Originally published in the FinanceEstonia International Forum 2014 E-Journal in June 2014. As last year, this publication is a treasure trove of insight on the future of the financial services industry from leading industry practitioners.
Prior to the FinanceEstonia International Forum, Aare Tammemäe, Chairman of FinanceEstonia spoke with Nasir Zubairi, Founder and Principal of New Buckland. The discussion considered financial industry consumers and what they really want, the newest disruptions in the FinTech industry and how the “old” and “new” in FinTech can play together.
Aare: Considering the financial industry, what does the consumer really need? Do we even know?
Nasir: That is a big question and there are a broad set of requirements because the mass market is so heterogeneous, both in a big population such as the UK (a core financial market) and within the small population of Estonia.
One conclusion I have reached is that the mass market does not want a fragmented set of services, nor do they want something particularly “disruptive”. To affect the most people I believe the service has to look, feel and behave like a bank – we are not ready to accept a drastically different model for financial services but we are ready for improvements in the quality of service we receive.
We want our money to be stored safely, we want to use our money to pay for goods, we want ways to access credit and investments to increase our purchasing power, we want to perform transactions both domestically and inter- nationally with the least amount of friction and cost possible. And we want it all through a single channel – banking as an enabler of transactions today and trans- actions tomorrow, not a set of products in their own right. That is how we need to frame the business strategy to come up with the right solutions.
Today we have a very fragmented system. Though FinTech firms are doing the right thing by focusing and building core capability in specific niches, the overall friction for customers is arguably getting worse and acting as a barrier to wholesale adoption of the new services. For example, I access TransferWise to perform international payments; I separately access Zopa to make investments and, if needed, borrow money; I access my bank to deposit money and use my card to make payments. Each service has its own access channel and sign-up process; it is too much.
Banks are sticky, the top 5 UK banks still share 85% of business banking and 90% of retail banking. The reason? Even though they are more expensive than the set of FinTech challengers and their user experience is still far behind, they are a one-stop shop for services. Easy, simple, frictionless access is absolutely critical to winning. We have all these brilliant FinTech projects but they need to be homogenised, delivered as a single service to customers.
What might be the concept of financial services in the future? Do you think these new banking-like ventures will be more TransferWise type initiatives or will they merge into this complete service package?
TransferWise has done fantastically well, but is there really any competitive advantage and uniqueness in their technology product? Not really, what they have is great marketing. A number of the new FinTech challengers to traditional banking are not really delivering anything more than innovation in process and some innovation in business model.
If you want to go large and change the game in a mature market such as the UK then something more creative is needed, something which changes the basis for competition in the industry and delivers product and business model innovation that is defensible. I don’t think the current wave of FinTech firms have quite the right model for sustainability, I doubt they are the firms that we will be talking about in 5 or 10 years time.
I think it is still early days in the evolution of financial services. Great things are happening and will continue to hap- pen. I think we will see greater collaboration in the future between financial services firms to deliver better access to customers and reduce friction. I believe we will have more clarity on the industry’s development within the next 3 years.
Are there any other technological ideas around which might change the way we interact with the financial industry?
I believe the insurance and asset management/pension fund sectors are in need of a hack. The insurance sector in the UK is essentially a peer-to-peer network, it works, but in an almost hysterically inefficient manner. The UK asset management and pension fund sector makes billions in profit each year but there is cataclysmic crisis brewing in people not having enough funds for retirement. Obviously there is also still a lot going on in the e-money and payments sectors. I’ve been reading about Facebook’s potential entry into e-money and international payments; that would be an interesting move.
Can you elaborate a bit more on asset management and insurance please? What could the possible disruptions and their impact be on today’s financial industry be?
The overarching problem is that there is a complete lack of transparency in both sectors. I don’t really know why am I paying X amount of money to insure my house, the only thing I know is that it seems like a lot and the price goes up each year. The average man on the street has no idea how it actually works and why the costs are what they are. Likewise in the pension fund sector, no one really understands what is being done with their money.
Transparency sounds very simple, but it’s always quite difficult to achieve. How could it work in reality?
It doesn’t matter if customers actually delve into how each business works, what is being done and why the costs are what they are, but it’s important that customers can easily find out if they want to. It’s about a company’s willingness to show and explain to us how it’s done.
