9/12/2009

Business Valuation

By CA. Aparna RamMohan

Presentation Plan
Topics Duration
• Introduction • 10 Minutes
• Factors affecting the valuation • 20 Minutes
• Methods of Valuation • 45 Minutes
• Discount or Capitalization Rate • 45 Minutes
BREAK • 15 Minutes
• Discounts & Premiums • 20 Minutes
• Valuation using Multiples • 20 Minutes
• Economic Downturn & Valuation • 20 Minutes
• Case Study • 25 Minutes
• Open Discussion • 20 Minutes

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Introduction

Section 1

Definition of Business Valuation

• Business valuation:
– a process and a set of procedures
– used to estimate the economic value of an
owner’s interest in a business.
• Valuation is used by financial market
participants:
– to determine the price they are willing to pay or
– receive to consummate a sale of a business.

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In Simple Terms

Business Valuation is a
process of arriving at a value
acceptable to both the buyer
and the seller.

Some Reasons to Get a Business

Valuation
• Buying or Selling Business • Going Public
• Dissenting Shareholder • Goodwill Impairment
Disputes • Litigation
• Dissolution of Business • Merger or Acquisition
• Divorce • Partner or Member Buyout
• Employee Benefit Plans • Purchase Price Transfer
• Eminent Domain Work
• Estate Settlement • Reorganization of Business
• Family Succession • Regulatory Mandate
• Going Private • Value Enhancement

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What Does a Valuer Need to Know?

• Accounting • Growth Analysis
• Best Practices • Industry Information
• Capital Structure • Legal Environment:
• Corporate Governance Federal, State, Local
Implications • Management Strategy
• Economics • Regulatory Standards
• Financial Statement • Statistics
Analysis • Taxes

What Affects Valuation Results?

• Approach / Model
• Assumptions
• Data
• Purpose / Objectives
• Regulations
• Time Period

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List of Elements of a Good Model

• Minimum complication in computation
• Consistent Results
• Cost-Effective
• Data Integrity
• Easy to Explain
• Generalized Assumptions
• Impervious to Extreme Values
• Logical Assumptions

Risk Factors in Business Valuation

• Failure to Consider Vital Information
• Ignoring Restrictions on Economic Benefits
• Improper Beta Benchmark
• Inappropriate or Incorrect Firm Size or
Industry Adjustment
• Inappropriate Tax Adjustment

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Factors affecting Valuation

Section 2

Valuation Approaches
• Business valuation for going concern
– It is important to understand the benefits,
business is able to generate in future out of its
existing stock of assets although value of existing
assets is not ignored by accountants
• Business valuation in case of liquidation
– The emphasis is what can be fetched by selling the
assets either on piecemeal basis or taking as a
whole

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Valuation in case of amalgamation

• The maximum price which a potential
purchaser will be ready to pay will be:
– Price = Value of (combined – existing) business
• Both tangible & intangible assets are
considered for valuation
• Valuation = NRV of the surplus assets which
are to be sold + the PV of the additional
earnings / cash flows which will accrue to the
acquirer as a result of the acquisition.

Valuation depends on
• Business Value Standard
– The business value standard is the hypothetical
conditions under which the business will be valued.
• Premise of Value
– The premise of value relates to the assumptions, such
as:
• the business will continue forever in its current form (going
concern), or
• the value of the business lies in the proceeds from the sale
of all of its assets minus the related debt.

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Business Valuation is affected by

• Economic Conditions
• Financial Analysis
• Normalization of financial statements

Economic Conditions
• National, regional and local economic
conditions existing as of the valuation date
• The conditions of the industry in which the
subject business operates.
• A common source of economic information
are:
– Publications by the Central and State Government,
– Publications & Reports by Industry associations
– Reports by Economists, Financial Analysts etc

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Financial Analysis
• The financial statement analysis generally involves:
– ratio analysis (liquidity, turnover, profitability, etc.),
– trend analysis and
– industry comparative analysis
– Size and volume analysis
• Industry Comparison helps in:
– discovering trends affecting the company / the industry over time
– risk assessment
– Determination of the discount rate and
– selection of market multiples
• Comparison in different time periods in viewing:
– growth or decline in revenues or expenses,
– changes in capital structure, or
– other financial trends.

