Fundamentals of Business Valuation

Common Standards of Value

Fair Market Value

The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.

Hypothetical participants–Kevin Costner. Exception is when multiple players would have invested more than FMV and the market is very hot. Have means to execute the transaction.

Fair Value for Financial Reporting

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Investment Value

The value of an asset or business to a specific or prospective owner. Accordingly, this type of value considers the owner’s (or prospective owner’s) knowledge, abilities, expectation of risks and earnings potential, and other factors.

Synergistic Value

Is derived from benefits resulting from an acquisition, including:

• Cross-selling opportunities

• Shared administrative / infrastructure costs

• Broadened product or service offerings

• Improved purchasing power

Premises of Value

Going Concern: Value as an active business with future earnings power

Liquidation Value: Value of a business or asset when it is sold in liquidation

• Value as an orderly disposition is a value in exchange on a piecemeal basis

• Value as a forced liquidation

• Value as an assemblage of assets

Book Value – Synonymous with shareholders’ equity (book value of assets – book value of liabilities)

Not an appropriate measure of business value because of the potential for unrecorded intangible assets, understated valued for the tangible assets as well as unrecorded assets and liabilities.

Replacement Value – Refers to the current cost of a similar new property having the nearest equivalent utility to the property being valued.

Methods Used to Calculate The Estimated Future Benefits

Linear Benefit Stream Assumption – estimated future benefits are expected to remain constant or grow or decline at a constant rate

Unweighted Average Method = Sum of Variables
                                                 Number of Variables

Weighted Average Method = ew1 + ew2 +ewnN
                                                w1 + w2 + wN

	2012	$175,000	6
	2011	$122,300	5
	2010	$160,500	4
	2009	$117,800	3
	2008	$135,900	2
	2007	$115,700	1
	Unweighted Average	$137,867
	Weighted Average	$144,971

Capitalization / Discount Rates

Capitalization and discount rates are the yield rates on the business investment. The yield rate is comprised of two main elements:

• Safe rate of return on secure investments

• An additional return that compensates the investor for the relative degree of risk, in excess of the safe rate, inherent in the investment

Risk Adjustment Factors

• External Factors

• Internal Factors

• Investment Factors

Discount Rate: A rate of return used to convert a series of future income amounts into their present value.

Capitalization Rate: A divisor (or multiplier) used to convert a defined stream of income to a present indicated value.

Capitalization Rate = Discount Rate Less Long-Term Sustainable Growth Rate

Cost of Capital

Ibbotson Build Up Method

Ke = Rf + ERP + IRPi + SP + SCR

Ke = Cost of Equity

Rf = Risk Free Rate

ERP = Equity Risk Premium

IRP = Expected Industry Risk Premium

SP = Size Premium

SCR = Company Specific Risk Premium

Notes:

ERP = Duff & Phelps has the following eight measurements of size that can be used to determine an Equity Risk Premium:

• Market value of equity

• Book value of equity

• 5-year average net income

• Market value of invested capital

• Total assets

• 5-year average EBITDA

• Sales

• Number of employees

Capital Asset Pricing Model

Assumptions underlying the capital asset pricing model:

• Investors are risk averse

• Rational investors seek to hold portfolios, which are fully diversified

• All investors have identical investment holding periods

• All investors have the same expectations regarding expected rate of return and how capitalization rates are generated

• There are no transactions costs

• There are no taxes

• The rate received from lending money is the same as the cost of borrowing

• The market has perfect diversity and liquidity so an investor can readily buy or sell any fractional interest

Capital Asset Pricing Model

ER = Rf + Beta(ERP)

ER = Expected return

Rf = Risk Free Rate

ERP = Equity Risk Premium, Expected return on a market portfolio (actual capital appreciation on the S&P 500 Index)

Beta = measures the volatility of the subject security as compared to the market

Modified CAPM

K = Rf + B(ERP) + Si + Spi

Rf = Risk Free Rate

B = Beta (risk measured with respect to a market index)

