- This article takes a closer look at how to value a business using the discounted cash flow and asset-based methods.
- The Discounted Cash Flow method of valuation is based on the fundamental principle of finance that any asset is worth the present value of all its future cash flows.
- With asset based valuations, a business is judged by their ability to grow their net asset value or NAV each year.
In part 1 of this series, we listed the four main methods of valuing businesses:
- Comparable Companies
- Precedent Transactions
- Discounted Cash Flow and
- Asset Based Valuations.
We also looked in detail at the first two of these.
In this article we will consider the second two in more detail and think how all four methods are used for real estate-based businesses.
The Discounted Cash Flow method of valuation is based on the fundamental principle of finance that any asset is worth the present value of all its future cash flows. The notion of a ‘present value’ is a way to express in today’s money a payment that you are not going to receive until sometime in the future.
Imagine, for example, that a rich uncle had promised to give you $100,000 when you reached the age of 25 and that you were now only 20. What would that promise be worth today?
The answer is that it is worth the amount of money, which, if invested for five years would end up being worth $100,000. That sounds awfully theoretical, but in practice it is easy to buy a note or bond which will pay out $100,000 in five years’ time and the cost of such a note equals the value of $100,000 in today’s money.
So, how do we apply DCF to a coworking business?
It’s easy to explain in principle how we use this method, but a little more difficult in practice.
The first task is to prepare some financial projections for the business for the next five years, drawing up a profit and loss account and balance sheet for the next five years. A moment’s reflection will tell you that this is no easy task – how do you know what business will be like in 2022, let alone 2025 or 2026?
Some things you may be able to predict five years ahead, like loan repayments or rent payments, but most things you will not, so you will need to make lots of assumptions to fill in the gaps. Once this is done you will have to take the projected profit figure for 2026 and use that to estimate a value for the business from 2026 going forward as a lump sum. There are various ways to do this, which I will not explain now, as I don’t want to make this even more complicated.
Once you have all the profits figures for 2021-2026 and the estimated lump sum value in 2026, you work out what all these amounts are worth in today’s money using the same logic as we did for your rich uncle’s gift, and add them all together to produce the value of the business in today’s money.
Is this as complicated as it sounds?
Actually no. It’s more complicated than it sounds, so you probably won’t be doing it yourself. Instead, you will likely hire a consultant or investment banker to do it for you.
In case you are wondering, it was this method that was used to justify the $47 billion valuation for WeWork in 2019.
You see, if you make the right assumptions, you can come up with whatever number you like.
Professional investors are well aware of both the logic of this method and also its practical drawbacks, and will tend to use it alongside other methods to try and arrive at some kind of composite valuation.
Now let’s take a look at the final method of the four main methods: Asset Valuation.
Valuing a company on the basis of its assets would be a nonsense in many cases. Take Apple Inc., which gained and lost again in 2020 the title of being the world’s most valuable company. Aside from its enormous cash pile and the shares it holds in other companies, Apple is ‘asset lite’ and its $2 trillion market capitalisation is only backed by $324 billion of assets.
Its value comes from its ability to generate profits from innovation, not from owning a huge pile of assets. Most of its products are manufactured by sub-contractors and their assets do not appear in Apple’s accounts. Even Tesla, which does own factories and inventories as a manufacturer only has assets of $52 billion to support its $635 billion Market cap.
By contrast there are certain industries where the value of a business is directly linked to the value of its assets. Another company that was, at least momentarily, the most valuable in the world is Saudi Aramco.
That valuation is founded on its huge oil reserves. Oil and gas companies and other natural resource companies are valued on the basis of the value of their assets. The value of a gold miner, for example, is the value of its reserves of gold less the cost of production, adjusted for risk.
Other categories of business valued on the basis of their assets include, fairly obviously investment companies, but also real estate companies, at least those which own real estate.
The two largest real estate developers in the United Kingdom are British Land plc and Land Securities plc, and both are these days structured as real estate investment trusts or REITs. The performance of these businesses is judged by their ability to grow their net asset value or NAV each year and this is the number that investment analysts look for when the annual results are published.
Some operators of coworking space/serviced offices also own the buildings from which they operate and for these businesses the value of the land and buildings will form part of the valuation process. The value of the assets will provide a ‘floor’ to the valuation in that even without the coworking business, the assets have a market value.
It is tempting to think that a profitable coworking business is worth the value of the real estate plus the value of the coworking business on top. We have a technical term in the industry to describe such a belief – it is called “having your cake and eating it too”.
The reason why this is a fallacy is that the income that they would generate is implied in the value of the property assets. Therefore, the correct formula is more like the following:
Value of Coworking Business = Value of Assets + Value of Business – Value of Rent of Assets.
To complicate things further, most valuers would not consider the income from a coworking centre to be worth as much as that from a long term rent paid by a major corporation, because the coworking commitment is usually much shorter and the credit rating of the client generally lower.
To compensate, a valuer will apply a higher cap. rate, or discount rate to the projected income from a coworking business, making future payments worth less in today’s money.
Indeed until fairly recently the major real estate firms, such as JLL, CBRE, C&W and DTZ pretty much ignored the coworking sector which they derided as having a liquidity mismatch – borrowing long and lending short, and hence bound to fail—though I suspect it was more a question of laziness.
The employees of those firms could not be bothered to do the relatively small ticket work of servicing coworking space, but would rather spend their time schmoozing institutions for their bigger ticket deals.
Having considered all four main valuation methods, the next article in this series will look in more depth at valuing coworking businesses.