Normalization of Financial Statements

The most common normalization adjustments
fall into the following four categories:
• Comparability Adjustments
• Non-operating Adjustments
• Non-recurring Adjustments
• Discretionary Adjustments

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Comparability Adjustments
• The valuer may adjust the subject company’s
financial statements to facilitate a
comparison:
– with other businesses in the same industry
– with other businesses in the same geography
• Intention of these adjustments are to
eliminate the differences between:
– published industry data presentation
– company’s financial statements presentation

Non-operating Adjustments

Assume Then That’s Why

• business were • the seller would • non-operating

sold in a retain any assets assets (such as
hypothetical which were not excess cash) are
sales transaction related to the usually
production of eliminated from
earnings or price the balance
those non- sheet.
operating assets
separately.

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Non-recurring Adjustments

Non recurring adjustment are not expected to recur,

such as:

• the purchase or sale of assets,

• a lawsuit, or
• an unusually large revenue or expense

These non-recurring items are adjusted so that the

financial statements will better reflect the
management’s expectations of future performance.

Discretionary Adjustments

• The owners of • In order to • Similarly, the rent

private companies determine fair paid by the subject
may be paid at market value, the business for the use
variance from the owner’s of property owned
market level of compensation, by the company’s
compensation that benefits, perquisites owners individually
similar executives in and distributions may be scrutinized.
the industry might must be adjusted to
command. industry standards.
At par with Fair Market Market
Industry Value Rate

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Factors considered by an investor

• Risk vs. Reward –
– An Investor must evaluate a company from the viewpoint that it is risking its own capital to
capitalize another company.
– And for that risk and use of money, they deserve a reward.
– The higher the risk of financial loss, the more reward will likely be asked of a potential
portfolio investment company.
• How Much Capital is Needed? –
– An Investor will try to assess the amount of capital that a business needs in order to succeed.
– Too little capital and the business risks failing.
– Invest too much capital, and the Investor has tied up more money than it needed, thus losing
other potential investment earnings.
• How Fast Will Revenues Grow? –
– Another factor that the investor must consider is the rate at which revenues are predicted to
increase until they can take out their “reward” or financial return.
– Some companies may take up to five years or more before they even see a profit and are able
to incorporate with an IPO.
– The longer that Investor money will be tied up, the more return they will ask for at their exit
point.

Methods of Valuation

Section 3

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The Valuation Approaches

Income Approach

Market Approach
Asset Based
Determines value Determines value Determines value
by calculating the by adding the by comparing the
net present value sum of the assets subject company
of the benefit less external to other
stream liabilities of the companies in the
generated by the business (net same industry, of
business asset value) the same size,
(discounted cash and/or within the
flow) same region.

Deciding the method to be adopted

• Is the Discretion of the valuation professional
• Analysis of the advantages and drawbacks of each
technique on the subject Company
• Most agreements and court decisions encourage
use of more than one technique,
• If more than one technique is used, then, they
must be reconciled with each other to arrive at a
value conclusion.
• A measure of common sense and a good grasp of
mathematics is helpful.

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Income Approach
• Fair market value = net cash flow * discount or capitalization rate.
• There are several income approaches, including:
– capitalization of earnings or cash flows,
– discounted future cash flows (“DCF”), and
– the excess earnings method (which is a hybrid of asset and income
approaches).
• Only DCF requires data for multiple future periods.
• Others look in single period historical data.
• Income Approach results in the fair market value of:
– controlling interest --> since the entire benefit stream of the subject
company is most often valued
– marketable interest --> the capitalization and discount rates are
derived from statistics concerning public companies.

Adjusted present value

• APV is a business valuation method similar to the standard DCF Model.
• Instead of WACC, cash flows would be discounted at the unlevered cost of
equity, and tax shields at the cost of debt.
• APV is the net present value of a project if financed solely by ownership
equity plus the present value of all the benefits of financing.
• The method is to calculate the NPV of the project as if it is all-equity
financed (so called base case). Then the base-case NPV is adjusted for the
benefits of financing.
• Usually, the main benefit is a tax shield resulted from tax deductibility of
interest payments. Another benefit can be a subsidized borrowing at sub-
market rates.
• The APV method is especially effective when a leveraged buyout case is
considered since the company is loaded with an extreme amount of debt,
so the tax shield is substantial.
• APV and the standard DCF approaches should give the identical result if
the capital structure remains stable.

