It has often been said that valuation is more of an art than a science. Or at least to become a strong practitioner of valuation you need to be one darn creative scientist. I can think of no place where this is closer to the truth that when analyzing or creating valuations for companies in developing economies, such as many of those in China, South-East Asia, and even Africa and much of South America.
Ralph Waldo Emerson (who moonlighted as an IBD analyst summer intern at a BB, don’t ya know…) can lend us a hand here.
RWE is oft-quoted as saying the following,
As to methods, there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tried methods, ignoring principles, is sure to have trouble.
And so I’d like to briefly describe below a few principles to remember when valuing companies in developing economies (in for the bulk of my experience, China).
1) First, focus on the underlying business model. And second, focus on the underlying business model. There’s nothing that puts a valuation off course immediately than establishing an incorrect understanding of where the company derives value. This is where diving deeply into any and every available piece of literature, company filings, research estimates, equity research reports, and press releases is valuable. If, for example, the Bangkok Napa Valley Wine Company Ltd. is for sale, one needs to first and foremost locate what revenue streams actually exist for this company.
Is it import/export of wines? Is it a monthly subscription service (wine of the month) kind of deal? Is it a standalone store? Web outlets? Is it a discount wine retailer? Could it even really be a travel agency planning trips for high net worth individuals to Napa? Maybe even just a trading company. Especially in developing economies, business can become creative and diverse with their revenue streams and expectations, so check to see where the underlying numbers are coming from!
2) When it comes to Comparable Companies, take twice (or three times) as long as you think to develop the initial Universe of Comps. Inevitably, as you move further into the process, many of these initially rosy comparisons you’ve found will fall by the wayside, so if you are looking for a final comp table with 10 firms, start with 40 in the Universe, not 20. To reach the end of your analysis, print out your booklet and look meekly at your MD while he/she glares at the two comparable companies you’ve been able to find isn’t a strong move. I’ve been there.
3) With private companies, expect the process to take twice as long as you had hoped, so get a head start and knock out a few of those 5 a.m. nights early in the valuation process. Small and medium-sized business owners in developing economies often have (painting with broad brush strokes here) next to no idea what capital markets or private equity investments are. So the due diligence process and fleshing out all the details of the financials, as well as even learning whether or not you can trust the head of the business, will take longer than originally budgeted for, so churn through whatever good information you have as early as possible in the process to allow for lag time on the other end for information that proves challenging to ascertain.
4) Identify where the company may stand out, in a positive or negative way. This may be in relation to the sub-sector itself (is the company involved in multiple games in town at once?), products and services (how are the company’s products exceptional?), distribution channels (BIG ONE in developing economies – a retail company in India/Laos is going to have a heck of a time delivering sofas/refrigerators due to quality of roads…), geography (how is the company distributed? In developing economies, perhaps more than the West, often businesses can be hyper-localized, so this is worth checking) and end customers (who is actually forking out money for our product?) In developing economies and especially China, many times this actually turns out to be the government itself…
5) Prepare for a massive valuation adjustment. There, I said it. Even when you’ve crunched all the numbers and formatted your Excel spreadsheet to have the perfect margins, you’re going to need to go back at Adjust your ratios and multiples. This is perhaps where the ‘art’ comes in to play, where the experts’ experience gives them an edge, and even if I conducted valuation exercises for the rest of my life I will new things every single day.
This perhaps deserves a post itself. Stay tuned for next week!
So sound off below: What is the most important thing you’ve learned about valuing a company? What was one mistake you’ve made early on that you’ve learned now and corrected?
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