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Is it time to revalue valuations?

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When you buy a car or a flat it is usually for a while; not less than five years for a car, going up to maybe 30 years for a flat. A lot of people might pay the going rate because that’s what it is. Most folks, I know, would ask themselves what it’s really worth before they decide what they ought to pay. All of us do a mental valuation of the assets. For a car, you might say the size of the engine, seating, fuel efficiency, durability and design matters. A Japanese sedan might be valued over a competitor’s C segment version simply because a combination of these elements is more valuable than its rival model. Similarly, a flat will be valued for its location, size, amenities and the reputation of the builder.

 

I’m surprised why companies aren’t valued around this simple logic and why investors don’t demand it. Imagine a car being valued at a 10 multiple of its mileage! Or a house at 20 times annual rent?

If these ratios seem incredulous, why do we apply them so easily to an entity like a commercial firm which is usually worth many times as much as a car or a house, and has many more stakeholders. What has amazed me over the years is this: the part that is valued and reported in great detail, viz. the net tangible assets, is always a minor contributor to the worth of a business, anyway we cut it. Let’s look at the two big markers in the life of a firm. One is market value (if it is listed) or an acquisition or merger. In both cases you will find that the book value will not form more than 30 per cent of the market capitalisation or acquisition price.

So why aren’t we demanding equal rigour in the assessment of the remaining 70 per cent of a billion dollar firm? Seems counterintuitive. Especially given that nothing in the balance sheet really tells us what the firm can really do in the future. And that is really where the value of the firm lies. An investor pays for the future of a firm. Not the past. Unless he is interested in asset stripping.

So what are we looking for in the comprehensive intrinsic value of the firm? Granted that firms operating in some businesses will be more attractive than stagnant categories; healthcare and e-commerce by any yardstick are growth businesses, mythical unicorns notwithstanding. But within the category of such businesses, what separates the value of one organisation from the other?

Fundamentally, the real sources of value that drive the quality of any firm’s future can be divided into three logical buckets: what we like to call its three R’s. Recipe (the big one), reputation (share of mind ) and restaurant (net tangible assets). The last is of little consequence outside of its ability to enable the other two, which are the real forward looking assets in the firm. They are the ones that reflect the quality and resilience of a firm’s forecasted earnings. Now the billion dollar question is how to put a value to them.

There is a mountain of evidence lying within a company’s MIS today that points specifically to how these assets individually drive value. Ticket size, stock turns, working capital requirements, cost of capital, stickiness, advocacy, you name it. Organise them under any methodology you favour, but don’t ignore it.

The argument on how verifiable these assets are should have been closed a couple of decades ago. It was worth debating in the days when goodwill was less than a fifth of the purchase price. Not today, when the books can’t explain three fourths of enterprise value. If we think none of the prevailing methods are good enough, then let’s fix that. But to suggest it has no value because we don’t agree with the assessment; that would be throwing the baby out with the bathwater.

This article was published in Business Standard on May 29th 2016

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