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Discounted cash flow

• DCF approach describes a method of valuing a project, company, or
asset using the concepts of the time value of money.
• All future cash flows are estimated and discounted to give their
present values. The discount rate used is generally the appropriate
WACC, that reflects the risk of the cashflows. The discount rate
reflects two things:
– the time value of money (risk rate) - investors would rather have cash
immediately than having to wait and must therefore be compensated
by paying for the delay.
– a risk premium (risk premium rate) - reflects the extra return investors
demand because they want to be compensated for the risk that the
cash flow might not materialize after all.
• Discounted cash flow analysis is widely used in investment finance,
real estate development, and corporate financial management.

The Methods under DCF

• Equity-Approach
• Entity-Approach
• Weighted average cost of capital approach
(WACC)
• Total cash flow approach (TCF)

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Equity-Approach
• Flows to equity approach (FTE)
• Discount the cash flows available to the
holders of equity capital, after allowing for
cost of servicing debt capital
• Advantages: Makes explicit allowance for the
cost of debt capital
• Disadvantages: Requires judgement on choice
of discount rate

Entity-Approach
• Adjusted present value approach (APV)
• Discount the cash flows before allowing for the
debt capital (but allowing for the tax relief
obtained on the debt capital)
• Advantages: Simpler to apply if a specific project
is being valued which does not have earmarked
debt capital finance
• Disadvantages: Requires judgement on choice of
discount rate; no explicit allowance for cost of
debt capital, which may be much higher than a
"risk-free" rate

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Weighted average cost of capital

approach
• Derive a weighted cost of the capital obtained
from the various sources and use that discount
rate to discount the cash flows from the project
• Advantages: Overcomes the requirement for debt
capital finance to be earmarked to particular
projects
• Disadvantages: Care must be exercised in the
selection of the appropriate income stream. The
net cash flow to total invested capital is the
generally accepted choice.

Total cash flow approach (TCF)

• This distinction illustrates that the Discounted Cash
Flow method can be used to determine the value of
various business ownership interests. These can
include equity or debt holders.
• Alternatively, the method can be used to value the
company based on the value of total invested capital.
In each case, the differences lie in the choice of the
income stream and discount rate.
• For example, the net cash flow to total invested capital
and WACC are appropriate when valuing a company
based on the market value of all invested capital.

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Asset-based approach
• The underlying theory - The value of asset-based analysis of a
business is equal to the sum of its parts.
• Based on the principle of substitution:
– no rational investor will pay more for the business assets than the
cost of procuring assets of similar economic utility.
• Steps:
– Asset Value = Acquisition value – accumulated depreciation
– These values must be adjusted to fair market value wherever
possible.
• Not suitable for going business concerns as:
– the value of a company’s intangible assets, such as goodwill, is difficult
to determine apart from the company’s overall enterprise value.
– In these cases, the asset-based approach yields a result that is
probably lesser than the fair market value of the business.

Current Cost Valuation

• Tangible fixed assets
– Price to be paid to replace such assets at their present condition.
– If replacement price of the same type of tangible assets is not available, then,
replacement price of the next best substitute may be taken.
• Investments
– Quoted investments are taken at current market price
– Unquoted investments are taken at cost unless the available information is
sufficient to determine their current MP.
• Stock
– Current Market Value of the stock in hand is taken up.
• Debtors
– At their net collection amount
• Intangibles
– Valued at their current acquisition price less the proportionate value already
expired.

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Control of shareholders
• Points to be considered:
– shareholder whose interest is being valued would have any authority
to access the value of the assets directly
– Controlling Shareholder
– Non Controlling Shareholder
• Shareholders own shares in a corporation, but not its assets, which
are owned by the corporation.
• A controlling shareholder may have the authority to direct the
corporation to sell all or part of the assets it owns and to distribute
the proceeds to the shareholder(s).
• The non-controlling shareholder, however, lacks this authority and
cannot access the value of the assets.
• Value of a corporation's assets is rarely the most relevant indicator
of value to a shareholder who cannot avail himself of that value.

