Limitations of Using Book Value Multiples to value MFI stock

In the absence of market information, (as the sector is still in a nascent stage and MFI’s stock don’t trade except for a few MFIs in Latin America), it is natural for most investors to value an MFI based on its Book Value – utilizing a valuation range constructed from multiples of book value . Book value – variously called shareholder equity and net worth – is broadly defined as total assets minus total liabilities . This difference is the excess value a business has generated in its life. Book value is then multiplied by pre-determined coefficients to create the valuation range. However, the Book Value method may not be appropriate for valuing MFIs because of the following reasons:

1) Backwards Looking Nature: Book value is sum of the total excess value generated by a business. Hence, book value measures only what a business has done, and does not necessarily have bearing on what it will do. In mature companies and industries, past history is often a strong indicator of future performance; in such situations, book value is an effective tool for determining a company’s present value. Microfinance, however, is not a mature industry, nor are many MFIs truly mature companies. Prior operating history is therefore not a good predictor for future results.

Historically, the microfinance industry operated along purely social lines. MFIs sourced operating funds from donors and philanthropic organizations in the form of grants, soft loans, and subsidized loans. These investments did not require profit maximization; at most, some investments required a nominal interest rate and future return of capital. MFIs utilized these funds as budgets, not as commercial equity investments; the firms did not have an incentive to build a surplus. Excess funds were generally utilized to explore new niches or to lower borrowing costs. Additionally, microfinance activities were often only one of many initiatives under an NGO’s umbrella. Excess profit generated through microfinance quickly flowed back into other parts of the NGO.

MFIs looking for commercial financing have refined their outlook to marry their social missions with the profit seeking ends of capitalism . Managing their businesses for profit while offering financial services to the poor and very poor allows MFIs to dramatically scale their businesses. Commercially financed MFIs will necessarily operate very differently than they have in the past; investments can no longer be viewed as budgets, and an entire class of investors will demand profit maximization. Examining their history of value creation – the premise behind a book value valuation approach – is a misleading method of determining an MFI’s value creation potential.

2) Lack of Comparables: Without commercial history in the microfinance sector comparables to assess potential MFI profitability and an MFI’s risk profile do not exist. Selecting the appropriate coefficients for book value is impossible in such an environment. Multiple coefficients for the book value approach are based upon two factors: one, the return to an investor a unit of book value will yield, and two, the return an investor expects from a particular investment. In practice, the amount of profit delivered per unit of book value (or sales or assets, or otherwise) is generally not known to any degree of specificity. This value is generally determined by examining multiples ascribed to similar companies or by examining a “standard” long term business model of a company or industry. Owing to its unique evolution and young age, microfinance sector does not have a set of comparable companies from which to draw from. A long term “standard” business model for the microfinance sector is also difficult to ascertain; at this stage, no one knows if a 2% return on assets, a 20% return on sales, or a 15% return on net portfolio outstanding is appropriate. Without either tool, determining the appropriate multiples is impossible.

The situation is further complicated by the differences between microfinance firms. Due to the youth of the industry, a plethora of models continues to persist. Each model has different operating profiles, different profit potentials, and carries different risks. Some key differences include:
• Full Grameen model vs. Self Help Group – Grameen hybrid
• Livelihood consulting vs. pure MFI
• Full intermediation vs. service company operations
• Significant regional variations
A multiple used to value one microfinance firm rarely transfers to another. Hence, even after a handful of MFIs successfully source investments in the near to medium term, selecting book value multiples based on comparables will be difficult. An effective approach must both be forward looking and function in a nascent industry. A valuation approach that meets these requirements is the discounted cash flow (DCF) valuation.