Our method of valuation is as same, in nature, as other discounted cash flow-based methods and also agrees that the value of business should be directly related to sales growth, sensitivity of margin to other factors (sales growth mainly), and risk resulted from liquidity and debt. The difference is only that, to fully demonstrate the relativity of value (our core philosophy, refer to our article – micro-economy relativity), our model was designed to be able to highly efficiently facilitate massive screening of stocks (refer our article-theories and concepts). Instead of subjectively projecting and estimating uncertain numbers of sales and margins, our basic logic is to firstly calculate multiples with current enterprise price and 12 months trailing data (EBI or sales) and then try to rule out the determining factors that cause difference among or explain, when fail to rule out those factors, the difference among multiples of companies. By using enterprise price, we tried to normalize impact, on our model, from different debt levels of companies assuming that buyers are able to terminate debt before mature even with higher market price.
As indicated in our analysis of "theories and concepts ", the differences in multiples of companies are hidden in the following intrinsic factors:
- #1 They are hidden in long term industry trend. This can be explained by the differences of the average sector multiples and can completely or partially be ruled out by narrowing segmentation of our database.
- #2 They are hidden in sensitivity of demands for products and services of individual company to industry changes. This cannot be ruled out for most of time but is able to be explained by acceptance of products and services and brands awareness.
- #3 They are hidden in business operating and management. This can be explained by different sensitivities of gross margin/sales and SG&A/sales (or as demonstrated by changes in percentage of EBI/sales for every 1% changes in sales).
- #4 They are hidden in debt burden and liquidity of cash flow. Since we use multiples based on enterprise price, this can be explained by premium of early repayment of debt and as well difficulty of buyers to repay it.
Depending on whether the company has a positive and large enough EBI (profitable or distressed), we use enterprise price/EBI and enterprise price/sales to evaluate correspondingly. Due to different environment of trading, adjustments in valuation are significantly different for public equity and private equity.
Valuation of public companies
Measurement 1 - based on relativity of space
When try to evaluate stocks using our models, we assess companies with its closest peers in the same sector and then try to find reasonable explanations for the differences in multiples from firstly hidden difference #3 and #4, which are easier to be quantified. And then we will try to assess whether the difference from brands or customers’ loyalty of product and service have been explained in the multiples.
Measurement 2 -based on relativity of time
On the basis of measurement 1, we will then pursue further explanation for changes in price along time sequence. As demonstrated by our article - relativity of time, the factors that we identify and measure in two consecutive periods of time include temporary and permanent changes in cash flow, multiple that can be measured by changes in sales growth and in margin, and other irrational behavior in market such as irrational short selling.
Valuation of PE
The difference in valuation of a private equity with that of public equity in the same sector comes from:
- Sensitivity of demand for its products and service as a result of relatively smaller company and market or less recognized brand, which may be the major reason why a private equity company is often evaluated under a much smaller multiple compared with its public peer.
- Re-investment of return, which is always reflected in multiple/price of public stock but barely considered as a routine operation by PE investors and thus forms another reason lower multiple of PE transaction.
- Cost of exit. In theoretical proving of our model as demonstrated in theories and concepts article, you can see that we assume annual cash flow is reinvested and accumulated in stock price and that we, on purpose, ignore terminal value of companies. We think ignoring it will not significantly impact our relative valuation model just because the cost of exit of a publicly trading stock is often so small that we can theoretically assume a continuity of stock/cash flow in long run. However, when comes to a private equity company, while exit of annual cash flow of PE company is relatively simple the whole exit cost is huge, compared with its public peer, due to being in small trading market and short life cycle of PE investment.
- Debt is relatively easier to be measured compared with its public peers.
Therefore, to evaluate a PE company we still firstly apply relativity of space with adjustments described above in evaluating a PE company as we do in evaluating a public company. Due to lack serial time sequence in PE transaction we cannot apply our relativity of time to measure the result from our application of relativity of space. Therefore, an extra time value model will be applied to the valuation based on method described above to measure sensitivity of internal return to forecast of sale and exit price.
Valuation of distressed debt and equity
While for some company being in distressed situation they are still able to generate a positive EBI, the EBI is usually too small to be used in comparison of multiples. Therefore, we preferred to use sales and enterprise price/sale ratio with adjustment of EBI/sale (or price/EBIT or price/EBITDA ratios) to evaluate company in such a situation. Depending on company’s size and market in which they are trading, we still follow measurements in valuation of public stock or PE company to calculate its enterprise value after being adjusted by its current EBI or EBIT or EBITDA margin and assess the possibility of restructure. Varying with enterprise value, price of debt can be estimated by its priority of claim or by possible combined solution of debt payback and conversion of equity.