Income vs Asset Approach

• Income-based approaches
– requires the valuation professional to make
subjective judgments about capitalization or
discount rates
• Adjusted net book value method
– is relatively objective, adjustment of current book
value to the fair market value

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Use of Asset-based approach

• Adjusted net book value may be the most relevant
standard of value:
– where liquidation is imminent or ongoing;
– where a company earnings or cash flow are nominal,
negative or worth less than its assets;
– or where net book value is standard in the industry in
which the company operates.
• None of these situations applies to the Company which
is the subject of this valuation report. However, the
adjusted net book value may be used as a “sanity
check” when compared to other methods of valuation,
such as the income and market approaches.

Market approach
• Based on the economic principle of competition:
– that in a free market the supply and demand forces
will drive the price of business assets to a certain
equilibrium.
• Buyers would not pay more for the business, and
the sellers will not accept less, than the price of a
comparable business enterprise.
• It is similar in many respects to the “comparable
sales” method that is commonly used in real
estate appraisal.

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Indicators to Market approach

• The market price of the stocks of publicly traded companies
engaged in the same or a similar line of business, whose
shares are actively traded in a free and open market, can
be a valid indicator of value when the transactions in which
stocks are traded are sufficiently similar to permit
meaningful comparison.
• The difficulty lies in identifying public companies that are
sufficiently comparable to the subject company for this
purpose.
• Also, as for a private company, the equity is less liquid (in
other words its stocks are less easy to buy or sell) than for a
public company, its value is considered to be slightly lower
than such a market-based valuation would give.

Guideline Public Company method

• The Guideline Public Company method entails a comparison of the subject
company to publicly traded companies.
• The comparison is generally based on published data regarding the public
companies’ stock price and earnings, sales, or revenues, which is
expressed as a fraction known as a “multiple.”
• If the guideline public companies are sufficiently similar to each other and
the subject company to permit a meaningful comparison, then their
multiples should be similar.
• The public companies identified for comparison purposes should be
similar to the subject company in terms of:
– industry,
– product lines,
– market,
– growth,
– margins and
– risk

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Guideline Transaction Method

• Also known as Direct Market Data Method
• Involves determination of market multiples by reviewing
published data regarding actual transactions involving
either minority or controlling interests in either publicly
traded or closely held companies.
• In judging whether a reasonable basis for comparison
exists, the valuation analysis must consider:
– the similarity of qualitative and quantitative investment and
investor characteristics;
– the extent to which reliable data is known about the
transactions in which interests in the guideline companies were
bought and sold; and
– whether or not the price paid for the guideline companies was
in an arms-length transaction, or a forced or distressed sale.

Discount or Capitalization Rate

Section 4

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Discount or capitalization rates

• A discount rate or capitalization rate is used to determine
the present value of the expected returns of a business.
• The discount rate and capitalization rate are closely related
to each other, but distinguishable.
• The discount rate is composed of two elements:
– the risk-free rate, which is the return that an investor would
expect from a secure, risk-free investment, such as a high
quality government bond; plus
– a risk premium that compensates an investor for the relative
level of risk associated with a particular investment in excess of
the risk-free rate.
• Most importantly, the selected discount or capitalization
rate must be consistent with stream of benefits to which it
is to be applied.

Difference between D/R & C/R

• Discount Rate
– is used to calculate the net present value of a
series of projected cash flows.
• Capitalization rate
– is applied for a single period of time data
valuation

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Methods of calculating discount rate

Capital Asset Pricing Model

Weight Average Cost of Capital

Built up Model
METHODS

Capital Asset Pricing Model (“CAPM”)

• Determines the appropriate discount rate in business
valuations.
• The CAPM method originated from the Nobel Prize winning
studies of Harry Markowitz, James Tobin and William
Sharpe.
• Ke = Rf + Rp,
• Rp = Beta*(Rm-Rf)
• Beta is a measure of stock price volatility.
• Beta is published by various sources for particular
industries and companies.
• Beta is associated with the systematic risks of an
investment.