ERP = Equity Risk Premium

Si = Size Premium

SPi = Specific Company Risk

Weighted Average Cost of Capital

WACC = (ke x We) + (Kd/(pt)[1-t] x Wd)

WACC = Weighted Average Cost of Capital

Ke = Cost of common equity capital

We = Percentage of common equity in the capital structure, at market value

Kd/(pt) = Cost of debt capital (pre-tax) for the company

T = Effective income tax rate for the company

Wd = Percentage of debt in the capital structure, at market value

Exercise: Calculate the after-tax cost of debt capital, the cost of equity capital, and the WACC given:

Pre-tax cost of debt = 7.5%

Marginal tax rate = 40%

Risk free rate = 6.1%

Market risk premium = 6.0%

Beta = 1.4

Equity represents 60% of invested capital

Projecting Future Benefit Streams

Net Cash Flow to Equity

Net Income (after-tax)

+ Non-cash charges (e.g. depreciation, amortization, deferred revenue, deferred taxes)

• Capital expenditures necessary to support projected operations

• Additions (deletions) to net working capital necessary to support projected operations

+ Changes in long-term debt from borrowings necessary to support projected operations

• Changes in long-term debt for repayments necessary to support projected operations

= Net cash flow to equity

• Dividends paid to preferred shareholders

= Net cash flow to common shareholders equity (after-tax)

Net Cash Flow to Invested Capital

Net Cash Flow to Equity

Net Income (after-tax)

+ Non-cash charges (e.g. depreciation, amortization, deferred revenue, deferred taxes)

• Capital expenditures necessary to support projected operations

• Additions (deletions) to networking capital necessary to support projected operations

+ Interest expense net of the tax benefit resulting from interest as a tax-deductible expense

= Net cash flow to invested capital (after-tax)

Income Approach

1. Capitalization of Earnings / Cash Flows Method

Assumes that all of the assets, both tangible and intangible, are indistinguishable parts of the business and does not attempt to separate their values. Assumes the critical component to the value of the business is its ability to generate future earnings/cash flows.

It is important that any income or expense items generated from non-operating assets and liabilities be removed from estimated future benefits prior to applying this method. The fair market value of net non-operating assets and liabilities is then added to the value of the business derived from the capitalization of earnings.

Example: Company XYZ has five-year weighted average earnings on an after-tax basis of $750,000. The appropriate rate of return for this type of business is 19.85%. Assuming zero future growth and non-operating assets of $650,000, the value of XYZ based on the capitalization of earnings method is :

Net earnings to equity $750,000

Capitalization rate / 19.85%

Total 3,778,337

Value of Non-Operating Assets + 650,000

Marketable controlling interest value $4,428,337

2. Discounted Earnings / Cash Flows Method (a.k.a. Discounted Cash Flow Method)

This is based on the theory that the total value of a business is the present method of its projected future earnings, plus the present value of the terminal value. This method requires that a terminal value assumption be made. The amounts of projected earnings and the terminal value are discounted to the present using an appropriate discount rate, rather than a capitalization rate.

Steps:

1. Determine the estimated future earnings of the business

2. A terminal value is often determined at the end of the fifth year. The terminal value that is often used is merely the fifth-year earnings projected into perpetuity.

3. The discount rate determined incorporates an appropriate safe rate of return, adjusted to reflect the perceived level of risk for the business being valued.

4. The estimated future earnings and the terminal value are then discounted to the present using the discount rate determined in Step c) and summed. The resulting figure is the total value of the business using this method.

Example:

Assume the following pre-tax adjusted cash flows as relating to the XYZ Company.

