Valuation is neither a pure art nor a pure science but a perfect combination of both. To me it is like preparing a culinary dish which requires the knowledge of food science and skills plus creativity to make it appealing for its users.
The ultimate purpose of any firm’s operations is to create value for its shareholders, therefore it is important to understand the source and meaning of this value. This will help us in understanding which ingredients to use and from where to source them for preparing our culinary dish – the valuation model.
Value for the shareholders is created by investing capital at a rate higher than the cost of capital or the opportunity cost of capital. Secondly, the more funds we invest in business at returns above the cost of capital the more value we create (i.e. growth rate at which we invest these finds creates more value). These investments can be made by selecting suitable business strategies to maximise the business cash flows and profits. So our key ingredients would be future profits and cash flows resulting from business strategies.
Now the question is how far in the future we should look to estimate the effects of business strategies. We have to choose the horizon period- our next ingredient. Normally, for the corporate valuations, practitioners take arbitrary period ranging from 5 to 8 years as the horizon period. Taking a very short period does not give us a true picture of the effects of our strategies and a very long period suffers from time period bias or external economic events and also estimation issues.
So, we should estimate future profits and cash flows from 5 to 8 years based on our assumptions. The very first figure to be estimated is the sales or gross income. After doing the industry, competitor and business analysis a growth percentage is estimated which is then applied to the past sales data. Next in line, is the cost of goods sold or cost of service. This is generally taken as a percentage of sales or income based on past averages after applying the effect of inflation to it. After deducting the cost of goods sold from the gross sales we arrive at estimated gross profits for each year.
After the gross profit, we reduce operating expenses to arrive at our very key figure called EBIT or operating income. How should we estimate the operating expenses? Should we consider a percentage from the past data or should we use a futuristic figure? While, we can apply the percentage derived from the past data it is prudent to apply a benchmarked percentage rate as a futuristic estimate. By benchmarking with the industry rate of operating expenses, businesses can identify their own weaknesses and strive to improve their control on expenditures.
Sales – COGS = Gross Profit – Operating Expenses = EBIT
Now from this EBIT we reduce the tax. There are three tax rates to choose from- actual, effective and marginal. We do not consider actual tax rates or effective tax rates as these have the effects of interest tax shields and deferment of taxes. It is better to use the marginal tax rate for valuation of firms.
EBIT – Tax = Net Operating Profit After tax
Congratulations, we have prepared the dough for our valuation dish which is called NOPAT, by using the above ingredients. Next, we will have to make some adjustments to this NOPAT to finish our valuation base before we move on to prepare our sauces and dressings.