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Criticisms of CAPM Model

• Beta is derived from the volatility of prices of publicly-
traded companies, which are likely to differ from
private companies in their:
– capital structures,
– diversification of products and markets,
– access to credit markets,
– size,
– management depth,
– and many other respects.
• CAPM method may be appropriate where private
companies can be shown to be sufficiently similar to
public companies.

Weighted Average Cost of Capital

• Cost of capital = weighted average of the
company’s cost of debt and cost of equity.
• Calculation of WACC is based on the subject
company’s:
– existing capital structure,
– the average industry capital structure, or
– the optimal capital structure.
• WACC captures the risk of the subject business.
• The existing or contemplated capital structures
are better choices for business valuation.

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Appropriate Match for WACC

• Choices of applying the rate to an appropriate economic income streams:
– pretax cash flow,
– aftertax cash flow,
– pretax net income,
– after tax net income,
– excess earnings,
– projected cash flow
• Appropriate choice is critical to the accuracy of the valuation results
• Most chosen choice – After tax cash flow
• Rationale for the choice:
– this earnings basis corresponds to the equity discount rate derived from the
Build-Up or CAPM models
– the returns obtained from investments in publicly traded companies can easily
be represented in terms of net cash flows.
– At the same time, the discount rates are generally also derived from the public
capital markets data.

WACC Formula

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Built-Up Method

Determines the after-tax Principle --> investors

net cash flow discount would require a greater
rate. It is called built up return on classes of
because it is the sum of assets that are more
risks associated with risky. First element is Rf,
various classes of assets. which is the min return.

Large-cap equity stocks Small cap stocks are

are inherently more risky riskier than blue-chip
than long-term stocks, requiring a
government bonds, greater return, called the
requiring a greater size premium, the third
return. Second element element (based on
is equity risk premium. industry reports)

Risk Factor in the Built-Up Method

• In determining a company’s value, the long-horizon equity risk premium is
used because the Company’s life is assumed to be infinite.
• Built up discount rate (systematic risk) for:
– Large Cap Equity Investors : Rate = Rf+ Rp
– Small Cap Equity Investors : Rate = Rf+ Rp + Size Premium
• These three elements of the Build-Up discount rate are known collectively
as the “systematic risks.”
• Discount Rate = Systematic Risks + Unsystematic Risks
• Unsystematic Risks:
– Industry Risk Premium
– specific company risk

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Butler Pinkerton Model (BPM)

• Historically, no published data has been available to quantify specific
company risks.
• However as of late 2006, new ground-breaking research has been able
to quantify, or isolate, this risk for publicly-traded stocks through the
use of Total Beta calculations, using a modified Capital Asset Pricing
Model ( CAPM) to calculate the company specific risk premium.
• Total Beta (CAPM Model) = Firm's beta + size premium + company
specific risk premium
• The equality is then solved for the company specific risk premium as
the only unknown.
• The BPM is a relatively new concept and is gaining acceptance in the
business valuation community.

Rate for Small private companies

• Capitalization rate for small, privately-held companies is significantly
higher than the return that an investor might expect to receive from other
common types of investments, such as money market accounts, mutual
funds, or even real estate, due to higher risks.
• Those investments involve substantially lower levels of risk than an
investment in a closely-held company.
• Depository accounts are insured by the government (up to certain limits);
mutual funds are composed of publicly-traded stocks, for which risk can
be substantially minimized through portfolio diversification.
• Closely-held companies, on the other hand, frequently fail for a variety of
reasons too numerous to name.
• There are no government guarantees.
• The risk of investing in a private company cannot be reduced through
diversification, and most businesses do not own the type of hard assets
that can ensure capital appreciation over time.