Take the pension fund industry, I’ve had a fund for many years and even I, as an ex-banker, trader and finance professional, get very confused. Why does my pension fund go down at times when there are portfolio management techniques to protect the capital invested and provide a minimum return each year? Why am I charged a 2% administration fee?
Once in a while I receive a written report about what’s been happening with my pension. I don’t understand why I can’t access this information online in real time at my leisure and why it can’t be written in simple English? A rule of thumb for all this financial literature should be that an 11 year old can read and easily understand it (see the Flesch Reading Ease test). My fund has billions under management so I wonder how many customers they have and how many of these glossy reports are being sent out. It is very inefficient and costly in this modern day and guess who pays?
Workplace pensions in the UK are a key channel for retirement savings. People go through multiple jobs during their career and each new employer will undoubtedly utilise a different fund manager for their pension provision. Most people I am sure, as I, would like to consolidate their pension funds at each step to the pension provider of our newest employer. However, transferring funds from one pension fund provider to another is a ridiculously opaque process and the fees charged for consolidation are staggering. I understand there are costs involved in fund redemptions but, again, there is little transparency on why the costs are so high.
Many pension funds, such as mine, invest in overseas assets to spread risk. Each time they purchase or sell these overseas assets they require foreign currency. The funds, due to lack of diligence and specialism, are often charged up to 10bps on the currency exchange by their custodian (Russell Research report 2012) – think about that, it’s crazy! I am certain there are other areas where costs can be significantly stripped out to benefit the customer. Saving 1% in costs and increasing performance by 1% in the UK pension fund sector as a whole would lead to a 25% increase in the total value of pensions, that’s something worth striving for!
Should we wait for the insurance companies and pension fund providers to figure it out and make changes themselves?
Just as in banking, large firms in the insurance and fund sectors have stopped caring about the customer. They have delivered innovation but the value of these innovations has been captured internally and boosted profits. Innovating for profit is fine, but you should always share the profit of innovation equitably with customers to protect market share for the long-term. No business is ever safe.
There needs be an incentive for change to occur. The government in the UK is pushing for some reform and this could be a catalyst for innovation and improved service. New entrants also pro- vide an incentive for change by providing more competition, pushing existing participants to deliver more accountability and transform their practices. However the barriers to entry into the insurance and investment sectors are significant – can any new entrant make a dent big enough to start a wave of change within the industry?
I believe in starting small. Resolving any large problem starts from focusing on a small piece, fixing that piece and moving onto another piece, eventually you solve the whole problem. Like a big jigsaw puzzle – start with one corner, solve the corner, move onto the next corner, etc.
It’s an open opportunity for FinTech then, there is no one battling this cause.
As most people, I just want to see my pension fund go up and have confidence that I will have enough money to enjoy my retirement. The service providers’ job is to fulfil this need.
I am sure there are ways to better fulfil this need. The Government needs to be more actively involved in fuelling new innovation and ideas in the sector. We are sitting on a ticking time bomb – what will happen to society and the economy in 20 years when people cannot afford to retire? The problem is actually even more acute in the US, the average American only has $10,000 saved towards retirement.
Is there an opportunity for the “old” and “new” players to work together? As you said, the newcomers’ impact today is still very small.
They will absolutely work together. Spanish banks are doing some interesting things with innovative FinTech firms; Morgan Stanley is actively looking to partner with best in breed FinTech firms to enhance their capabilities and State Street partner with FinTech firms to broaden the range of services they offer clients. HSBC have just set aside £200m to invest in new innovation projects and partnerships.
Traditional firms will not disappear as long as they adapt and embrace new ways. I can see a world where a number of banks focus on being the “smart pipes, the plumbing of financial services” providing a foundation for other industry participants to sit on top, in turn allow- ing them to focus more on servicing customers.
If banks decide to innovate in their business then shouldn’t they find the companies out there which are already solving these problems?
They need to develop a capability regard- less of whether they build in-house or look for partners outside, they need a skill set in innovation. Experts need to be brought in to build the capability. All banks need to be investing in new talent that understands and can implement innovation processes. I have no doubt that we are nearing a fundamental change in the way customer’s use and access financial services, nobody really knows the entirety of what that change is yet, but it is coming. Banks need to be prepared to respond to the new threats, to have agility in process and, ideally, be the ones driving the change. Those that do will be the businesses of tomorrow.
In relation to Estonia, could that possibly be a small Estonian bank with good marketing and other tactical skills? Could such a bank become successful in Europe if it had the right offering?
