Value creation is the ultimate goal of any business, but how can you measure it effectively? In this article, you will learn about some of the most common and useful methods to assess the value that your company or project generates for its stakeholders. You will also discover the advantages and limitations of each method, and how to choose the best one for your situation.
Economic value added (EVA) is a measure of the net profit that a company or project earns after deducting the cost of capital. The cost of capital is the minimum return that investors expect from investing in the company or project. EVA shows how much value is created or destroyed by the company or project over and above the cost of capital. EVA is calculated as: EVA = NOPAT - WACC x Capital Where NOPAT is the net operating profit after tax, WACC is the weighted average cost of capital, and Capital is the total capital invested. EVA is a simple and intuitive method that aligns the interests of managers and shareholders, and encourages efficient use of capital. However, EVA may not capture the long-term growth potential of the company or project, and may be sensitive to accounting choices and assumptions.
EVA is an effective framework for measuring shareholder value creation or otherwise for more mature firms or asset rich firms. Here, it is implicitly assumed that the external factors that influenced a firm in the past continue to influence the firm in the future largely to the same degree. In practice, NOPAT is adjusted for depreciation, research expenses, and spending for creating intangible assets (e.g. patents). Also, many practitioners make market value adjustments to capital employed.
Accounting and business always have their versions of defining value-generating companies. Let's understand a few nuances from my experience 1) NOPAT is not a reliable indicator of shareholder wealth as it doesn't account for cash left. In other words, EVA is not well suited for companies with intangible assets. 2) WACC is a complex attribution of capital structure (equity vs debt), firm's leverage potential(increase debt to equity ratio to reduce WACC), and market volatility(beta). 3) It doesn't factor in the Company's growth potential (E.g, a high-growth industry or market segment with a substantial TAM) Bottomline - Arguably one of the best valuation tool, where the focus is on increase shareholder's wealth and net operating profit.
Discounted cash flow (DCF) is a method of valuing a company or project based on the present value of its future cash flows. The present value is the amount that a future cash flow is worth today, given a certain discount rate. The discount rate reflects the risk and opportunity cost of investing in the company or project. DCF shows the value that the company or project can generate for its owners over time. DCF is calculated as: DCF = CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n Where CF is the cash flow in each period, r is the discount rate, and n is the number of periods. DCF is a flexible and comprehensive method that incorporates the time value of money, the risk and uncertainty of future cash flows, and the growth potential of the company or project. However, DCF may be difficult to apply in practice, as it requires accurate estimation of future cash flows and discount rate, and may be sensitive to changes in these parameters.
The DCF method for measuring corporate valuation presents several practical challenges: 1)How do you forecast revenue and its growth? 2)What figure should be used for the Weighted Average Cost of Capital (WACC) as a discount rate? 3)More challengingly, how do you measure the equity risk premium related to WACC? The tricky aspect is that the valuation outcome can vary significantly with even small differences in the WACC and growth rate assumptions. Accurately or even reasonably determining INPUTS for these factors is often elusive, leading to a scenario where numbers are frequently adjusted. One solution to this issue is to employ multiple valuation methods and compare them to determine a final figure, which may be presented as a range.
DCF method is used to determine an investment's 'Fundamental value' i.e. its present & future cashflows as it doesn't depend on market sentiment and valuation multiples for certain industry segments. DCF could be a good tool for mature companies with predictable returns and revenue from multiple sources. DCF is not optimal for startups & early stage, companies with cyclical revenue. From a practioner's view point, here are a few nuances with DCF methodology 1) How well you determine discount rates for valuing assets (The Risk Profile) 2) Forecasting accuracy of your future cash flow (revenue, profitability etc.) 3) Estimating the terminal value for any business. 4) DCF sensitivity analysis vis-à-vis WACC, Revenue growth rate & margins.
Market multiples are a method of valuing a company or project based on the ratio of its market value to a certain financial metric. The market value is the price that the company or project can fetch in the market, either through trading or acquisition. The financial metric is a measure of the company or project's performance, such as earnings, sales, or assets. Market multiples show how the market values the company or project relative to its peers or industry average. Market multiples are calculated as: Market Multiple = Market Value / Financial Metric Some common market multiples are price-to-earnings (P/E), price-to-sales (P/S), and enterprise value-to-EBITDA (EV/EBITDA). Market multiples are a simple and convenient method that reflects the current market conditions and expectations, and allows for easy comparison and benchmarking. However, market multiples may not capture the unique characteristics and prospects of the company or project, and may be affected by market fluctuations and anomalies.
En este apartado me gustaría agregar que los múltiplos del mercado deben complementarse o ratificarse con otros métodos como el EVA, el cash-flow descontado u otros métodos alternativos de valuación. Los múltiplos de mercado no debe utilizarse como único método, porque pueden incluir sesgos importantes aunque se utilicen como referencia dentro de la misma industria. Un ejemplo de ello es el de empresas, que aunque dentro de un mismo segmento, pudieran estar atravesando por ciclos de crecimiento distintos como el caso de un aumento en las nóminas de operaciones por el lanzamiento de nuevos productos. Este es un caso típico donde podemos encontrar diferentes EBITDAS, los que a su vez potencian sus diferencias por el uso de múltiplos.