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Discounts & Premiums

Section 5

Discounts and premiums

• The valuation approaches yield the fair market value of the Company as a
whole.
• In valuing a minority, non-controlling interest in a business, however, the
valuation professional must consider the applicability of discounts that affect
such interests.
• Discussions of discounts and premiums frequently begin with a review of the
“levels of value.”
• There are three common levels of value:
– controlling interest,
– marketable minority, and
– non-marketable minority.
• The intermediate level, marketable minority interest, is lesser than the
controlling interest level and higher than the non-marketable minority interest
level.
• The marketable minority interest level represents the perceived value of
equity interests that are freely traded without any restrictions.
• These interests are generally traded on the stock exchanges where there is a
ready market for equity securities.

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Marketable Minority
• The intermediate level, marketable minority interest, is lesser than
the controlling interest level and higher than the non-marketable
minority interest level.
• The marketable minority interest level represents the perceived
value of equity interests that are freely traded without any
restrictions.
• These interests are generally traded on the stock exchanges where
there is a ready market for equity securities.
• These values represent a minority interest in the subject companies
– small blocks of stock that represent less than 50% of the
company’s equity.
• Controlling interest level is the value that an investor would be
willing to pay to acquire more than 50% of a company’s stock,
thereby gaining the attendant prerogatives of control.

Controlling Interest Level

• Controlling interest level is the value that an investor would be
willing to pay to acquire more than 50% of a company’s stock,
thereby gaining the attendant prerogatives of control.
• Some of the prerogatives of control include:
– electing directors, hiring and firing the company’s management and
determining their compensation;
– declaring dividends and distributions, determining the company’s
strategy and line of business, and
– acquiring, selling or liquidating the business.
• This level of value generally contains a control premium over the
intermediate level of value, which typically ranges from 25% to
50%.
• An additional premium may be paid by strategic investors who are
motivated by synergistic motives.

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Non-marketable minority level

• Non-marketable, minority level is the lowest level on the chart, representing the
level at which non-controlling equity interests in private companies are generally
valued or traded.
• This level of value is discounted because no ready market exists in which to
purchase or sell interests.
• Private companies are less “liquid” than publicly-traded companies, and
transactions in private companies take longer and are more uncertain.
• Between the intermediate and lowest levels of the chart, there are restricted
shares of publicly-traded companies.
• Valuation discounts are actually increasing as the differences between public and
private companies is widening .
• Publicly-traded stocks have grown more liquid in the past decade due to rapid
electronic trading, reduced commissions, and governmental deregulation.
• These developments have not improved the liquidity of interests in private
companies, however.
• Valuation discounts are multiplicative, so they must be considered in order.
• Control premiums and their inverse, minority interest discounts, are considered
before marketability discounts are applied.

Discount for lack of control

• The first discount that must be considered is the
discount for lack of control, which in this instance is
also a minority interest discount.
• Minority interest discounts are the inverse of control
premiums, to which the following mathematical
relationship exists: MID = 1 – [1 / (1 + CP)].
• Mergerstat defines the “control premium” as the
percentage difference between the acquisition price
and the share price of the freely-traded public shares
five days prior to the announcement of the M&A
transaction.

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Discount for lack of marketability

• Marketability is defined as the ability to convert the business interest into
cash quickly, with minimum transaction and administrative costs, and with
a high degree of certainty as to the amount of net proceeds.
• There is usually a cost and a time lag associated with locating interested
and capable buyers of interests in privately-held companies, because
there is no established market of readily-available buyers and sellers.
• All other factors being equal, an interest in a publicly traded company is
worth more because it is readily marketable, which is also true conversely.
• The discount for lack of control is separate and distinguishable from the
discount for lack of marketability.
• Several empirical studies have been published that attempt to quantify
the discount for lack of marketability. These studies include the restricted
stock studies and the pre-IPO studies. The aggregate of these studies
indicate average discounts of 35% and 50%, respectively. Some experts
believe the Lack of Control and Marketability discounts can aggregate
discounts for as much as ninety percent of a Company's fair market value,
specifically with family owned companies.