Of course! With an aggressive and well thought through strategy there is no reason why an Estonian Bank couldn’t be the next generation leader in financial services across the world. In this day of technology businesses can scale so rapidly it is shocking. There are many examples from other industries where small firms, largely ignored initially, have quickly risen to lead.
Honda is one of my own favourite case studies. Though they had quickly become a large domestic producer of motorcycles nobody outside of Japan had heard of them. In the early 1960’s they began mass producing the Super Club, a 50cc moped now considered the “Model T” of motorcycles and the biggest selling motorcycle in history. They exported this model to the US, a country dominated by big bikes and by a big manufacturer, Harley Davidson. American Honda Motorcycle Company took control of the US motorcycle market by the end of that decade by really understanding their customers and using that knowledge to drive innovation in product, process and business model that blazed them past incumbent industry participants.
Originally published in The Huffington Post on 02 April 2014.
Fact: The more we understand about the lives and environment of our target customers the better we are able to market our products to them and accelerate adoption.
Focusing on the use of technology by a market and their “Normal” level of technology sophistication can provide significant insight into the likelihood of that market’s adoption of new technology products and services, allowing firms and stakeholders to better define their target market and to refine their product offering for greater customer take-up.
Markets are complex and fascinating. Understanding how they work and how they pertain to and define your product or service are critical to the success of your business. “Will customers buy my product/service?” “Why will they buy?” The concept of “adding value” is core to any business case.
Generally and particularly so in the tech industry, your peer group – the guys you hang out with in Tech City, the guys you sit next to in your shared workspace – are not the right benchmark for your product to succeed. They are not representative of the mass market. If they think your idea is great and they are likely to use it, you really really need to double check whether less tech orientated consumers will adopt your product. There are early adopters but there are also too-early adopters. Niche products proliferate amongst tech folk, many of which will never get to the mainstream. There is a “market perception bias” due to peer group and the pressure to deliver cool innovation relative to localised behaviour. The product/service misses the mass market as it is too cutting edge.
The Adoption Curve
Most people are familiar with the Adoption Curve (The Bass Diffusion Model to give it its proper name – find out more on Wikipedia) that describes the penetration of a new product in a population. Be it subconsciously, it defines our forecasts when launching new products and, by inference, investment decision-making and capital allocation.
An issue with the model: keeping all parameters constant while varying the size of the market, the length of time to fulfil 100% market potential is always the same.
Estimates of the key parameters are made on existing sales data or synonymous comparables data. The size of the market variable is arbitrary – there is no prescribed science behind it. You can make it 1000 or 100 million and the key output, the estimate of customers, do not change except in scale relative to the initial input.
I hope you agree, this does not make sense. A firm launches a product, it is selling well. They then incorrectly assume that their existing customers are a sub-set of a very large market and build marketing strategy and estimates on sales revenue on this misplaced market definition. It will take them forever to “own” the market; it cannot be that the length of time to saturate a large, more heterogeneous market is the same as a small and more appropriate one.
Market segments are defined by habits and behaviours as well as in many cases, law. They are not defined by demography – age, location, density….though, in certain cases, demographics may act as a good proxy.
Banks don’t sell mortgages to the “UK market” they sell mortgages to people in the UK that are looking to buy property, a need driven by the behaviours the people within that group and in this example, the laws that apply, which further segments the broad market; commercial mortgages, investment mortgages, first-time buyers, etc. More granular still, individual mortgage “products” are defined to appeal to specific customer groups that are driven by even more granular behaviour; e.g. their level of risk aversion, their accumulation of wealth, their use of time.
Broadly (and maybe controversially?) speaking, I believe it is good practice for young businesses or for any business launching a new product to focus on a very small market segment, really understand it, own it, then broaden the market definition and leverage their experience and brand credibility from previous success to sell to new target customers.
Understanding your customer’s normal level of technology use is key to marketing and success
First, lets get everyone on the same page with a couple of definitions:
“Technology”, does not just relate to computers or electronics. It is more broadly defined as “The application of scientific knowledge for practical purposes” this could relate to machinery, pipes, a saucepan and even a comb.
“Innovation“, is not just invention, is not just a new product or service, I define it broadly as “something new that adds value”. This could relate to a process, a product or service, a business model.
Combining the two, “technology innovation”, therefore is the application of scientific knowledge to create something new that adds value.
