The investment landscape appears to be continuing its inexorable march towards a post-COVID “new normal”, characterised by elevated inflation rates, hawkish central banks and opaque economic outlooks. Against this uncertain backdrop, it has become even more important for vendors to seek independent and robust assessments of their company’s valuation prior to commencing any potential sale process.
By way of recap, there are a number of methodologies which can be used to value a company, with some of the common methods including:
- The discounted cash flow (“DCF”) method;
- The capitalisation of maintainable earnings (“COE”) method;
- Asset based approaches; and
- Industry specific rules of thumb
While a DCF is generally considered to be the most theoretically robust valuation methodology, the other methods can potentially be as (if not more) appropriate, depending on factors such as the nature of the company being valued and the availability of information required to perform a reliable DCF valuation (e.g. detailed medium / long term financial forecasts).
The COE method involves determining a maintainable earnings figure for a company and multiplying that figure by an appropriate capitalisation multiple. This methodology can be considered a short form of a DCF, where a single representative earnings figure is capitalised, rather than a stream of individual cash flows being discounted.
As such, the COE method can, in theory, approximate the accuracy of the DCF method with fewer requirements for detailed forward looking information.
Valuing companies using the COE method
The COE method typically involves the following key steps:
- Determining an appropriate level of maintainable earnings for the company (usually based on normalised LTM or current fiscal year earnings);
- Determining an appropriate industry peer group for the company and calculating an industry average multiple (usually based on relevant trading comparables and precedent transactions); and
- Assessing whether the company should be valued in line with, at a relative premium to, or at a relative discount to, the peer group average multiple. This assessment has traditionally been based on benchmarking the company against peer group companies using characteristics such as:
(i) Earnings growth track record;
(ii) Future earnings growth prospects; and
(iii) Overall quality of company
While the first two steps of the COE method can usually be performed by a qualified valuation practitioner with limited ambiguity, the third step is generally far more subjective, with each of the traditional bases of relative valuation benchmarking having key potential limitations:
Using Return on Assets (“ROA”) as a basis of valuation benchmarking
Investopedia defines ROA as: “a financial ratio that indicates how profitable a company is in relation to its total assets…A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.”
Per the Investopedia definition, ROA has traditionally been used to assess a company’s efficiency and profitability. However, ROA also has a key inter-relationship with a company’s investment returns and valuation which tends to be overlooked, namely:
1. Companies with higher sustainable ROAs should deliver superior returns to investors over time, due to the fact that such companies should consistently generate higher earnings on existing and incremental capital deployed. Empirical evidence showing the relationship between ROA and total shareholder returns (TSR) for ASX All Ordinaries constituents between FY14 – FY19 (i.e. pre-COVID) supports this thesis:
Source: Nash Advisory, CapIQ
2. Companies which are expected to deliver superior returns to investors over time should, by definition, be valued at a premium to their industry peer group (assuming a similar cost of capital)
Summary
Companies that can demonstrate superior sustainable ROAs should command premium valuation multiples relative to their industry peers. Moreover, calculating sustainable ROA based on historical financial information is a comparatively straightforward and objective exercise, with normalisations generally not required in order for comparison between peers to be meaningful.
As such, Nash Advisory is of the view that ROA benchmarking should be considered alongside other qualitative and quantitative measures (i.e. earnings growth track record, future earnings growth prospects and overall quality of company) when performing peer group benchmarking to assess an appropriate capitalisation multiple for valuation purposes.
