If you ask the simple question of “what is a share price?” – many people struggle to answer. People will have an opinion on whether the share price of Telecom or Air NZ is too low or too high – but they can’t answer the simple question of “why?”. I usually get an answer about assets – but nothing very specific.
So how does (or should) an investment banker think about the value of a business?
I am going to use a minimum of jargon here – I promise. Please see the glossary page for some definitions of valuation terminology, why various terms are used and more information about the valuation methodology.
In really basic terms a business is worth the present value of the cash flows that it will generate into the future. This is the perfect high-level answer to “what is a share price?”. Those are the after tax cash flows available to shareholders – from today to forever. A very neat piece of corporate finance is used calculate the value of those cash flows – a discounted cash flow (DCF) analysis.
A DCF takes two pieces of information to determine the present value of the cash flows – an estimate of the cash flows into the future (typically 3-5 years of forecasts and then an estimate into perpetuity, or forever) and an assessment of the potential variability of those cash flows called the discount rate. Basically the bigger the cash flows and the less the variability the better.
The total present value of the future cash flows of a business is called the Enterprise Value. This is the total value of the business – debt and equity. To determine the value to the shareholders we need to remove a figure called Net Debt. Net Debt is basically the long-term borrowings (i.e. bank debt) less cash or equivalents – from the balance sheet. If cash is a bigger amount than long-term borrowings that is fine – Net Debt is negative and being deducted from the Enterprise Value is therefore an addition. The value of shareholders equity in a business (or market capitalisation for listed companies) is simply the Enterprise Value less Net Debt. To then determine a value per share – simply divide the value of shareholders equity by the number of shares outstanding. That is the complete answer to the “what is a share price?” question.
Immediately people start asking about working capital – payables, receivables, etc. We actually deal with these in the cash flow – adjusting for changes in these variables. Calculating a share price is actually a reasonably simple equation. Sorting out estimates of cash flows and their variability can be more challenging.
The valuation professional then does a couple of pieces of additional analysis to check the DCF analysis. They will complete comparison company and comparison acquisition analysis – basically looking at earnings multiples (Enterprise Value as a number of times earnings) of comparable companies on reputable financial markets or from mergers and acquisitions transactions.
That is how an investment banker should be examining a business valuation.