Lets say there is an arbitrary line that represents the technology innovation that is available to us. The further along the line the more “high-tech” the product and service. We can benchmark a “Normal” (mean) for the sophistication of technology people within homogeneous groups are comfortable using on a regular basis. Either side of this Normal, is a range that represents the inferior and new technology that we are willing to utilise today. For a very large market definition, this is, unsurprisingly, normally distributed.
As time goes on and users accept and use more innovative technology, the normal shifts to the right, i.e. the normal level is at a level of more sophisticated technology tomorrow than it is today. This is usually an incremental transition and takes time. There are very few “disruptive” products or services that have led to a large shift in the normal level of technology utilised by a market. “New and Improved” trumps disruption every time. To ensure you acquire rapid acceptance and use of your service or product, you need to target somewhere to the right of the normal line. Excellent – all fits well with the adoption model.
But wait, we know there are more distinct groupings within the population. What if we were to consider the habits and behaviours of “technophiles” and “technophobes” as exogenous to the mass market?
To generalise, technophiles are more likely to adopt new technology innovations and will be less accepting of inferior technology, while technophobes are less likely to adopt, relative to the mass market. The chart is likely to look like this, with technophile and technophobe adoption of technology skewed appropriately.
Now let’s make this more useful; let’s multiply the y-axis by the size of each market segment to give us a representation of the number of consumers likely to use the product:
Where do you want your product to sit?
To me, it’s fairly obvious that, for a product to be successful in the mass market, a business should be targeting the technology sophistication of the product to be slightly inferior to the normal level of technology sophistication acceptable to a market of technophiles. I.e. if the guy sitting next to you in google campus or a.n. other tech workspace thinks your product is cool and innovative (for them), it should ring an alarm bell in your head – check, re-check, and check again what is normal for your mass market.
Originally published in Entrepreneur Country, 23 January, 2012.
Spreadsheets, revenues, customer acquisition costs, EBITDA, cash flow, burn rate….words that can make entrepreneurs turn to stone in fear and their anxiety bubble to bursting. There is no magic formula to making a small business become a great business, but there is a golden rule for ensuring the path is smooth; the management team, especially the CEO, need to live, breathe and dream the business financials.
From my experience with mentoring small and growing business, preparing, forecasting, managing and understanding the financials of their business are the biggest gaps in the arsenal of an entrepreneur. Entrepreneurs come to the table with brilliant ideas for marketing, strategy, operations and sales, but, more often than not, have no idea when it comes to putting the numbers together properly.
The first thing I do with any of my mentees is to dispel their fear of spreadsheets and show them how easy it is to put together some reliable and useful financial data. I take pride, almost shed a tear, when I hear them bandy about terms like “EBITDA” (Earnings Before Interest, Tax, Depreciation and Amortisation) with confidence, and see their comfort in contrasting their overheads (the fixed costs of a business; costs that cannot easily be removed and are not directly linked to revenue, this includes permanent staff) with their variable costs (such as costs of goods sold, costs incurred directly as a result of each unit sold/service rendered), and using the information to revise their operating plans to ensure better cash management.
I am not going to try and prescribe a standardised financial model – every business is unique, and, in my opinion, there is no set template. However, I do want to provide some (hopefully) simple guidelines on an important financial metric for any private business owner – how much their business is worth.
EBITDA is key
Net profit, revenues and costs are often falsely considered to be the most important factors when it comes to the worth of a business. Aside from the “king”, cashflow, the focus should be on EBITDA. EBITDA allows you to look at the performance of your business operations while eliminating all non-operating items, such as financing costs and tax, as well as non-tangible items such as depreciation and amortisation.
EBITDA Margin (EBITDA as a percent of sales) is extremely valuable because it helps you analyse whether a company is more or less profitable as a percentage of sales. A business should always understand if the new business it has added in the past year was as profitable as its past business, using the information to better allocate future resources to extract most value.
EBITDA margin also comes in handy when comparing companies of different sizes against each other and when potential investors or buyers are looking at the future prospects of a business. EBITDA margin will provide a true apples-to-apples comparison so that you can see which business’s operations delivers the greatest profitability on sales.
Straightforward valuation – using comparables
The use of comparables provides a quick and easy way to obtain a ballpark valuation for a business. In my experience, it is the method most frequently used to assess equity investment as it incorporates the intangible factor of market sentiment (demand) into the valuation. Young businesses use the metric to predict a future (exit) valuation to convey the returns possible for the investor(s). To make things simple, using a standard rule of thumb (given that forecasts are unreliable), a multiple of 5 times EBITDA (5xEBITDA) is acceptable.
