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Issues in valuation of Service sector companies

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Business valuation is a set of processes and procedures used to determine the economic value of an entity or set of assets. Though there are standards and premises of value that must be established at the beginning of any engagement, it is equally important to understand the nuances applicable to that particular industry when performing a valuation exercise.

In this article, we discuss the specific valuation issues that are applicable to Service Industries
Service Sector entities are a nebulous block consisting of various different kinds of industries. Each industry would have its own nuance and would also have its own issues which play an important role in evaluating the company that belongs to that particular industry. Few common features of service sector companies include:
a. Lack of tangible physical assets
b. Dependency on key management team
c. Lesser upfront capex
d. Lack of strictly comparable peers
e. Dependencies on a platform or a technology
f. Enhanced subjectivity in valuation assessment
g. Fast changing and evolving
h. Certain industry specific issues encountered while doing valuation in service industries:

I. Software Industry
Software in a sense is a word that is used a very common parlance. The word Software Industry supposedly covers a wide homogeneous array of enterprises that may have completely different business models and functioning. This wide spectrum of coverage is a single-most important challenge that is faced in valuing companies in the software sector. Eg. An Infosys Limited is completely different from Facebook which inturn is completely different than Oracle Inc.
To focus our discussion, we have broadly divided this homogeneous mass of entities into:

a) Software Services Firms and b) Software Product Firms. Software Service Firms are those firms that concentrate on creating solutions for clients, usually other businesses, whilst Software Product Firms are firms that that develop and sell their own products.
Regardless of which market segment your software company is in, these key factors make the major difference to its value:
a) Earnings growth prospects
Earning growth prospects is a key parameter that determines the value of the software company. Because of a high-dependency on this parameter, it becomes extremely important to correctly assess the Earnings growth prospects of the entity. A key issue in evaluating the Earning growth prospect is to also understand the technology curve that is currently underway and the changing behavioural patterns. Software products can be highly profitable if focused on the right market segment with significant demand. Product firms especially can experience significant revenue growth quickly with the right product mix.

b) Profitability
Usually software companies have a better profitability margins as compared to traditional sectors. Key cost for software companies include a) Development Costs and b) Marketing Costs. Both of these are predominantly people costs that for a part of the employee benefit costs for an entity. The firms that manage growth while keeping their cost from escalating are far more valuable than their unprofitable counterparts.

c) Stability of earnings
Maintaining consistent level of sales and profitability can be very difficult especially for pure product software companies. Competition can introduce an alternative product and sudden market changes can make a star product obsolete very quickly.
This is where the service companies tend to do better – the customer loyalty tends to translate into repeat business, stable prices and steady earnings. The costs of entering the new market segments are also lower for software services companies as they tend to rely on existing customers and referrals to do so.
d) Changing technology and obsolescence
A key feature to be considered in valuing software companies, is the dependency of the company on a particular technology or a particular channel. Empirical evidence suggests that technology companies perish significantly faster than brick-and-mortar business, one of the reasons for such sudden perishability is the pace of change in technology or dependency on a particular mode of service delivery.

Other Issues in dealing with software companies
i. Estimation uncertainty on account of exponential nature of technology
It is common to hear software company owners very disappointed with the valuation performed by a qualified valuation professional using the more commonly used methods of valuation. While the earnings based approach continues to remain pivotal in the valuation assessment, it may not necessarily have the same weightage in certain software product companies especially given the ‘the exponential nature of the technology that can be leveraged’ through some of these products.
Once efforts have been made to code and stress tested by a core group of users, the cost for the next unit sold is almost INR 0 for a digitally duplicated copy that is downloaded. To go from 100 users to 1 million users will require more staff, but it is not even close to the additional resources required for the same scaling in the manufacturing, distribution, services or retailing environment.

ii. Importance to concentrate market-share and audience
It is commonly seen in recent times that software companies especially Product companies would want to enhance the pace of gaining market share even at the cost of profitability and positive cash flows. This need is aided by private equity money that is available for fuelling the pace. At the very heart of this need is a fact of ‘Concentrated Market Share’ that differentiates software companies from traditional companies. Eg. Social Media as a segment is now as large as generic pharmaceutical business world over. However, whilst the generic pharmaceutical segment would have more than 100 companies competing and surviving, the social media space would have 3-4 players. Technology enables rapid scalability and concentration for these companies and accordingly there is hightented importance for growth and market share. The current showdown in the Indian e-commerce market is also a classic analogy of the Concentrated Market Share’ feature of software industry.

