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Valuing a software company – Part I - Views on News from Equitymaster

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Valuing a software company – Part I
Jul 3, 2007

Valuation is one of the most intriguing and complex factors that investors come across while making their decisions on buying/not buying into a stock. Especially when it comes to software companies, which do not have large asset values to boast of (a large part of their assets, i.e., their human resources, do not find way into the financial statements), valuation becomes all the more subjective. There are numerous ways to value a software company – market focused methods like price to earnings and price to sales, or earnings focused methods like discounted cash flow and EBIDTA based valuation. In this series of articles, we shall help you briefly understand these various ways of valuing a software company, by taking an example of the industry benchmark – Infosys Technologies. In this article, we shall focus our attention on the market-focused valuation methods.

Market focused valuation methods are based on the concept that a company’s value is equal to the price that an investor would pay for a comparable company. There are three market-focused methods normally used in valuing software companies.

Current stock market price

The first market-focused method is the current market price. This method assumes the stock’s current price should at least be equal to the last price paid for the company’s stock or the last transaction price. The last transaction may have been a sale of company stock, or the price at which incentive stock options were granted. The company’s value is determined by multiplying the stock price by the total number of shares outstanding. The investor should carefully consider if the transaction price paid was an arms-length transaction or a bargain price, which was utilised to accomplish another purpose. Another issue to be considered is changes in the company, which would affect its value since the transaction took place.

Public company revenue multiple (Price to sales)

Computation of revenue multiple Rs m
Market capitalisation 1,110,984
Trailing twelve months revenue 138,930
Revenue multiple (x) 8.0
The second market focused method is the public company revenue multiple. This method looks at public software companies and calculates a revenue multiple by dividing the public company’s market capitalization by its revenue.

This method is most often used because of its simplicity, but its simplicity comes with difficulties in its application. In order for the revenue multiple to be applicable, it assumes the various companies produce the similar profit margins and cash flow. The bottomline is that no body will pay the same revenue multiple for a company that makes 50 paise profit for each rupee of sales and one that makes 25 paise profit for each rupee of sales. In addition, comparability in the size of the market place, growth rates, market penetration, user base, and distribution channels must be considered, as multiples of revenue paid by investors, are based on many factors. Private companies normally have lower revenue multiples than public companies.

Public company earnings multiple (Price to earnings)

The public company earnings multiple is very similar to the revenue multiple, except it compares market capitalisation to company earnings. The concept behind using a multiple of earnings is that earnings more effectively reflects the difference in the return to the investor between companies than the revenue multiple. This method has two primary considerations - first the earnings period that most represents the company and the level of earnings to use in computing the multiple.

Computation of earnings multiple  
Market capitalisation 1,110,984
Trailing twelve months earnings 38,560
Earnings multiple (x) 28.8
The most common earnings period used is the latest twelve months, but based upon the particular situation it may be more appropriate to use the prior year, the last fiscal year, or the next year as projected. Price to net income is also very popular. Other levels of income to be considered are pretax earnings, gross cash flow, earnings before interest and taxes (EBIT), and earnings before interest, taxes, depreciation and amortization (EBITDA). The earnings multiple is computed as follows:

Conclusion

This concludes the first of the series on valuation of software companies. The second article on this series will focus on the earnings based valuation methods with descriptions on discounted cash flow analysis and EBIDTA based valuation analysis of software companies.

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