For a good valuation to take place, it is important that the systems and processes set up are allowed to function independently.
Why are some companies valued differently from others, and what makes it more lucrative to invest in one vis-a-vis the other? The answers are many, but let’s understand some of the issues that affect valuation for Indian companies today.
As is obvious, valuation of an Indian company by an accredited firm or agency is critical in promoting its financial health and stability among its stakeholders. However for (ensuring) a good valuation there are certain key issues that need to be addressed especially with respect to Indian companies. Let us evaluate some of these.
First, for a good valuation to take place, it is important that the systems and processes set up are allowed to function independently. It has been observed that promoters of the company succeed in creating an excellent process flow; however this is not maintained during actual decision-making. This disconnect results in delays and a certain ‘nimbleness’ among the decision makers, thereby influencing the company’s valuation at that point.
‘True’ governance is another crucial variable for good valuation. Having a well-defined governance framework safeguarding the interest of the shareholders is very essential. There is a need to implement the ‘maker-checker’ system to ensure that the balance sheets/ financial statements are not manipulated and that the shareholders are up-to-date with the company’s actual financial position.
Assessing the true scalability of a company’s business by evaluating its Terminal Growth is another key aspect that is an indicator of its perpetual growth. Terminal growth is an essential factor to be considered, as it has been observed that many companies after achieving a reasonable growth in the first 3-4 years, tend to due to economic and cyclical factors. However on achieving saturation if the company is still able to post 7-8 per cent of terminal growth, it is considered a positive indicator in its valuation.
From a shareholders perspective, it’s very important to get a reasonable mix of debt and equity. These metrics are used to assess the enterprise value of the company i.e. accurate value of equity and debt. Companies should prevent over leveraging since it tends to be a dampener on the equity value. For e.g: this is usually observed in the Infrastructure sector which is highly over leveraged, when compared to the reality of the sector.
Correct assessment of the earnings per share (EPS) in dilutive businesses like infrastructure and real estate is yet another key factor to consider. This is due to the fact that though a company’s financial books might reflect internal profitability, the same may not be an accurate indicator for sustainable growth.
The Infrastructure and real estate sectors are both good examples that a company might be making profits and raising capital (both equity and debt), but still need not be good to invest into, due to non-EPS accretive growth, thereby reducing valuations. FMCG companies on the other hand are categorized as mostly non-EPS diluted businesses as they are able to achieve sustained growth through internal accrual. They are able to post a high ROE (return on equity) and hence enjoy a good valuation.
The other side
The factors stated above can be objectively arrived at. However, this isn’t enough, since there are ‘softer’ aspects of valuation, which need to be considered, as well. These include looking at how the company is handling issues of employee attrition, its labour policies and the overall morale enjoyed by company employees.
Even though a company might be doing well financially, but still, if it finds its self unable to successfully address issues of labour unrest, the same will significantly affect the company’s valuation. A real life example of the situation stated above was observed recently at a major automobile manufacturer’s plant in North India, where the senior management failed to resolve a major labour unrest. The events that subsequently transpired severely affected not only employee morale, but also the company’s valuation in the markets.
As can be seen, there is many a slip between the cup and the lip. However, prudent governance coupled with a transparent and focused approach to managing these parameters, leads to a better probability of success. In the end, value creation is of prime importance, and that is what builds investor confidence in the long run, leading to higher returns and better valuation.
Mohit Ralhan is a managing partner in Indus Balaji Private Equity