Projected annual cash flows to be received at the end of:

Year 1 $15,000
Year 2 22,000
Year 3 45,000
Year 4 63,000
Year 5 79,000

The pre-tax discount rate is 25%

The pre-tax capitalization rate is 22%

Calculate the value of the business

1. Calculate the present value of the annual cash flows

*Present value factor =

1/(1 + d)^N

b) Calculate the present value of the terminal value

Terminal Value = 79,000/.22 = $359,091

End of Year Terminal Value Present Value Factor Present Value

5 $359,091 0.328 $117,782

2. Add both present values

PV of annual cash flows $100,782
PV of terminal value + 117,782

Total Value of Business $218,564

Other Approaches

1. Excess Earnings / Treasury Method

(From ARM 34 and RR 68-609) This method combines the income and asset-based approaches to arrive at the value of a business. Its premise is that the total estimated value of a business is the sum of the values of the adjusted net assets (as determined by the adjusted net assets method) and the value of the intangible assets. The determination of the value of the intangible assets of the business is made by capitalizing the earnings of the business that exceed a “reasonable” return on the adjusted (identified) net assets of the business.

Steps:

1. Determine the estimated future earnings of the company without regard to growth.

2. Determine the unweighted or weighted average of the GAAP net assets.

3. Select a reasonable rate of return to apply to the GAAP net assets whose value was determined in Step b. Use comparable companies or industry averages.

4. Multiply the value of the GAAP net tangible assets of the business (as determined by Step b), by the rate of return determined in Step c. The product is that portion of total earnings of the business attributable to a reasonable return on the weighted average or unweighted average net adjusted assets.

5. The earnings determined in Step d” and then subtracted from the total earnings determined in Step a). The difference is the excess earnings attributable to the intangible assets being valued by this method.

6. Select a capitalization rate that corresponds to an appropriate rate for a safe return, adjusting it accordingly to reflect the perceived level of risk associated with the company.

7. The amount of excess earnings determined in Step e) is then divided by the capitalization rate determined in step f). The amount thus derived is the estimated total value of intangible assets.

8. Determine the adjusted net assets at fair market value.

9. The final step in valuing the entire business is the mere addition of the value of the intangible assets to the adjusted net tangible assets.

Example:

Assume the following date about ABC Corp.

A.

1. The five-year weighted average historical after-tax economic earnings are $500,000.

2. The GAAP weighted average net assets are $1,200,000.

3. The value of adjusted net assets are $975,000.

4. The industry weighted average after-tax return on equity is 14%.

5. The appropriate after-tax intangible capitalization rate for ABC Corp. is 26.75%.

B. Determine the value of the entire business of ABC Corp.

Calculate the value of intangibles

Weighted average historical after-tax economic earnings $500,000

Less earnings attributable to tangible assets:

GAAP weighted average net assets $1,200,000
x industry ROE x .14 ($168,000)

Excess earnings attributable to intangible assets $332,000
Divided by intangible capitalization rate / 0.2675
Estimated value of intangibles $1,241,121

C. Determine the value of the entire business

Value of intangibles $1,241,121
+ Value of adjusted net assets $975,000

Total Value of Business $2,216,121

2. Excess Earnings / Reasonable Rate Method

This method applies a reasonable rate of return to the adjusted net assets rather than an industry rate of return as in the Treasury Method. This method is applied to the latest year’s balance of adjusted net assets rather than to an unweighted or weighted average of net assets.

Steps:

1. Determine the estimated future earnings of the company.

2. Determine the current adjusted net assets at fair market value, using the adjusted net assets method. This determination must exclude goodwill and other intangible assets.

3. Select a reasonable rate of return to apply to adjusted net assets whose value was determined in Step b).

4. Multiply the value of the adjusted net tangible assets of the business determined in Step b) by the rate of return determined in Step c). The product is the part of total earnings attributable to a return on adjusted net assets. Adjusted net assets exclude intangible assets.

5. The earnings determined in Step d) are then subtracted from the total earnings determined in Step a). The difference is the excess earnings considered to be attributable to the intangible assets being valued by this method.

6. Select a capitalization rate that corresponds to an appropriate rate for a reasonable return and that has been adjusted for any perceived level of risk and other releant concerns associated with the company.

7. The amount of excess earnings determined in Step e) is then divided by the capitalization rate selected in Step f), to arrive at the estimated value of the intangible assets..

8. The final step in valuing the entire business is simply the addition of the value of the intangible assets (determined in Step g)) to the value of the adjusted net tangible assets (determined in Step b)).

