined in future based on actual reported profit of the Company in future. In these cases where PE funds are willing to consider “earnout” model of valuation, promoters should request PE funds to consider lower discount to valuation multiples and should support their request with an objective analysis of value drivers / key success factors present in promoter company.
The whole exercise by promoters should be targeted not just to collect maximum data about comparable companies but to focus on its “meaningful analysis” and to use data for getting a fair valuation from PE funds. High quality of meaningful analysis is appreciated by PE funds and it would in all probability lead to decisive conclusions quickly and effectively. It is therefore important that promoters seriously undertake fair valuation analysis of their businesses before approaching PE firms for funding.