Categories
Investing

A2 Milk Ltd – A Rough Forward PE

The current Market Capitalization (MC) for The a2 Milk Company (ATM) is $12,664M, at the time of writing. The latest half year report shows an NPAT of $185M. If we double this to get a full year NPAT of $370M, then deduct the $618M cash that ATM has in the bank from the MC, this gives a PE of about 33 – not super attractive for an investor looking at a one year time period.

If we assume that the following year’s NPAT is ~$450M (~+21% to match current growth), this pushes the forward PE down to 27, which I think is arguably an attractive price to invest at for an investor looking at a multi year investment – excluding concerns of reduced demand from any possible upcoming recession. Given the lack of certainty of the global economic future, I won’t be buying at these prices.

Obviously this is a very sloppy calculation with some wild assumptions (such as no growth in the second half of the year), and I’m sure the purests won’t like me removing the cash in the bank from the MC.

However the purpose of this calculation is to try to see if the value in the current MC can be justified, and given the nature of valuations containing forecasting, I believe it’s best to accept that all values are rough, to be slightly pessimistic in my forecasting, and include points of value which we know about (such as cash in the bank).

Categories
Investing

A Checklist For Angel Investors

This article provides a checklist for Angel Investors prior to investing in a company. It’s a list of documents you’ll need and things you’ll need to check before buying shares in a private company.

  • Business Plan – This should include a SWOT analysis, Risk Analysis with mitigation if possible, forecast (with solid justification for the numbers), information about any planned future capital raises, and a plan for how they’re going to spend the money. There are some good Business Plan templates on the internet for this.
  • Exit plan – which should be a conversation about each directors intentions.
  • Evidence of the things in the Information Memorandum (IM) or business plan, such as a copy of contracts to prove ongoing sales.
  • Financials for the past few years (which you’ll need for the valuation).
  • Financial Models – I like to see that a company has done some financial modelling to show that they’ve can justify their decision to seek funding from an investor. They should have modelled the projection of the business without investment, with other types of investment, etc. It should be obvious to you why they’re willing to give up part of their precious business rather than just take a bank loan.
  • A Company Constitution – You’ll want to have a commercial lawyer check this after you’ve checked it. Getting a good lawyer is very important. All lawyers say that they do commercial law, but the fact is most are only good at family law. It’s very important that you get a lawyer that specializes in commercial law – which usually means hiring a big law firm.
  • A Shareholders Agreement – Again, you’ll want to have a commercial lawyer check this after you’ve checked it.
  • Valuation – The company will likely have their own idea of the value of the company. You’ll need to do your own valuation to ensure that you can see value (and the right ROI) of your investment in the company. You’ll need to be able to justify this to the investor if you want to negotiate on the price.
  • Check the Companies Register for existing ownership structure, company history, and search each director and shareholder to ensure that they don’t have a conflict of interest.
  • Check the Insolvency and DRO Register to see if any of the directors have a history there. You may wish to give the director a change to talk about the reason they are listed on the register before walking away from the investment.
  • Check the LINZ database to ensure that the addresses of the directors matches that of the NZ companies database and also get clues about their financial position from dates of mortgages registered against the property title. I recommend using Prover for this, as property data in NZ is complicated, and I believe that this company does the best job of assembling this data into a useful tool.
  • Check the ID (Drivers License / Passport) of the person that you are dealing with to ensure that they are who they say they are, and are listed on the Companies Register as a director.
  • View the Directors Resolution.
  • Search for the directors, shareholders and company on Google and social media websites and read up as much as you can.
  • Ensure that the Shareholders Agreement or other legal document ensures that IP is owned by the company, and new IP that is relevant to the business, which is created by the directors of the company is owned by the company. This stuff should all be in the Shareholders Agreement.
  • Get a list of assets owned by the company.
  • Get the following Warrants from the company, if they are relevant: There is no outstanding debt, PAYE is all paid, there are no undeclared convertible notes or other unlisted shareholdings, etc. Your lawyer can help with a list here, as they are likely to have a boiler plate template with a list of warranties – though it’s your responsibility to check these off before the contract stage.
Categories
Business Investing

How To Do A Business Valuation

There are a number of different ways to value a business, and although there are a few recognized methods, business valuations are as much of an art than a science.

This article discusses the types of valuation available, when to use each type and links to other articles showing how to do each respective type of business valuation.

Choosing The Right Type Of Valuation

The outcome of a valuation will depend on the type of valuation chosen, the values used in the valuation and the reason for the valuation. That’s why the first step in valuing a business is to choose an appropriate method of valuation.

The Football Field Approach

The Football Field approach isn’t really a type of valuation, more of a method of helping to choose a valuation type. Ironically, given that choosing the type of valuation is the first thing to do, a Football Field can only be done once you’ve done every other type of valuation available.

This isn’t my favorite way to choose what type of valuation to use, but it’s something that I do because it helps get your head around the valuation and give some sense of how the chosen valuation method fits in with alternative ways to value the business.

When I do a Football Field, I perform each type of valuation that can be done on the business thrice; once with a pessimistic view, once with an optimistic view, and once with a view of what the most likely outcome is. Then I place them all in a graph so I can see how each type of valuation compares.

You can then use this to see any commonalities between the different types of valuations and where the upper and lower values are.