iii. Lack of comparable companies
When relative valuation is used to value a publicly traded company, the comparable firms are usually publicly traded counterparts in the same sector. With software and young companies, the comparison would logically be to other software and young companies in the same business but these companies usually do not have the same business model or dynamics. We could look at the multiples at which publicly traded firms in the same sector trade at, but these firms are likely to have very different risk, cash flow and growth characteristics than the software firm being valued.
iv. Valuing young high-growth technology disruptors
It might feel old-school to apply the tested discounted-cash-flow valuation to hot start-ups and the like, but it’s still the most reliable method even for this breed. Although the components of high-tech valuation are the same, their order and emphasis differ from the traditional process for established companies: Rather than starting with an analysis of the company’s past performance, begin instead by examining the expected long-term development of the company’s markets—and then work backward.
The focus is clearly on: a) the potential size of the market and the company’s market share and b) the level of return on capital the company might be able to earn.
The fact that young companies have limited histories, are dependent upon equity from private sources and are particularly susceptible to failure, all contribute to making them more difficult to value.

 

II. Logistics Industry
The Logistics industry has had its fair-share in terms of M&A transaction that have happened in the recent past. The Industry is in a constantly evolving phase though not as accelerated in pace as the software industry. Third party logistics is one of the most active sectors within the transportation industry for private equity investment and strategic buyer acquisitions. Shippers are continuing to consolidate their business with a smaller number of providers that offer a breadth of services in order to meet both domestic and international logistics and warehousing needs. The e-commerce boom in India coupled with the opening of FDI in certain warehousing businesses have significantly stirred activity in this sector.
On the valuation of the entities in the logistics sectors, many factors specific to the buyer and the target affect the cash flow multiple that will be paid in a given sale process.
In the logistics industry, non-asset or asset light operating models drive the highest transaction multiples. Historical and prospective growth represents an important consideration for valuation of logistics transactions. Broader industry conditions and volatility, not only within the economy but also the third party logistics industry, are also a factor in valuation of logistics acquisitions.
Finally, scale and size have an effect on valuation with higher cash flow multiples being paid for larger situations. In addition to this, the following are the main drivers for determining the price of a logistics company:
Main drivers that determine the price of a logistics company:
 Size (currently smaller companies have a much lower valuation multiple)
 Profitability and margins
 Synergies
 Interest of a buyer
 Customer base and concentration

 

III. Hotel Industry

Hotel industry in India is gaining its competitiveness as a cost-effective destination. Like all other valuation exercise, Hotel valuation is also a subjective process that involves many variables and assumptions. Consequently, the final value or value range can vary greatly from one appraiser to the next. However, it is important to remember that at the end of the day the valuation results must hold up to the “reasonable appraiser” test. Hotels are unique amongst other forms of real estate in how they generate revenue, and how the basis of their value is measured. For example, when looking at commercial or residential property the basis of measurement is a square metre (or square foot). Offices and floors are leased out based on this unit and the basis of revenue measurement is determined using the same unit. Not so with hotels. Hotels generate their cash-flow through: Rooms; Food and beverage facilities; Gym, spa, and health centres; and Other operating departments like KTV and entertainment centres, conference facilities etc… Trying to value hotels against commercial and residential property techniques would not be an efficient way of determining the true value of a hotel. When an individual or organisation commissions a hotel valuation they want the certainty of knowing the method of valuation chosen was appropriate. Hotels are valued for a variety of reasons, including, but not limited to that fact that: Many companies are required to value their assets annually to satisfy regulatory and listing requirements; If a hotel is being put forward as collateral on a loan, having a reputable company of valuers undertake a valuation provides certainty to the lender and borrower as to the value of the collateral; Investors may be interested in purchasing a specific hotel and want it valued as an indication of where they should start their offer; A hotel owner may want to sell a specific hotel and want it valued as an indication of what sort of offer they should accept; and The value of a hotel may have increased since it was acquired and the owners wish to track the increase, or decrease, in value of their investment. The purpose of valuation may also influence the choice of methods. As stated earlier, there is no shortage of hotel valuation techniques, however, these techniques can be categorised into three groups.

