30 Oct 2019, 11:16 — 7 min read
Background: Examining the quantitative and qualitative factors that impact business valuation, with a special focus on the retail industry.
Online players didn’t just introduce Indians to ecommerce and the convenience of shopping online but also to another important aspect of business namely, valuation. Until the race to valuations began, to most people, a Unicorn meant a legendary creature. Today, it denotes a startup that is valued at USD 1 billion or more. There’s an entire club of unicorns and it’s growing by the day.
With valuations of online players crossing billions of dollars, one wonders how the players manage them. A simple reason could be the sheer population of India—over 130 crore. The players are burning cash, creating market and aiming for market share. Will this end the small retailers? Yes, and no. In a geographically, socially and economically diverse market like India, there’s plenty of space for all players. However, it will intensify the competition, compelling them to figure out survival strategies and differentiators. It is therefore essential to build a scalable business model wherein one can create value for shareholders/owners.
For those trying to get higher valuations and raise funding, it is important to ensure that hygiene factors like your board, auditors, transparency factors are set to high. To target growth, the business model should be scalable.
Valuation is critical for any retailer’s growth story. Retail valuations have changed ever since the IPO of D-Mart (Avenue Supermart Pvt. Ltd.). D-Mart has led to an investor frenzy for retailers who are good and worth buying and has changed the dynamics of the entire industry.
Valuation has a lot of aspects and not just pure profitability. Let's delve into a few of the important factors...
To us, valuation is a number on which a buyer and seller agree to transact. Even if a company is valued at some amount by a senior valuer, the question is are there buyers at that price? Look at India’s largest retailer Reliance Retail for instance. As per reports in a leading newspaper, the shares were trading off the market at a very high valuation of PE of over 200—nearly double than most of its listed peers. Why was its valuation so high? One has to understand that this is only on off-market trade and that limited supply is the major reason for the high price. But since there were buyers at that price and some sellers too, its valuation was at 200 times FY19 profit. This is what we mean by valuation. For this reason, valuation of a listed company is its traded price. If there is a decent volume which implies buyers and sellers agreeing to transact the valuation is pretty much determined and fair.
Also read: The valuation game: What does it mean?
An important question to consider is why do different companies trade at different PE and EV/EBITDA values? Because it depends on a company’s potential to perform in the future.
A company with a stable growth of about 10-15% would always give a lower multiple than a company with a potential growth of 30-35% year-on-year. This means the multiple will rationalise over a few years and therefore it is viable to invest at this high premium today. In case of Reliance Retail also, the profitability has been greater than 100% from FY18 to FY19. At the same valuation, it would have been 400 times PE in FY18 and now is only 200 times. If it continues to grow this way, the valuation may go below 100 times. This is how valuation changes so much in just a year. Therefore, if the performance goes on for a few years it will be well within the range of 30-90 times for all listed peers.
Operating ratios have huge impact on valuation. It is key to manage trade payables and inventory. The better the inventory turnover, the more comfort one has over the value of inventory at hand. One becomes skeptical on factors like obsolescence, slow moving if inventory turnaround is slow. Also, how promptly one pays one’s creditors matters. Here, the key is optimum based on one’s balance sheet strength.
On the flip side, a company purely funded by creditors may not survive long if one is paying creditors too fast. Payments should be decided considering the following factors: Is it bringing in margins? How much is one’s dependence on fixed assets? What percent of expenses are rental? That is key to achieve more profitability.
Given the new accounting standards, all leases are now finance leases. Therefore, there is a change in treatment which we will see in balance sheets of all large companies once they are published. These are key factors to look at when valuing a retail company on quantitative aspects.
Another important aspect is to look at non-quantitative values like quality of management, transparency, composition of board, brand recall, reputation and also track record of investors. These things make a huge difference. One may assume that being in the same industry and having a similar growth rate may result in similar valuations for companies. This is not so in the real world, where qualitative factors matter to investors.
So for those trying to get higher valuations and raise funding, it is important to ensure that hygiene factors like your board, auditors, transparency factors are set to high. These are very important and allow investors the confidence they need to rely on your performance. Scalability is also an important factor. To target growth, the business model should be scalable. To me, that’s the biggest problem for mom-and-pop stores. For the category, the biggest challenge in raising funds or access any type of organized finance is their scalability. They need to innovate and prepare ways to scale up their business model and make it robust.
A scalable and profitable business model is what attracts investors. The closer one is to this, the higher the chances of success.
Also read: Technology stepping up the retail play
Article by Ankit Jain published in STOrai Magazine. Ankit Jain is an investment banker with expertise in Corporate Finance, Transaction Services, International Tax Planning, and Tax Structuring. He currently heads the Investment Banking practice at ShineWing India. Working with the organization’s clear vision and business standards, he has spearheaded successful closure of transactions and provided well-rounded advice to many Indian companies and MNCs.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views, official policy or position of GlobalLinker.