In the latest Bayfield Training Webinar, Robert Leigh and Sonia Martin-Gutierrez present: An Introduction to Corporate Valuation Modelling.
Corporate valuations are an essential tool for analysts, project managers, strategic and financial planners, and associates. This webinar discussed core accounting principles such as balance sheets, profit and loss accounts, and cash flow statements. Moreover, it reviewed the current corporate valuation models, such as Discounted Cash Flows (DCF) and the multiples approach.
Income Statement and Balance Sheet
The first key financial statements evaluated by Robert are the income statement and balance sheet. The income statement, sometimes called profit or loss, measures a company’s profitability over a one-year period. You use the income statement to determine trends in revenues and expenses. For example, is revenue declining or increasing compared to the previous year. A real estate income statement breaks down a property’s income and expenses and shows you how much money the investment is making or losing.
The first section of an income statement summarizes the period’s gross income. Gross income is comprised of rental income and any other types of revenue generated by the property. The total gross profit is calculated by adding each line item. The following section of a profit and loss statement will detail each type of operating expense. The term “operating expenses” refers to the money spent on running the investment property. Property taxes, cleaning and maintenance, utilities, repairs, and management fees are considered operating expenses. A profit and loss statement’s final section will show the net operating income (NOI). The net operating income (NOI) represents the profit or loss on the property. The net operating income (NOI) is the figure that will be used in your calculations when analyzing an income property.
An element of interest in a real estate scenario is capital allowances. Capital allowances are a valuable financial savings tool because they are a key tax benefit within a company’s real estate expenditure and are included in most property transactions or developments. Capital allowances are a method of obtaining substantial tax relief for capital expenditures on certain commercial real estate assets. Taxpayers can deduct their eligible capital allowances from their taxable profits, lowering the amount of tax they must pay.
Next is the balance sheet. The balance sheet is a snapshot of the financial position of a company. The balance sheet shows the total assets of the company as well as how those assets are financed, whether through debt or equity. A statement of net worth or a statement of financial position are other terms for the balance. The fundamental equation that the balance sheet is based on is Assets = Liabilities + Equity.
Cash Flow Statement
The cash flow statement measures the cash position of a business, i.e. the inflow and outflow of cash and cash equivalents in the business over the course of an accounting year, and it also aids the business in determining the availability of cash.
The cash flow statement is divided into three main segments: cash flow from operations (CFO), cash flow from investing (CFI), and cash flow from financing (CFF). If we take a hotel, for example, we want to see a high positive CFO. The primary source of CFO for a hotel would generally be operating income from the rental rooms.
CFI is important because it details the purchase and sale of the company’s capital assets, which are assets with a useful life of more than one year as defined by the balance sheet. CFF is important because it considers the company’s stock purchase or sale and any other proceeds or payments related to debt financing.
Discounted cash flow
The most common valuation method used is the discounted cash flow (DCF) method. DCF analysis attempts to determine the current value of a company or asset based on future revenue projections. The concept is straightforward: the value of an asset is simply the sum of all future cash flows that have been risk-adjusted. The NPV (net present value) of expected future cash flows is calculated using a discount rate. The discount rate is typically the real estate’s desired or expected annual rate of return when evaluating real estate investments. A DCF is dependent on several assumptions. These assumptions (inputs) include rental rates, occupancy trends, financing, and absorption in real estate.
The advantages of a DCF are that it helps determine the intrinsic value of a business without the need for comparable peer companies. Moreover, we can change inputs (e.g. WACC, rental rates, occupancy trends) and thus carry out both scenario and sensitivity analysis. In addition, it is well suited to model via excel.
However, as Robert warns, there are limitations to using a DCF. Firstly, it is based on many assumptions. Secondly, the company valuation is made in isolation and does not contain any competitor analysis. Thirdly, it is often made overly complex and thus prone to error.
The final kind of valuation method is the multiples analysis. The multiples approach is a valuation theory based on the assumption that similar assets sell for similar prices.
The two types of valuation multiples are enterprise value multiples and equity multiples. The enterprise-value-to-sales ratio (EV/sales), EV/EBIT, and EV/EBITDA are all examples of enterprise value multiples. Examining ratios between a company’s share price and an element of the underlying company’s performance, such as earnings, sales, book value, or something similar, is what equity multiples are all about. The price-to-earnings (P/E) ratio, the price-earnings-to-growth (PEG) ratio, the price-to-book ratio (P/B), and the price-to-sales (P/S) ratio are all common equity multiples.
There are advantages and disadvantages associated with using a multiples approach. Multiples are easy to use and calculate due to their simplicity. Generally speaking, the information needed to calculate your ratios is publicly available.
However, it can be quite hard to calculate peer comparable multiples with real estate because much of the information is private. Moreover, because it simplifies complex information into a single value, this simplicity can also be considered a disadvantage. This simplification can lead to misunderstandings and make it difficult to separate the effects of different factors.
Furthermore, multiples depict a snapshot of a company’s current state rather than its potential. As a result, they demonstrate how a business develops or progresses. As a result, multiples represent short-term values rather than long-term ones.