Example:

1. Assume the following about XYZ Co.:
   

1. The five-year weighted average historical pre-tax economic earnings are $470,000.

2. The value of the latest year’s net adjusted assets is $1,350,000.

3. The company’s assumed reasonable rate on adjusted net assets is 12%.

4. The appropriate pre-tax intangible capitalization rate for XYZ Co. is 43.25%.
   

2. Determine the value of the entire business.

Calculate the value of intangibles

Weighted average historical pre-tax economic earnings $470,000

Less earnings attributable to tangible assets:

Adjusted net assets $1,350,000
x reasonable rate .12 = (162,000)

Excess earnings attributable to intangible assets $308,000
Divided by intangible capitalization rate / .4325
Estimated value of intangibles $712,139

Value of intangibles $712,139
+ Value of the adjusted net assets $1,350,000

Total Value of Business $2,062,139

Market Multiples

Price Earnings Ratio – Discount or Capitalization Rate is the inverse of the PE ratio

Price/Cash Flow

Price/Revenue

Dividend/Price

Price/Book

Earnings Per Share

Price = V + (S + C)^e

V = value; S = Story; C = Competition; e = Emotion

Market Approach

1. Dividend Paying Capacity Method

Similar to the capitalization of earnings method. This method is based on the future estimated dividends to be paid out or the capacity to payout. It then capitalizes these dividends with a five-year weighted average of dividend yields of five comparable companies. (As per RR 59-60, must be considered for estate and gift tax purposes.)

Example:

ABC Co. has a five-year history of weighted average profits of $550,000. Its weighted average dividend payout percentage over the last five years has been 40%.

Dividend payout ratio = $550,000 x 40%

Amount of Dividend = $220,000

The weighted average dividend yield rate of five comparable companies over the last five years is 12.5%. Therefore the value of ABC Co. under the Dividend Payout Method is:

$220,000 = $1,760,000
.125

Asset-Based Approach – considers a company’s tangible and intangible assets

1. Book Value Method = Book value of assets – book value of liabilities

Frequently used for buy-sell agreements.

2. Adjusted Net Assets Method = FMV of assets – FMV of liabilities
   

Often used to value of a non-operating business (e.g. holding or investment company). Used to value businesses that continue to generate losses or which is to be liquidated in the near future. Does not address the operating earnings of the business.

Common Economic / Normalizing Adjustments

1. Bring values on the balance sheet to market values

2. Allowances for Doubtful Accounts – adjust so that net accounts receivable represent the market value of such receivables

3. Notes Receivable – BS should reflect the market value of notes receivable

4. Inventory Valuation – bring to market value; sometimes an adjustment from LIFO to FIFO is made and the amount of the adjustment to inventory is usually the amount in the LIFO reserve

5. Depreciation Methods – use industry standards and estimated useful lives, not tax motivation

6. Leases – capital versus operating lease

7. Adjust fixed asset values to reflect appreciation or impairment

8. Capitalizing vs. Expensing Policies – adjust to industry standards if needed

9. Timing of Income and Expense Recognition – adhere to industry norms

10. Accounting for Taxes – try to recognize any potential deferred tax liabilities

11. Extraordinary or Non-Recurring Items – extraordinary items are unusual in nature and infrequent in occurrence – e.g. settlement of litigation, gains or losses from the sale of assets, gains or losses from the sale of business segments or insurance proceeds from key man or property casualty claims

12. Compensation of Owners and Managers, Including Perquisites – adjust officer or owner compensation to more closely reflect the reasonable compensation of a replacement executive

13. Contingent Liabilities – consider including contingent liabilities in the adjusted net assets

    1. Pending lawsuits

    2. Unrecorded product service liabilities

    3. Unrecorded past service liabilities

    4. Unrecorded pension plan liabilities

    5. Unrecorded accrued warranty liabilities

    6. Environmental liabilities

    7. Capital gains tax on unrealized appreciation of assets

    8. Operating vs. Non-Operating Items – identify and remove non-operating assets (and related liabilities) from the valuation process

Intangibles – identify and value intangible assets

Typical off-balance sheet items include:

