Determining the value of a company's shares is important in situations such as, for example, a sale, a merger or a family transfer. In this context, valuations are often based on future cash flows through methods such as DCF (Discounted Cash Flow) or APV (Adjusted Present Value).
Although these methods are generally well-supported professionally, there are important concerns that, if (partially) ignored, can lead to pitfalls. These include (non-exhaustive):
1. Overly optimistic forecasts
Entrepreneurs (fortunately) often have a positive view of the future, especially for young businesses or businesses in niche markets. This can lead to overly optimistic revenue and return projections.
A too rosy forecast increases the value on paper, but can lead to disappointment in negotiations, because buyers usually estimate things more conservatively. Critical assessment of the substantiation and realism of forecasts is therefore essential.
2. Wrong estimation of the risk profile (WACC)
The Weighted Average Cost of Capital (WACC) reflects the company's risk profile and is used to discount future cash flows to the valuation point. The higher the risk, the higher the WACC and the lower the value (and vice versa). Factors affecting the risk profile include:
- Dependence on management
- Distribution and quality of revenue (recurring revenue)
- Supplier dependency
- Market position and competition
- Entry barriers
- Size of the company
Assessing these risks is subjective, but requires a thorough analysis. A wrong assessment can lead to an over- or undervaluation.
3. Insufficient consideration of working capital and investments
Cash flows depend not only on revenue costs, but also on working capital requirements and investments in other assets. Growth of a business often means higher inventories, larger accounts receivable positions and additional investments in tangible assets such as machinery and transportation equipment. Such investments depress cash flow and must be properly factored into forecasts and thus valuation.
4. Equity bridge
The present value of future cash flows (enterprise value) should be adjusted in a DCF/APV valuation for the items below to then arrive at the value of a company's shares:
- Cash/cash-like items (increase value): such as cash, prepaid taxes, non-operating receivables, investments and the like.
- Debt/debt-like items (reduce value): such as interest-bearing debt, pension obligations, past due creditors, etc.
The above items are also called the "equity bridge," or the steps from enterprise value to equity value.
Misclassification of these items can significantly affect the final stock value.
5. Scenario and sensitivity analysis
Because valuations depend on various subjective assumptions (regarding forecasts, risk profile, investments), it is advisable to work through several scenarios, such as:
- Variations in sales growth, margin and profitability
- Different levels of investment
- Higher or lower WACC
This leads to a range of outcomes, depending on the chosen assumptions. Scenario analyses thus place a valuation in a broader perspective and offer parties involved a guideline to ultimately arrive at a responsible price.
Price ≠ Waarde
The calculated value is often not equal to the final price. A price generally arises in negotiations and can be influenced by strategic interests in the market, emotional factors (in case of family transfer or divorce) and by other stakeholders (for example, in consultation with the tax authorities).
Conclusion
On balance, the essence of a business valuation based on future cash flows is that with the thorough and substantiated determination of cash flows, the associated risk profile (cost of capital) and equity bridge, the chance of pitfalls in the valuation is minimized. Whereby a scenario analysis places the sensitivity of the input variables in a broader framework. This produces a valuation that is appropriate for the purpose of the valuation.
