Equity and Business Valuation Frameworks (Part 2 of 6)
In the context of Alternative Investment Funds (AIFs), moving beyond fixed income leads to the more complex world of equity and business valuation. While basic equity valuation often focuses on shareholder returns, AIFs typically deal with growth-oriented unlisted companies, requiring a shift toward comprehensive business valuation models.
2.1 Approaches to Equity Valuation
Equity valuation attempts to estimate the worth of a single share in a company from the perspective of an investor.
The Dividend-Based Approach
The traditional approach to valuing equity shares mirrors bond valuation: it uses the Present Value (PV) of expected future dividend cash flows.
- Formula Logic: The value is the sum of all future dividends discounted back to the present.
- Limitations for AIFs: This methodology has limited relevance for AIFs because they primarily invest in unlisted companies with high growth potential. These companies often reinvest all earnings back into the business rather than distributing them as dividends.
- The Shift: Because dividends are rare in the early stages of investee companies, AIF managers must value the entire business to eventually arrive at the per-share value.
2.2 Fundamentals of Business Valuation
To determine the value of a business, three primary pillars or "approaches" are used.
The Three Pillars of Valuation
- Income Approach (Earnings Based): This is primarily driven by Discounted Cash Flow (DCF) analysis. It is considered the most comprehensive because it accounts for value drivers that cost-based methods ignore.
- Market Approach (Relative Valuation): This uses earnings multiples (such as P/E or EV/EBITDA) to compare a company against its peers.
- Cost Approach (Asset Based): This values a company based on the sum of its individual assets minus its liabilities.
Challenges in Business Valuation
- Subjectivity of DCF: While theoretically strong, the income approach requires numerous assumptions and judgmental factors, making it inherently subjective.
- The "Apple-to-Apple" Rule: Relative valuation is only effective if comparable data is available. If a company has a unique business model or no listed peers, market multiples can be misleading.
Core Valuation Methodologies Summary
| Approach | Primary Methodology | Key Logic |
|---|---|---|
| Income/Earnings | DCF & Earnings Capitalisation | Uses future expected earnings to measure Free Cash Flow (FCF). |
| Economic Profit | Projected Economic Profit | Value = Current capital employed + PV of future projected economic profit. |
| Market | Relative Valuation | Employs trading or transaction multiples from comparable peers. |
| Contingent Claim | Option Pricing Models | Uses options models to factor in embedded "real options" in cash flow. |
| Asset Based | Net Asset Value | Uses existing physical and financial assets as the base. |
2.3 Enterprise Value (EV) vs. Equity Value
Before performing a valuation, it is vital to distinguish between the value of the entire business operation and the value specifically belonging to shareholders.
Enterprise Value (EV)
EV represents the debt-free/cash-free value of the operating business. It is a measure of the business's worth regardless of how it is financed (debt vs. equity). EV is typically measured with reference to earning potential, specifically EBITDA (Earnings before interest, tax, depreciation, and amortisation).
Equity Value
Also known as Market Capitalisation for listed companies, this is the total value of the funds belonging strictly to the equity shareholders. It represents the residual value after all other claims, including debt and preference capital, have been satisfied.
The Core Equation
The relationship between these two figures is calculated as: Enterprise Value (EV) = Equity Value (Market Cap) + Total Debt (Net of Cash) + Preference Capital
Practical Illustration (14.3)
Consider a company with the following balance sheet data:
- Estimated Market Cap: INR 1,000 crore
- Long Term Debt: INR 200 crore
- Preference Capital: INR 50 crore
- Cash Balance: INR 5 crore
Calculation:
- Net Debt = 200 - 5 = INR 195 crore
- Enterprise Value = 1000 + 195 + 50 = INR 1,245 crore
Key Takeaways
- Business vs. Share: In the AIF space, share valuation is almost always derived from a total business valuation.
- EV Primacy: Enterprise Value is the preferred starting point for professional valuers as it reflects the true operational worth of a company independent of its capital structure.
- Methodology Selection: The choice between Income, Market, or Cost approaches depends heavily on the company's maturity and the availability of peer data.
Important Terms
- EBITDA: A proxy for operating cash flow used frequently in Enterprise Value calculations.
- Going Concern: The assumption that a business will continue to operate into the foreseeable future, which is essential for DCF models.
- Free Cash Flow (FCF): The actual cash generated by a business that is available for distribution to all capital providers.
- Market Capitalisation: The total market value of a company’s outstanding shares of stock.