CHAPTER 11: VALUATION (PART 3) — RELATIVE VALUATION, PORTFOLIO VALUATION & IPEV GUIDELINES
11.7 RELATIVE OR MULTIPLE-BASED VALUATION
Relative valuation is a pragmatic, widely used market-based approach in corporate finance. It operates on the core premise that the value of a business is best determined by comparing its financial parameters to the current market prices of comparable, listed peer companies or transaction multiples of similar firms.
The Challenge of Valuing Unlisted Companies
While relative valuation is straightforward for public companies with daily market prices, unlisted companies in the alternative investment space present unique challenges:
- Lack of Direct Market Pricing: Unlisted companies lack continuous market price validation.
- Unsuitability of Trading Comps: Standard public "trading comparables" are often unsuitable because unlisted portfolio companies are smaller, highly illiquid, and operate in different growth phases.
- Use of Listed Peer Surrogates: To overcome this, analysts identify listed companies with highly similar business models (listed peer surrogates) and apply their trading multiples to the unlisted firm.
- Enterprise Value Focus: Most relative valuation multiples estimate the Enterprise Value (EV) of the firm rather than its Equity Value.
Isolating Equity Value from Enterprise Value (Simple Line Format)
Because firm-level multiples yield Enterprise Value, the debt and non-equity claims must be adjusted to isolate the residual value belonging to the equity shareholders:
Equity Value of Unlisted Firm = Enterprise Value (derived from peer multiple) - Book/Market Value of Outstanding Debt - Preference Capital + Cash Balance
Core Relative Valuation Multiples
| Multiple | Full Form | Primary Valuation Focus |
|---|---|---|
| EV / EBITDA | Enterprise Value / Earnings Before Interest, Taxes, Depreciation & Amortization | Compares enterprise value with operating earnings and is commonly used for comparing companies with different capital structures. |
| Price / Book Value (P/BV) | Market Price / Book Value | Compares a company's market value with its net asset / book value. |
| Price / Earnings (P/E) | Market Price / Earnings Per Share | Compares the company's share price with its earnings and indicates how much investors are paying for each unit of earnings. |
1. EV/EBITDA Multiple (11.7.1)
- Mathematical Representation:
EV/EBITDA Multiple = Enterprise Value of the Firm / EBITDA - Operational Rationale: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) serves as an excellent proxy for pure operational efficiency. It measures profitability completely independent of the company's capital structure, tax regime, and non-cash accounting policies.
- Relevance for Alternative Assets: EV/EBITDA is highly effective for capital-intensive, asset-heavy, or long-gestation businesses (such as infrastructure and real estate SPVs) as well as high-growth start-ups. These companies often show negative net profits (PAT) due to heavy interest or depreciation burdens, but maintain a positive, healthy EBITDA.
Illustration 11.5 (EV/EBITDA Application)
Using the parameters established in the DCF model from Part 2:
- Given Parameters:
- Derived Enterprise Value (EV) = INR 26,737.79 lakh
- EBITDA of the company = INR 2,246.87 lakh
- Formula:
EV/EBITDA Multiple = EV / EBITDA
EV/EBITDA Multiple = 26,737.79 / 2,246.87 = 11.90x
2. Price to Book Value (P/BV) Multiple (11.7.2)
- Mathematical Representation:
P/BV Multiple = Value of the Firm / Networth - Networth Definition (Simple Line Format):
Networth = Net Fixed Assets + Long Term Investments + Net Current Assets - Long Term Liabilities
Or simply:
Networth = Shareholders' Funds = Share Capital + Reserves and Surplus - The "Premium" in Alternative Financing: In healthy listed companies, a P/BV ratio of 4x to 5x is considered standard. However, in early-stage start-ups or tech ventures, book value can be negative due to massive accumulated losses from R&D and customer acquisition, rendering P/BV ineffective. Investors in such companies focus heavily on future cash flows and pay a substantial premium over the hard book value.
3. Price-Earnings (P/E) Multiple (11.7.3)
- Mathematical Representation:
P/E Multiple = Current Market Price of Share / Earnings Per Share (EPS)
Or:
Total Equity Value = Net Profit After Tax (PAT) * P/E Multiple - EPS Formula (Simple Line Format):
Earnings Per Share (EPS) = Net Profit After Tax / Total Outstanding Equity Shares - Peer Group Application: The P/E multiple is the most widely used public market metric. For unlisted firms, analysts apply the median P/E multiple of listed peer group surrogates to the unlisted firm's net profit after tax to establish total equity valuation.
Illustration 11.7 (P/E Multiple and Share Price Valuation)
- Given Parameters:
- Net Profit After Tax (PAT) = INR 100 lakh (INR 1,00,00,000)
- Paid-Up Capital = INR 200 lakh (divided into 20,000,000 shares of face value INR 10 each)
- Applicable P/E multiple of listed peer group = 32
- Step 1: Calculate Earnings Per Share (EPS):
EPS = PAT / Total Outstanding Shares
EPS = INR 1,00,00,000 / 2,00,000 shares = INR 5.00 - Step 2: Calculate Current Market Price (CMP):
CMP = P/E Multiple * EPS
CMP = 32 * INR 5.00 = INR 160 per share
11.8 VALUATION OF AIF PORTFOLIO INVESTMENTS
Alternative Investment Funds hold a highly diverse pool of illiquid, unlisted assets. Because unlisted portfolio companies are not priced daily by the stock market, the fair value of these portfolio holdings varies significantly based on the specific valuation methodology adopted by the fund.