More scientifically, find firms listed on stock markets or firms where financial and valuation data is publically available that display similar “value characteristics” to your business. These characteristics include, industry, product/service, risk, growth rate, capital structure (% of debt and equity), and the size and timing of cashflows. Look at their EBITDA multiples and average across them:
|Your EBITDA multiple =||(market value of firm 1 ÷ current year EBITDA firm 1 + market value of
firm 2 ÷ current year EBITDA firm 2 +……etc.) ÷ no. of firms
Note, to forecast future value use the EBITDA from your forecasts for the year in which exit for the investor is planned, usually 5 years hence/the year for which you want the valuation. However, using today’s multiple does not account for changes in market sentiment over time.
There are other comparable measures that can be used, such as Price/Earnings ratio (P/E) and market-to-book ratio, but these are not as reliable as the EBITDA multiple. For example, the P/E ratio does not account for the differences in capital structure of a business (earnings include interest deductions), a key factor in valuation.
Accounting based comparables such as P/E are also not particularly appropriate for unprofitable companies experiencing rapid growth. These accounting ratios have been shown to have little predictive ability for IPOs and vary greatly amongst publicly traded firms in the same industry.
Venture Capital Method
As it says on the tin, this method is often employed in the Venture Capital industry to calculate the percentage ownership a VCrequires for an initial investment in a firm, particularly one that has negative cashflows and earnings but with significant, yet highly uncertain, growth potential. A business owner can thus pre-empt and be better prepared for negotiations by understanding the valuation methodology.
The method essentially values the business at some future point when it has achieved positive cashflows and earnings and the VC may look to exit, be it via IPO or private sale. This “terminal value” is then discounted back to today to calculate the % ownership the VC requires, factoring in their required rate of return and estimated dilution in future rounds of financing.
There are four key steps to the method.
Step 1 – calculate terminal value. Multiply the projected net income in the exit year by a “comparable” metric (as described in the previous section). In this instance, it may also be worth scouting for comparables for VC exits of similar businesses. Alternatively, you could be more scientific and use a discounted cash flow method as described later.
Step 2 – Calculate the discounted terminal value. The terminal value is discounted back to a representative value in today’s money, based on the target rate of return (yield) the VC wants to earn on the investment. This rate of return has to adequately justify the risk and effort the VC undertakes on the investment – typically this number is between 40% to 75%.
Discounted Terminal Value = Terminal Value ÷ (1 + Target Rate of Return)Years of investment
Step 4 – Estimate future dilution and calculate current ownership percentage. Seldom does one round of financing enable all future potential. The VC (and so should you) expect further rounds of financing to occur, each one assumed to “dilute” the initial equity holding of the VC. No golden rules here, a little finger in the air, but assuming two further rounds, one potentially being an IPO, each selling 25% of equity, is probably cautious enough for a start-up, lower if a more established business with proven revenues. The “Retention Ratio” of the VC has to be calculated and then applied to the required final % ownership to discover the initial current percent ownership required, and hence the value of the business (in the eyes of the VC).
Retention Ratio (%) = 1 ÷ round 1 equity % ÷ round 2 equity % … ÷ round n equity %
Required Current % Ownership = Required final % ownership ÷ Retention Ratio
Value of Business = VC Investment ÷ Required Current % Ownership
With the advent of new business models, particularly those that are internet based such as social media, it is has become difficult to estimate business value. There are few direct comparables and thus high uncertainty over future monetisation of the business model. Think Facebook, LinkedIn and StumbleUpon or businesses that rely heavily on advertising revenue. New, slightly orthogonal, yet intuitive techniques are being used to provide a valuation of the business, be it for use as an input into the more traditional models such as NPV, as an alternative comparable multiple, or as an outright measure in their own right. Below are a few suggestions.