Restricted stock studies

• Restricted stocks are equity securities of public companies that are similar in all
respects to the freely traded stocks of those companies except that they carry a
restriction that prevents them from being traded on the open market for a certain
period of time, which is usually one year.
• This restriction from active trading, which amounts to a lack of marketability, is the
only distinction between the restricted stock and its freely-traded counterpart.
• Restricted stock can be traded in private transactions and usually do so at a
discount.
• The restricted stock studies attempt to verify the difference in price at which the
restricted shares trade versus the price at which the same unrestricted securities
trade in the open market as of the same date.
• The underlying data by which these studies arrived at their conclusions has not
been made public. Consequently, it is not possible when valuing a particular
company to compare the characteristics of that company to the study data.
• Still, the existence of a marketability discount has been recognized by valuation
professionals and the Courts, and the restricted stock studies are frequently cited
as empirical evidence. Notably, the lowest average discount reported by these
studies was 26% and the highest average discount was 45%.

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Pre-IPO studies
• Another approach to measure the marketability discount is
to compare the prices of stock offered in initial public
offerings (IPOs) to transactions in the same company’s
stocks prior to the IPO.
• Companies that are going public are required to disclose all
transactions in their stocks for a period of 3 years prior to
the IPO.
• The pre-IPO studies are sometimes criticized because the
sample size is relatively small, the pre-IPO transactions may
not be arm’s length, and the financial structure and product
lines of the studied companies may have changed during
the three year pre-IPO window.

Valuation using Multiples

Section 6

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Valuation using multiples

• A method for determining the current value of a company by examining
and comparing the financial ratios of relevant peer groups, also often
described as comparable company analysis .
• The most widely used multiple is the price-earnings ratio (P/E ratio) of
stocks in a similar industry. Using the average of multiple PERs improves
reliability but it can still be necessary to correct the PER for current market
conditions.
• Particular attention is paid to companies with P/E ratios substantially
higher or lower than the peer group.
• A P/E far below the average can mean (among other reasons) that the true
value of a company has not been identified by the market, that the
business model is flawed, or that the most recent profits include, for
example, substantial one-off items.

Steps for valuation

• Companies with P/E ratios substantially different from the peers (the
outliers) can be removed or other corrective measures used to avoid this
problem.
• P/E multiples are popular in part due to their wide availability. The value of
a business should, however, be reflected in multiples based on enterprise
value (EV/EBITDA, EV/EBIT, EV/NOPAT) of a company.
• These multiples reveal the rating of a business independently of its capital
structure.
– Determine Forecast Period
– Identifying peer companies
– Determining correct Price Earning Ratio (P/E)
– Determining future company value
– Determining discount rate / factor
– Determining current company value

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More details
• Identifying peer companies
– Important characteristics include: operating margin, company size, products,
customer segmentation, growth rate, cash flow, number of employees, etc.
• Determining correct Price Earning Ratio (P/E)
– The price earnings ratio (P/E) of each identified peer company can be
calculated as long as they are profitable. The P/E is calculated as: P/E = Current
Stock Price / (Net Profit / Number of shares)
• Determining discount rate / factor
– Determine the appropriate discount rate and factor for the last year of the
forecast period based on the risk level associated with the target company
• Determining current company value
– Calculate the current value of the future company value by multiplying the
future business value with the discount factor. This is known as the time value
of money.

Enterprise value
• Enterprise value (EV) = Total enterprise value (TEV) = Firm value
(FV).
• It is an economic measure reflecting the market value of the whole
business.
• It is a sum of claims of all the security-holders:
– debtholders,
– preferred shareholders,
– minority shareholders,
– common equity holders, and others.
• Enterprise value is one of the fundamental metrics used in business
valuation, financial modeling, accounting, portfolio analysis, etc.
• Enterprise value = common equity at equity value + debt at market
value + minority interest at market value - associate company at
market value + preferred equity at market value - cash and cash-
equivalents.

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More about Enterprise value

• All the components are market, not book values.
• Cash is subtracted because when it is paid out as a dividend, it reduces the
net cost to a potential purchaser. Therefore, the business was only worth
the reduced amount to start with. The same effect is accomplished when
the cash is used to pay down debt.
• Value of minority interest is added because it reflects the claim on assets
consolidated into the firm in question.
• Value of associate companies is subtracted because it reflects the claim on
assets consolidated into other firms.
• EV should also include such special components as unfunded pension
liabilities, executive stock options, environmental provisions,
abandonment provisions, and so on, for they also reflect claims on the
company's assets.
• EV can be negative in certain cases—for example, when there is too much
cash in the company.
• EV=NPV of the company.