• The use of operating leases (capitalized leases)

• Use of finance affiliates

• Sales or factoring or receivables

• Use of securitization

• Take-or-pay and throughput contracts

• Use of joint-ventures

• Guaranteeing the debt of affiliates

Financial Ratio (Trend) Analysis

Common-Size Analysis

Types of Discounts and Premiums

Two primary discounts are:

1. Discount for lack of control (DLOC)

2. Discount for lack of marketability (DLOM)

Two points about the application of these discounts:

1. Should apply DLOC and then DLOM

2. The application of these discounts is multiplicative not additive

Example:

Gross value of entity $5,000,000
x subject percentage 12%
12% Interest (pre-discounts) $600,000
Less: Discount for lack of control (25%) ($150,000)
Minority, marketable value $450,000
Less: Discount for lack of marketability (20%) ($90,000)

Minority, non-marketable value $360,000

Calculation of Overall Discount = 1 – [(1 – .25) x (1 – 20%)]
= 1 – [(.75) x (.80)]
= 1 – .60
= 0.40

Overall discount = 40% (not 45%)

Discounts for Lack of Control

Popular Method

Benchmark against premiums paid for publicly-traded companies; use difference in price of target company five days before the announcement of the acquisition; Mergerstat Review is a good source

Computation of Implied Minority Discount from Mergerstat Review Data Formula:

X = 1 – [1 / (1 + y)]
x = implied minority discount
y = median premium paid

Application:

X = 1 – [1 / (1 + .375)]
x = 1 – (1 / 1.375)
x = 1 – 0.7272
x = 0.2728

DLOC is 27.3%

Reasons for using a DLOM in valuing controlling interests include:

• Uncertain time horizon to complete the offering price or sale

• Cost to prepare for and execute the offering or sale

• Risk as to eventual sale price

• Non-cash and deferred transaction proceeds

• Inability to hypothecate (or inability to borrow against the estimated value of the stock)

Discount for Lack of Marketability

Factors that may increase the discount:

• Restrictions on transfers

• Little or no dividends or partnership payout

• Little or no prospect of either public offering or sale of company

• Limited access to financial information

Factors that may decrease the discount:

• “Put” option

• Limited market available that may be interested in purchasing shares (e.g. ESOP)

• Imminent public offering or sale of company

• High dividend or partnership payouts

Factors that may increase or decrease the discount:

• Size of block – depending on size and circumstances

• Buy-Sell agreement – depending on provisions

Review of Studies to Determine the Size of the DLOM:

Restricted Stock Studies Comparison of private placements of restricted shares of public company stocks with publicly traded unrestricted shares of the same company. Restricted stock is stock of a publicly traded company that is restricted from trading for a specific period of time. It is identical to the publicly traded stock except that it is not freely traded. Although restricted stock cannot be sold in the public markets, it can be sold in private transactions. These transactions usually must be reported to the SEC and therefore become public record allowing a comparison be done of the price of the restricted stock to the publicly traded stock.

Pre-IPO Studies Comparisons of pre-initial public stock transaction values (restricted stock) with post-initial public offering transactions and stock value of the same company.

P/E Comparisons Comparisons of public companies PE ratios with PE multiples on acquisitions of privately held companies.

Issues and Observations

• The smaller the company, the larger the discount for lack of marketability

• Issuers of restricted stock are generally considered good credit risks – not necessarily true of CHBs

• Issuers of restricted stock are publicly traded companies for whom an active market exists for their stock

• Owners of stock in a CHB have no access to an active market for their stock; most CHBs will never be publicly traded
  

• Publicly traded companies offer annual dividends and/or an established record of capital appreciation in share price; CHBs seldom offer either

• Purchasers of restricted stock are institutional investors with investment goals and criteria far different from the individual purchaser of a CHB

• Institutional investors have different levels of risk perception and risk tolerance than purchasers of CHB stock

• Purchasers of restricted securities usually intend to market these securities in the future and a ready market will exist at that time

• Purchasers of CHB stock have little or no expectation to market the CHB stock in the future and if so, a limited market exists