Valuation Methods

Here follows a synopsis of various valuation methods, their appropriateness to different types of business and a link to a more in depth description of how to value a business using the respective method.

Discounted Cash Flow (DCF) Analysis

A DCF Analysis is primarily used by accountants to calculate the value of a business in terms of its total worth across a 5 year period. This valuation method is typically used when determining the monetary value of a business for the purpose of arbitration or contractual value. For example, it may be used to calculate the equivalent cash value of a shareholders stake in a company if that shareholder were to be subject to a Call or Put Option.

A DCF Analysis is less frequently used as a method to calculate the market value of a business because (while it may factor opportunity cost or depreciation of the value of money invested in the return in the business – AKA the “Discount”) it typically doesn’t consider a margin of profit for the buyer to entice a purchase.

That said, a DCF Valuation does provide the benefit of factoring in future growth of a company and therefore may be argued as a suitable way to value high growth companies; hence I use my own version of a DCF Analysis when valuing growth companies, which includes a margin of profit – a model that alters based on the exit strategy for the investment.

A DCF is probably the most complex method of performing a business valuation and is not relevant when profit is low compared to revenue (or if profit is negative), as there is value in such a company that is not apparent through the profit (such as goodwill, IP, etc.).

Here’s a Wikipedia article on how a DCF Valuation works.

Comparable Market Analysis

The Comparable Market Analysis (AKA Comparables Market / CM Valuation) involves finding historic sales prices of comparable businesses and using these to deduce what the business might be worth.

The Comparable method is typically used where there is a lot of sales data available in an open market – such as in a stock market or business broker.

The Comparable Market Analysis is heavily influenced by market sentiment and can result in wildly different valuations depending on when it’s done. This can lead to a Greater Fool scenario and also be subject to market manipulation. In the absence of these issues and a short investment time-frame, this is arguably one of the best valuation methods because it tells you what the business is worth at that time.

The problem I have with this type of analysis is that it doesn’t consider the return an investment can give you relative to the performance of the company in the absence of a sale or change in the market conditions, and it relies of the analysis of others.

Therefore, I posit that this type of valuation is most appropriate for stock market traders (but not stock market investors) and business brokers who have access to historic sales data and have some control over the market.

Discounted Dividend Model (DDM)

This is basically a DCF valuation based on dividend return instead of NPAT, which gives the perspective of value of a business based on the return to the investor in the absence of a sale. Truthfully I don’t use this method and don’t know much about it. There’s a really nice Wikipedia article on DDM if you’re interested to learn more.

I suppose this method could be useful for a retiree who wants to calculate Return On Investment (ROI).

Price-to-Earnings (PE) Ratio

The PE value of a company is calculated by dividing the Market Capitalization (MC) of the company by its earnings (Net Income – dividends). This can be done as a backward PE (where the last reported annual figures are used to calculate earnings) or a forward PE (in which the forecast earnings are used in the calculation).

More information on Price-to-Earnings ratios is available here.

Also, check out my own proprietary method for calculating PE.

Multiples Of Revenue

This is a common method of valuing businesses for sale by business brokers. It’s sort of a lazy method because it doesn’t attempt to calculate the value of a company in any depth. It doesn’t consider the effort required of the company to be profitable or the value of the assets that the company holds (though often business brokers will add the value of stock to this number). There are other methods of valuing a business that business brokers use, many of which consider a salary component for the owner, though these methods are beyond the scope of the type of investing I do; hence will not be discussed here.

The benefit of using multiples of revenue is that it does place some value on the company that is relative to its capacity to become profitable if that is not currently the case. Also the value of the goodwill, IP and other aspects could (lazily) be considered to be relative to the revenue of the company, which otherwise may not be recorded in the company’s profit.

This type of valuation is also often used when valuing companies whose customer base is on an Annual Recurring Revenue (ARR) pricing scheme.

I like this valuation method when based on multiples of ARR, but prefer to derive my own valuation method based on the component of a company’s ARR that has the capacity to be profitable (I blend elements of DCF in this method).

This is because I only want to invest in companies that are capable of being profitable so they can offer multiple exit opportunities (sale, Put Option, dividend return, etc.). Also, while theoretically a company could give a positive return on investment if the valuation is based on multiples of ARR, while the cost of growth is less than the multiple of ARR growth, this could lead to a Greater Fool scenario with no other exit than a sale.

Summary

There are a lot of methods to value a business, and I’m sure there are more than I have listed here, and after reading this you can probably appreciate why it’s important to chose a type of valuation that’s relevant to the purpose of your valuation.

Whether you’re valuing your business for sale, looking for investment or trying to decide what the business is worth so you can buy out a business partner at a fair price for all parties involved, there are many valuation methods to chose from. Though given the number of scenarios of requiring a business valuation and the variable nature of finding value in different businesses, there’s no single method for every case.

This is why I suggest that if you are an investor, you should come to your own conclusion about the method of valuations that you use, or make your own valuation methods as I have.

Addendum: An investor should also consider soft aspects of value in a business (such as IP or value in directors). An investor should also watch out for creative accounting and consider the reliability of forecast profit projections. There are a number of things to consider when valuing a business that are not discussed here, and they are learned with experience; hopefully this article sets you up with the basics to get started.