The Core Principles of Portfolio Valuation
- Reporting to Investors: AIF managers are legally and contractually obligated to perform periodic valuations of unlisted portfolio company holdings to calculate and report Scheme Net Asset Value (NAV) to their contributors.
- Methodology Consistency: Any change in the valuation methodology must be disclosed, justified, and approved according to regulatory guidelines.
11.8.1 The IPEV Valuation Guidelines
To establish transparency and global standardisation, AIFs in India and globally align their valuation policies with the International Private Equity and Venture Capital (IPEV) Valuation Guidelines. The central theme of the IPEV framework is that Fair Value represents the most robust measure of unlisted portfolio assets from an investor perspective.
The IPEV guidelines recommend seven core valuation techniques based on the stage of the business:
| IPEV Methodology | Application and Operational Mechanics |
|---|---|
| 1. Price of Recent Transaction | When the AIF conducts a follow-on investment round, the transaction price serves as the implied fair market value for the entire investment. The initial investment is carried at cost and is subsequently revalued based on follow-on funding rounds. |
| 2. Milestone Approach (Early-Stage) | Used for seed and early-stage start-ups where long-term cash flow forecasting is impossible. Valuations are tied to research milestones or technical outcomes. Option Pricing Models (OPM) are often used to allocate total equity value across different classes of shares based on a continuous distribution of outcomes. |
| 3. Multiples Approach | Applied to established, profit-making companies. Financial multiples (EBITDA, Revenue, P/E) are calculated using historical or sustainable peer group data. A standard illiquidity discount is applied to reflect unlisted risk, which is reduced if an exit is imminent. |
| 4. Net Asset Valuation (NAV) | Used as a backup or secondary method when the investee company is not performing satisfactorily, is experiencing recurring losses, or is a pure financial/investment entity. |
| 5. Discounted Cash Flow (DCF) | Recommended due to its strong theoretical backing, though it is highly sensitive to long-term assumptions regarding cost of capital (WACC) and terminal growth rates. |
| 6. Valuation of Debt Investments | Predictable debt instruments are valued on a discounted cash flow basis. For non-performing or distressed debt, valuations are based on the salvage value of the underlying collateral and the time required to convert that collateral into cash. |
| 7. Industry Metrics | Ideal for non-financial metrics in digital economy companies (e.g., Gross Merchandise Value (GMV) for e-commerce, Average Revenue Per User (ARPU) for SaaS, or value per subscriber). |
11.9 GENERAL APPROACH TO FUND VALUATION
Calculated scheme-level Net Asset Value (NAV) varies over the lifecycle of a typical close-ended Category I or II AIF.
- The S-Curve and J-Curve Dynamics: During the initial "vintage years" (the first 1 to 3 years of drawdown and capital deployment), the fund NAV is heavily driven by unrealized valuations (RVPI) and is reduced by upfront management fees and organizational costs.
- The Maturity Convergence: As the AIF reaches its mature years (harvesting phase) and successfully exits its unlisted holdings through trade sales, IPOs, or buybacks, the NAV of the fund converges directly with its ultimate gross cash realisations.
- Reporting Standard: To ensure complete compliance, benchmarking agencies and fund houses report all final performance metrics and valuation data in both INR and USD terms.
IMPORTANT TERMS FOR EXAM PREPARATION
- EBITDA Multiple: A valuation ratio that measures the value of a business (Enterprise Value) relative to its Earnings Before Interest, Taxes, Depreciation, and Amortization.
- Illiquidity Discount: A percentage reduction applied to the value of an unlisted share to account for the difficulty and transaction time required to convert the asset into cash.
- IPEV Board: The International Private Equity and Venture Capital Board which issues global, principles-based fair value guidelines for private capital investments.
- Option Pricing Method (OPM): A forward-looking valuation technique that treats different equity classes as options on the company’s future value and allocates valuation across those share classes accordingly.
- Listed Peer Surrogates: Publicly traded companies with highly similar operations, risks, and market dynamics used as benchmarks to value unlisted portfolio entities.
KEY TAKEAWAYS FOR DISTRIBUTORS
- Relative Valuation is Capital-Structure Agnostic: Relative multiples like EV/EBITDA measure the operating value of the entire enterprise, requiring the distributor to deduct outstanding net debt and preference capital to isolate the residual Equity Value belonging to the investors.
- IPEV Establishes Valuation Ground Rules: The IPEV guidelines prevent unlisted funds from arbitrarily valuing portfolio assets. They mandate structured methodologies, such as using the price of recent transactions, option pricing, or discounting cash flows.
- NAV Converges Over Time: Early-stage unlisted fund NAVs are highly subjective estimates of unrealised value. Only as the fund enters its maturity years does the reported NAV converge with actual cash payouts and realisations.