Customer Lifetime Value: Business value is a factor of the goods and services the business sells, which in turn is a factor of customer purchasing habits. As such, calculating the value that your customers contribute to your business over the lifetime that you hold customer relationships should give a good estimate for how much your business is worth. This methodology is a crude approximation of the Net Present Value technique (below), focusing on direct costs of servicing customers, ignoring other aspects of overhead that may be incurred.
|CLV =||[(Customer margin generated per year – other direct costs, e.g. marketing)
÷ (1 – retention rate + discount rate)] – Customer Acquisition Cost
Customer margin = % margin per purchase x price x no. of purchases in the year
Retention rate = the probability, per year, that you retain your customer
Discount (Interest) rate = arbitrary discount rate for discounting value of money to today, e.g. 10%
Customer Acquisition Cost = The costs involved to acquire a customer – e.g. spending on SEO ÷ conversion rate, direct mail or telesales costs ÷ response rate, credit checks, legal costs, etc.
The above equation will give you the lifetime value of one customer in perpetuity. For a mature business where customer acquisition has relatively stable growth each year, the value of the business can be estimated as follows:
|Business Value =||CLV x number of customers acquisitions in the next year x (1 + yearly customer growth rate) ÷ (Discount rate – yearly customer growth rate)|
Note: Growth cannot exceed the interest rate (more accurately, the weighted average cost of capital, described in the NPV section below). If it is expected that growth will exceed the discount rate in the short term, the formula needs to be split in order to accommodate the rapid initial growth period:
|Business Value =||Sum (for years t = 1 to N) [CLV x customer acquisitions x (1 + initial growth rate)t ÷ (1 + discount rate)t] + [CLV x customers acquisitions x (1 + initial growth rate)N+1 ÷ (Discount rate – stable growth rate) ÷ (1 + discount rate)N]|
Where t from 1 to N is the number of years for which the high growth rate is expected.
In order to make the above an even more precise reflection of business value, customers should be segmented as much as possible into broad purchasing categories with their own values for margin, retention rate and growth rate. E.g. loyal vs occasional buyers. Large corporates v SME, etc. The above formulae will need to be calculated for each customer segment and summed to calculate business value.
For even further precision, the CLV can be calculated more specifically, incorporating variable margin and retention rate information for the first few (N) years, potentially 5, using the formula below. The values for the final year, year N, can then be extrapolated in perpetuity using the formula above and added in to the calculation.
|CLV||SUM (for years t =1 to N) [Margint – other direct costst) x retention rate (t-1) ÷ (1 + discount rate)t]
+ [(MarginN – other direct costsN) x retention rate N ÷ (1 – retention rate + discount rate)] – Customer Acquisition Cost
Intangible Assets/non traditional multipliers: Increasingly becoming popular in the valuation of young internet businesses, Intangible assets and revenue itself, core drivers of business value, are being used in lieu of EBITDA as a multiplier. Using the same principles as with the EBITDA multiple, find businesses that have a similar risk and business profile to your own, be they publically listed or where the appropriate numbers can be acquired, and use an average across the firms to calculate an appropriate multiplier for your own business. Some examples of multipliers used:
a) Subscriber multiple, e.g. where the network of signed up users is the key to monetisation, be it online, publications, mobile = Business value per subscriber
b) Page view multiple, e.g. businesses that have a heavy reliance on online advertising revenues = Business value per page view
c) Revenue multiple = Business value per unit of revenue.
d) Asset multiple, e.g. wholesalers or asset management firms = Business value per value of assets held/under management
As the key metric for value is margin, it would be worth adjusting the above multiples to account for potential differences in margin between the comparator company (ies) and your company:
Observed multiple x [your company operating margin ÷ comparator company operating margin]
Net Present Value based valuation
Note: This may look complex at first to some, but when done in a spreadsheet such as Excel, it is really not that difficult. An example is provided at the end.
Taught at Universities and business schools, the NPV method is a well known cash flow valuation method used, for example, in assessing the present value/price of a stream of payments on financial instruments such as bonds. It has been borrowed for use in valuing businesses; ultimately, the current value of a firm is a factor of its future earnings potential.
This method is most appropriate for more mature businesses with stable growth, where future cashflows are relatively predictable. New ventures experiencing rapid growth and expansion should not use this technique except, to benchmark against a comparable type valuation. Venture Capital firms and other investors will place little faith in cash flow projections beyond a timeframe of 1 year to 18 months.
