By Eugenio Micheletti* for staffingamericalatina

The Comparable model (and particularly Enterprise Value/EBITDA) is, undoubtedly, the most used method for valuing an enterprise in this sector, with a wide approval between sellers and buyers.  But Discounted Cash Flows (DCF) offer solutions to the limitations of the model mentioned before, resulting both methods complementary to each other to achieve a fair value.

Since I perform corporate valuations in staffing and outsourcing sector, it calls my attention that few enterprise use DCF to determine a fair value.  It’s obvious that earnings of the last years and aggregated equity have both prevailing importance in enterprise value.   But we want to analyze in this article how and when DCF add to the aim of calculate a fair value, a key perspective on the near future when negotiating.

Regardless which is the multiple used for the valuation (Enterprise Value/EBITDA), when we value a company taking into account the earnings of the last years, we’re estimating the fair value supported by “reality” and “comparable” which is the management performance in the near past.  So far, these arguments are undisputed.

But, what if the management took wrong strategic decisions with impact in the earnings in the next years?

The DCF method forecast the main financial variables in accordance with assumptions of the senior management, generally weighting different scenarios for the next years.   Those projections are based in the performance of the company in the last years, but the focus is the future of the company results, and its proficiency to generate positive cash flows in the near future.

V =         FCF 1     + FCF 2 +    …      + FCF t   +  FCF t+1

                (1+WACC) (1+WACC)               (1+WACC)  (WACC – g)

Being Terminal Value    =              FCF t+1.

                                                               (WACC – g)

V = Enterprise value

FCF = Free Cash Flow

WACC = Weighted Average Cost of Capital

g = perpetual growth rate

Why both methods are necessarily complementary?

Suppose two extreme situations:

a-      A young and thriving business, with an excellent management, is growing and gaining market share, but its earnings are still low.

b-      A mature company is losing market share, and its senior management is taking wrong strategic decisions and deteriorating corporate image, but the last years has had high profits.

Aside the figures analysis, and forcing the hypothesis, in the case a- could happen that the valuation based in multiples determine a corporate value under that considered “fair”; on the other hand, in the case b- with the same model, we’ll obtain a higher value than that which potential buyers would pay.

*Eugenio Micheletti is Director of Emerging Staffing Brokers

emicheletti@emergingsb.com