Returns and CapitalIn practice, investment horizons used in equity markets by market participants can be very different and therefore, there are numerous approaches used to value companies. Some are grounded in fundamental corporate finance theory, some are the result of a fad or fashion that is the “flavour of the month”. However, whichever valuation approach is being used, the underlying question that the approach is trying to answer is the same: what return is being generated and how much capital is being used to generate the return? If a cash flow based valuation is used, the return (the company’s cash flows) and the company’s cost of capital (the discount rate calculated using a value of the company’s capital) will be used to calculate an absolute valuation. If a multiple-based valuation is used, return and capital multiples (P/E, EV/EBITDA) will be compared with those of similar companies to arrive at a relative valuation.
Returns take many forms, commonly used market-based returns include metrics such as earnings, cash flow and returns based on other profitability measures. Capital can also take various forms, from the accounting-based capital employed (used in ratio analysis) to market-based equity and enterprise value capital. The key thing to remember is that the return that is used must be consistent with the capital that is being used.
The most common forms of returns and capital used in valuation and analysis are as follows:
When looking at returns and capital, there are two basic valuation approaches: to value the whole of a company (the enterprise value or total firm value approach) or to value just the equity of the company (the shareholders’ share of value). The enterprise value approach will use returns (cash flow, profits, etc.) available to all the providers of capital, and the equity approach will just use the returns available to the equity shareholders. The enterprise value approach values all the capital provided to the company, whereas the equity value approach focuses on the value of the company’s shares.
In practice, the end objective is usually to calculate the equity value of a company to determine how much a company’s shares are worth. This could, for example, either be for a valuation being performed by an equity analyst on the buy or sell side or, if the valuation is being produced for a potential M&A transaction, to determine how much would be paid to acquire a 100% stake in the company.
An equity value produces the value of the shares directly and there is no more work required, but an enterprise value needs a bit more effort. The difference between the enterprise value and the equity value is called non-equity finance (or the “BG bridge”). This represents the proportion of the enterprise value owned by providers of capital other than the shareholders of the company. Determining the value of the non-equity finance allows the translation of an enterprise value into an equity value, so calculating the BG bridge correctly is a key element of determining the value of a company’s shares. The interaction between equity and enterprise valuations can be represented as follows:
The valuation approach taken determines how the BG Bridge is used. For example, if an absolute valuation approach [e.g. a Discounted Cash Flow (DCF)] is used to calculate an enterprise valuation, the valuation starts at the left-hand side of the bridge with an enterprise valuation of operations, adds in non-core assets (which are not generally included in an absolute valuation) and deducts the elements of the bridge (net debt, provisions – including pensions – and minority interest) to arrive at an equity value. If a relative valuation approach is used to produce a valuation (i.e. the approach uses the company’s share price to calculate equity value and the market value of debt, etc.), then noncore assets do not have to be considered (they are assumed to be correctly valued by the market and included in the share price of the company). Exactly how this affects the approach to calculating returns and capital will be dealt with at a later stage as well as how non-core assets are incorporated into a valuation.
Key learning points:
- There are various valuation approaches used in markets depending on the time horizon being used.
- A pragmatic approach to valuation would use both fundamentally based and short-term valuation approaches.
- Returns and capital are the core elements of valuation.
- The BG bridge describes how an enterprise valuation is translated into an equity value depending on the valuation approach (absolute or relative) used.