Rating a company is a useful piece of business intelligence and should be undertaken annually by firms

Valuation of a company is extremely important. If there is one thing that is common to a company of any size, be it a multinational firm with a global footprint, or any of its individual businesses or a small, single-product business, it is valuation. Anytime during the lifetime of a business, the requirement for its valuation emerges, specifically when considering the purchase or sale of a company or any line of its business.

A firm may sell a part of its business while restructuring or dispose some of its operating divisions. Other companies and investors, mainly institutional, are buyers of these firms. Valuation of a business concern is the baseline for any negotiation. Once a corporation knows its value — which can be obtained through a reputed valuation service — it can negotiate with the buyer and can reject the deal, if the offer made is less than what is required.

A company may require additional funds from time to time to run smoothly or prevent any financial distress. Any potential investor scrutinises the value of the firm and may also derive its valuation based on any future cash flows. Since the investors are interested to increase their return on investment (ROI), they are keen to fund any business when they feel their funds can take the company to the next level and improve its valuation. Both buyers and sellers have to find the economic value of either the entire company or the specific line of business with some reasonable correctness. With increased globalisation, mergers and acquisitions have become the norm for businesses to survive and in this context, valuation has become crucial.

Another important reason for valuation of one’s company is not for others but for self. The goal of any business in today’s scenario is shareholders’ wealth maximisation and value management has become a key strategic objective. Many corporations measure economic value creation for the company as a whole, periodically, using different techniques to measure performance against planned targets and suitably reward managers on achieving the same. So whether it is for other buyers or self, a company is valued economically at least once in its lifetime.

A firm is assessed by valuing its equity and the total company. Equity of any company is valued by measuring the expected future cash flows to the shareholders. The expected dividend paid by a company over a reasonable period of time is the stake of any shareholder of a firm, plus the present price of the expected values of equity at the end of this time. This reasonable period of time varies depending on the industry — three to five years for fast-changing industries like IT and longer, like 10 to 20 years for resource-based industries like oil. By discounting these annual dividend cash flows, one gets to derive the value of equity.

Free cash flows are used to find the value of the entire company and any past and projected earnings are transformed into a net cash flow framework. The first step is to project the earning patterns and the simplest way to do it is to keep the current level of earnings constant. However, such a simple measure is unrealistic in case the cash flows are expected to either grow, decline or show a cyclical pattern. So a year-on-year projection for as far as possible into the future is required. The second step is to convert the earning patterns into cash flows by adjusting the after-tax earnings with non-cash items like depreciation. Estimating future investment outlays to achieve the current level of earnings is the next and the third step. These future investments could be buying a new plant and machinery, putting money in research and development and any incremental working capital requirements. The final step is to estimate the ongoing market value of the business at a point in time. This approach can be further refined in a multi-business company, where the operating cash flows of each business unit are discounted. However, it needs to be understood that there is nothing automatic about estimating future cash flows and coming to an economic value of a business. Since these are estimations, each investor, buyer or an analyst, is free to choose the assumptions for predicting cash flows and interpret the results in their own manner. So there would definitely be a difference between the economic value of a company from the point of view of buyers and sellers and negotiating skills come into play here.

Valuation of a company is not without its challenges. To begin with, valuation has to deal with the problems of estimations and forecasting and an attempt at quantification of available objective data. Valuation of a business is one of the most complex tasks for any analyst since the entire process depends upon estimation, specific skills like prediction of earnings, cash flows, assessment of risk, strategic insight and interpretation of the impact of combining management styles, operations and resources.

Valuation should help companies establish new goals to increase their worth over the coming years. It should be an annual affair to undertake all three main types of valuations and to measure growth, losses and identify room for improvement. Knowing the valuation of one’s company is after all a useful piece of business intelligence.

(The writer is Associate Professor, Amity University, Noida)