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Risk Latte - Valuing a company - A perpetual cash flow approach

Valuing a company - A perpetual cash flow approach
Team Latte
Apr 25, 2007

Recently a small private equity firm (actually an "investment vehicle" for a few high net worth investors) acquired a 45% stake in one of the small but mature and mid-sized textile companies in Asia . The owner-shareholders wanted to sell out for some reason and approached the private equity firm (we call them the "buyers"). The valuation approach that the buyers used was extremely simple, perhaps a bit too simple, but something that they thought would fly. Valuation of companies, even the established and mature ones, is not an easy and simple task. There are layers of complexity that need to be analyzed and the financial modeling of cash flows can be pretty cumbersome and detailed.

But here is what the buyers did. They looked at the company and found that the company, aside from having current liabilities, which were less than $1 million had no significant long term borrowings or debts. Some medium term back financing was there for around $3 million. It had an asset base - all fixed assets - that was generating an average net profit of around $8 million for the last five years and this profit was partly being distributed amongst its shareholders and partly reinvested back in the business.

The buyers assumed that the average profits of $12 million will continue in the near as well as the distant future and that no reinvestment of profits would be necessary. Then they assumed that the company was debt free (ignoring the bank financing). The final assumption was that they needed at least 15% return on their capital going forward in perpetuity. Thus they computed the value of the company as cash flows divided by the expected return:

They did no cash flow projections, no EBITDA analysis, nothing. They simply used the formula above and arrived at the value of the company.

  • Is the above valuation methodology correct?
  • What is the rationale for the above valuation?

We will discuss this in the subsequent article.

 

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