One of the major benefits of the NPV method is that it incorporates the benefits of tax shields resulting from interest being paid on debt owed by the business. As such, interest should be deducted from the cashflows used in the calculation. Without going into the details of why, for each month of your financial projections a value called “Free Cash Flow” is calculated as –
|FCF (at time t) =||EBITDAt x (1 – Corp. Tax rate) – Capital Expendituret – increase in Net Working Capitalt|
Net working capital represent operating liquidity within the business calculated as:
Current Assets – Current Liabilities, excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances
Next, we need to calculate the “Terminal Value” of the business – what the stream of earnings beyond your projections are worth (ad infinitum; in perpetuity). This is important, as the bulk of a business’s value is often in the terminal value. It is calculated using the following perpetuity formula, where g represents a rational growth rate for future earnings (remember to consider the timeframe for which you are doing this – monthly growth rates will be lower than yearly ones), and r represents the discounting rate, the Weighted Average Cost of Capital (WACC) – calculated further below:
TV (at time T, the final time period in your projections) = [FCFT x (1+g)] ÷ (r-g)
The discount rate (WACC), r, is calculated as follows (bear with me on this one):
r = [D/V] x rD x (1-Tax rate) + [E/V] x rE
D = The value of debt in the business
E = The value of equity in the business
V = D + E
rD = discount rate/cost of debt
rE = discount rate/cost of equity
If you want to be really specific, you should use the target capital structure for the business, i.e. the target values for D and E, but then we get into a somewhat messy issue with the following calculation, needing to “un-lever” then “re-lever” the beta – let us not go there!
To calculate rE , the return expected by market investors on equity:
rE = rf + β x (rm – rf)
β (Beta) = degree of correlation with the market; can be found for comparable firms listed on the stock market using Google search
rf = risk free rate; typical is to use a government bond yields, say for 10 year UK gilts.
rm = Rate of return on (comparable) stock over a period, typically 10 or 5 years.
(rm – rf) = The market risk premium; to avoid complexity, 7.5% is a typical premium that can be used.
rD is straightforward; it is the rate at which you (can) borrow capital.
Now (finally) you calculate the business value. IMPORTANT – remember to adjust the r to reflect the right time period, i.e. typically, r is calculated on an annualised basis so when applying to monthly cashflows you need to divide the r by 12.
Firm Value (NPV) = [FCF1 ÷ (1+r)] + [FCF2 ÷ (1+r)2] + [FCF3 ÷ (1+r)3] +…..+ [(FCFT TV) ÷ (1+r)T]
The following is how I typically structure it in a spreadsheet with financial info, as I said, not as complex as it looks, when you take it bit by bit.
Illiquidity and control adjustments
If valuing your company on account of raising additional equity capital or considering a private sale, you must recognise that the buyer will undoubtedly apply an illiquidity discount to whatever valuation is arrived at by any of the methods above. Equity investors want to factor in the cost of liquidating their position quickly should they need to. As the equity is not publically traded on a stock market, the buyer will argue that they would need to consider 20-30% discount on value to sell on the equity. Hence, they will adjust your business valuation downwards by that percentage.
Private equity investors buy into companies for 4 key reasons:
• Tax arbitrage
• Debt (leverage) arbitrage
• Governance arbitrage
• Regulatory arbitrage
Now, you may uncover that the driver for the investment/buy out is governance arbitrage, i.e. the buyer believes that your business is not well run and wants to instil new management and new strategy to enhance business value in the future (bite your own ego on this one!). If this is the case, you can presume that they are attributing acontrol premium to the business; adjusting the value upwards by a percentage to account for the potential change in strategy and management. A control premium can also be assumed in most strategic investments, where a corporate is buying your business due to synergies (consolidation, combination, connection, co-creation) that may be realised through ownership. Bear this in mind when negotiating the selling price!
I have tried to make the above valuation methods as simple but as comprehensive as I can. There is no precise science, only best estimates. Hopefully you will now have the ability to compute a business valuation that you can have some degree of confidence in, for whatever reason you need it.
There are a number of additional factors that you can think about when valuing the business. With the Net Present Value methodology, incorporating the future capital structure of the business, as best as can be envisaged, and adjusting the WACC accordingly by levering and unlevered the beta, will give a more reliable enterprise value and is particularly apt when the business is being acquired through a debt backed/leveraged buyout. Those mathematically inclined may have noticed that there is an optimal balance between debt and equity to achieve a maximum valuation given any series of cash flows – often a driver for a PE firm acquisition. There are also a number of other ways to estimate beta using accounting information if a reasonable comparable cannot be found.
Below is a summary of the strengths and weaknesses of each method I have presented. Please do contact me if you have any further questions or would like to discuss/contribute to the information I have detailed here.