Company valuations are problematic for investors, according to management consulting firm Alvarez and Marsal’s senior director Antonella Puca.
The first thing to remember regarding the forces shaping company valuations is that it’s not just about the money, Puca explained to Investment Magazine’s Market Narratives podcast. While the traditional approaches still hold up, there are external forces that are playing a role in shaping the way investors look at valuations today.
“These days you have a lot of layers in the market, many of which may be driven by consideration that are not just related purely to financial returns,” she said.
An example of the non-financial factors affecting valuations might be a government with its own agenda, Puca explains, or a large non-profit organisation willing to pay more for a company because it might bring synergies to their overall operations.
“They may even be interested in using the tech that the company is developing for their own purposes that may bring additional value relative to what normal market participation may bring,” she said.
Add these factors to the other pandemic-fuelled sets of circumstances we’re seeing and company prices can depart from the idea of fair trading as we’ve known it since the 1950s, or what Puca calls “the idea of a capitalist system that’s purely driven by market forces”.
“The distinguishing factor is that financial returns are one component [but] they are not the only component, and sometimes not even the main component,” Puca described. “So, in fact… over the longer-term valuations are going to lead the market but in the shorter term you’ve got consider the other factors that influence prices.”
The respected analyst who is also director at the CFA Society explained that the three traditional approaches to valuations – asset-based, income and market – are still as important today as they’ve ever been.
“To get a real and solid approach on a company you need to look at all three approached in some capacity,” she said. “The market approach is certainly key… but the income approach and the asset-based approach are also very important.”
An art more than a science
Each of the traditional valuation approaches require nuance, Puca explained.
When using market-value approaches, for example, revenue multiples may be less significant as drivers than enterprise values and multiples of other metrics, she says. Puca uses the example of a solar plant whose output in terms of kilowatts of energy would be an important valuation marker. “You need to be aware of the metrics to figure out the multiple to use.”
The assert-based approach requires that you “look through corporate the veil” and identify the assets and liabilities that are key drivers of value, she said, which helps to identify the worth of each individual piece of a business on its own merits.
“The asset-based approach these days I would agree has to be very often to the side, but on the other hand that’s the approach you need especially in the situation of stress. This approach can give you a sense of a floor for a valuation of a company,” she added.
The income approach, on the other hand, can provide a more long-term perspective on a company – but it takes some licence on behalf of the valuer.
“You need to have a vision of the company, a longer-term vision of what the company can do in this market and build a model that reflects your vision,’ she said, adding that the current pandemic environment has made this method somewhat trickier.
“One of the challenges to the income approach, particularly during Covid disruptions, [is that] companies have had challenges with coming up with projections for future revenue, costs and profitability,” she said. “At the moment it’s very hard to imagine what those impacts are going to be.”
That difficulty can be offset by another critical element of the income approach – the valuers own critical assessment. Puca says the final part of this method is to “make adjustments” and overlay the valuer’s own perspective.
“That’s really where the skills of the analyst come into play,” she said. “It’s an art more than a science in many ways.”