Cost Approach: This is based on the principle that no one would pay for an asset than the cost to acquire or replace an asset with a similar asset in new condition. Adjustments from the new replacement cost are made for factors such as age, condition, changes in technology and economic factors which affect the whole hospitality industry. Valuation methods such as Depreciated Replacement Cost and Optimised Replacement Value fall under the cost approach.

 

Market Approach: This looks for comparisons across similar transactions and how the market has priced them. Consequently, if one wanted to value a 4-star hotel in Central, Hong Kong, one would look at other similar 4 star hotels in Central, Hong Kong, which have recently been sold, to act as a basis of comparison. Valuation methods using relative value include the Per Room Comparable, the EBITDA Multiple and the Capitalised Earnings method.

Income Approach: This is determined by the cash-flows one expects the asset to generate over its useful life and the certainty that the cash-flows will eventuate. Accordingly, assets with high, stable cash-flows should be valued higher than assets with low and volatile cash-flows, though assets with high and unstable cash-flows are interesting. Valuation methods based on the concept of the income approach include the Discounted Cash Flow method and the Adjusted Present Value method. Typically, valuations of hotels are performed using methods derived from both the market and income approaches. The market approach requires sufficient comparable transactions to have occurred and for all relevant information relating those transactions to be available for analysis; unfortunately, this is seldom the case, which is why such methods are not commonly used in isolation. Income approach methods such as the discounted cash flow method are frequently adopted as they can overcome the numerous problems encountered by other methods due to limited market data or lack of transparency. However, like all models; garbage in, garbage out – due consideration needs to be given to all the relevant factors. All income approach methods require four factors to be carefully assessed; namely: 

a)  Cash-flows from existing assets; 

b) Expected growth in these cash-flows; 

c) The discount rate; and 

d)  The time taken before the business becomes mature.

These factors are found across all income approach methodologies, and in addressing the factors mentioned above, it is important to have as much historical data regarding the market the valuation is taking place in, and the property itself. The difference between rack rates and average room rates can vary greatly from market to market and season to season, as can occupancy rates, F&B covers, average food check and other operating parameters. Unfortunately, reliable hotel data and hotel sales information are not always available. This is particularly true in China, where market data is harder to find or is incomplete. Appraising a hotel is a complicated undertaking, and not to be taken lightly. Some variations that could easily have a significant affect on value are lump sum deductions or additions that are not reflected within a hotel’s financials, such as deferred maintenance or excess land. Only a professional hotel valuator should be relied upon to appraise your hotel, as this property type requires a special set of skills and experience, which are not universal among appraisal professionals.

 

IV. Advertising Industry

Advertising agencies are traditionally known to prepare and place advertisements through magazines, newspapers, the internet, television and radio. However, globalization of the industry has led many agencies to expand their suite of services. Many advertising firms now offer media planning, market research, graphic design, media buying and public relations services. The commonly accepted methods of business valuation should each be considered when valuing an advertising agency. The four commonly accepted methods are: Asset-based/Cost-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities. This approach is also sometimes referred to as a “cost-based approach”; that is, the business value is equal to the cost of acquiring its physical assets. An asset-based valuation can be considered when valuing advertising agencies but tends to be less relevant than other approaches. This is because the value of an advertising agency is tied closely to its industry relationships, reputation, and talent, not its physical assets. Income approach to value (capitalization of earnings): This method is the most applicable for advertising agencies if they are expected to have a constant growth of earnings. The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate). Income approach to value (discounted cash flow): The value of equity under this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new firms with higher rates of growth, but requires predicting changes in future cash flows.

Market approach to value: This method utilizes market indications of value such as publicly traded comparable company stock as well as acquisitions of privately held advertising agencies. The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value. Many privately held advertising agencies are bought and sold, which allows for potential valuation multiples from privately held companies. The size of advertising agencies that were bought and sold over the past five years varies greatly, both in terms of their sales, and the purchase price paid for the companies. These wide-ranging deal values and market multiples may not be informative for valuating any advertising agency without further analysis. Care should be given to selecting private transactions that share similarities with the subject company. The financial metrics of a potential guideline transaction should be compared with those of the subject. Industry economic conditions also vary widely over time, affecting advertising agencies as investment opportunities.

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