Other Issues in Discounting

• Control – The power to direct the management and policies of a business enterprise

• Minority Interest Discount / Discount for Lack of Control

• Discount for Lack of Marketability

  • Marketability = Salability

• Blockage or Illiquidity Discount

Market may not be able to digest too much stock

• • Liquidity = How fast (at the current price)

    • If it is liquid, it is marketable

    • If it is non-marketable, it is illiquid

    • Just because it is marketable, doesn’t mean it is liquid

      • There could be restrictions or a buy-sell agreement

• Other Discounts

  • E.g. Key Person Discount

  • Environmental Liability Discount

  • Investment Company Discount

  • Lack of diversification discount

  • Non-homogenous discount

  • Restrictive agreement discount

  • Small company risk discount

  • Specific company risk discount

  • Built-in gains tax discount

  • Liquidation costs discount

  • Lack of Voting Rights Discount

Buy-Sell Agreements

• Stock-repurchase agreement – company agrees to purchase the interest of a departing owner.

• Cross-purchase agreement allows the remaining owners to purchase the departing owner’s cash

An appropriately constructed buy-sell agreement will address several important items including:

• What events (e.g. death, disability, etc.) trigger a buyout?

• How will the buyout be funded: insurance, financing or something else?

• How soon will the buyout occur?

• How is the interest to be valued – i.e., based on a fixed value, a formula, or a valuation?

The conversion of balance sheet and income statement line items to percentages of a total.

Key Financial Ratios

1. Internal Liquidity Ratios – measure a firm’s ability to pay its near-term financial obligations

Current ratio = Current Assets
Current Liabilities

Quick Ratio = Cash + Marketable Securities + Receivables
Current Liabilities

Cash Ratio = Cash + Marketable Securities
Current Liabilities

Receivables Turnover = Net Sales
((Beginning A/R + Ending A/R) / 2)

You can further convert the turnover ratio by dividing it into 365. This yields a rough indication of the average time required to convert receivables into cash.

Inventory Turnover = Cost of Goods Sold
((Beginning Inventory + Ending Inventory)/2)

Payables Turnover = Cost of Goods Sold
((Beginning AP + Ending AP)/2)

Cash Conversion Cycle = Inventory Turnover Period + Days to Collect Receivables – Payable Payment Period

2. Operating Efficient Ratios

Net Fixed Asset Turnover = Net Sales
((Beginning F/A + Ending F/A)/2)

Total Asset Turnover = Net Sales
((Beginning Total Assets + Ending Total Assets)/2)

3. Operating Profitability Ratios

Cost of Sales / Sales (%) = Cost of Sales
Net Sales

Gross Margin (%) = Net Sales – Cost of Sales
Net Sales

Operating Expenses / Sales (%) = Operating Expenses
Net Sales

Operating Margin (%) = Income from Operations
Net Sales

Return on Assets (%) = Net Income
((Beg. TA + Ending TA)/2)

Return on Equity (%) = Net Income
((Bg. Common Equity + Ending Common Equity)/2)

D. Business Risk (Operating) Analysis – refers to the volatility of earnings over time

Degree of Operating Leverage = % Change in EBIT
% change of Sales

E. Financial Risk (Leverage) Ratios

Long-Term Debt-to-Equity Ratio

Debt/Equity = Long-Term Debt + Deferred Tax Liabilities
Total Equity

Total Debt-to Total Invested Capital Ratio

Debt/Capital = Current Liabilities + Long-Term Debt
Total Liabilities + Total Capital

Total Debt-to Total Assets Ratio = Current Liabilities + Long-Term Debt
Total Assets

Interest Coverage Ratio = Earnings Before Interest and Taxes
Interest Expenses

Operating Cash Flow Ratio = OCF
Current Liabilities

Operating Cash Flow to Long-Term Debt = OCF
Book value of Long-Term Debt + PV of Lease Obligations

Operating Cash Flow to Total Debt Ratio = OCF
Total Long-Term Debt + Current Interest Bearing Liabilities