Flow Chart

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How Has the Economic Downturn

Affected Business Valuations?
Section 7

Expert’s Opinion
• In this section of business valuation, I have
summarized the opinion of an expert in the
field of business valuation.
• Mr Carlene Gaydosh talks about How Has the
Economic Downturn Affected Business
Valuations?

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Business Value
• In today's difficult economic environment, are you finding that
businesses have lost value?
– Yes, due to the uncertain economy people are less willing to take risk.
– The level of risk an investor is willing to take directly drives the value
of a business when it is being considered, particularly when analyzing
the income stream and how much income one requires to generate off
of a prospective investment.
• Is this a bad time to value and sell a business?
– There is never a bad time to value a business or market it for sale: the
unique economic activity we are currently experiencing creates
opportunities for investors and sellers.
– When someone finds himself or herself without a job, especially with
high unemployment and few available jobs, they often look for self-
employment opportunities and, many times, consider purchasing an
existing business.

Opportunities
• Franchise and home-based business models do well in periods of
high unemployment, because people look to replace their income
and, when they cannot find a job, they will look at a business
acquisition.
• Great opportunities available.
– Small businesses are more attracted to acquiring other small
businesses, in an effort to diversify products or services and increase
revenue.
– There are some great opportunities now to purchase businesses that
could benefit from the synergy of a complimentary fit with another
business in a similar industry or service sector.
• It is not just a good time to buy real estate, it is a buyers’ market for
business acquisition and that is where the greater opportunity is;
however, the greater the unemployment rate, the greater the
demand for businesses that are available for sale.

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Challenges
• The challenges of selling.
– Business owners that are considering selling their business
because it is failing due to declined sales and poor cash
flow may find it challenging to market the business during
these times because people are less inclined to assume
the risk.
– Potential buyers are finding it very difficult to borrow
money to purchase a business that is healthy, let alone one
that is struggling, even though there are loans available, so
they say.
– If a buyer is going to borrow the money to purchase,
lenders will look at a business valuation to determine the
amount it is willing to loan.

Various Perspective
• Business valuations are necessary to demonstrate to a
potential buyer the value, as well as provide a guide to
the seller what it is actually worth.
• Most business owners have an inflated perspective on
what their business is worth because they have put
their heart and soul into it, and entrepreneurs are
eternal optimists.
• Sellers also need to have the knowledge of what
factors drive the price of their business and manage
those vital factors in a manner to package the business
and ready it for sale to maximize the selling price.

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Example
• This is like getting a house ready for sale.
• You need to complete maintenance items and freshen the paint,
landscaping and “image.”
• A business is no different, in a sense – it needs to be cleaned up and
positioned within the market to make it more attractive to a potential
buyer.
• Some examples of housekeeping would be to discount and sell off old
inventory and assets.
• This puts cash into the business and leaves good assets and inventory on
the books.
• Accounts receivable also need to be analyzed and uncollectable accounts
written off or reserved and sent to collections.
• Current assets are a real focus, because they reflect the liquidity of the
business and having old account receivables on the books negatively
impacts the ratio analysis that will be conducted during a lender’s
valuation.

Educating the Seller

• The process of the business valuation will most importantly
educate the seller about the underlying drivers of the value
and get educated about steps that can be taken to increase
the value during the process.
• The exercise of having your business valued is very
educational and insightful to owners, and sometimes they
even decide not to sell the business during the process.
• Business valuations are performed for reasons other than
just to sell the business, even though usually that is the
primary purpose.
• These reasons include transferring ownership to a family
member for tax reporting or due to the death, divorce or
disability of the owner (the three D’s).

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Case Study

Section 8

Objective of this case study

• The case study is designed to give prospective
business acquirers, business owners,
financiers, and advisors some insight into the
role an independent business valuation may
have in identifying mispricing of assets and
grounding expectations regarding price and
value.

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Brief Background
• XYZ is a local franchised restaurant and pub serving quality lunches at
reasonable prices at ten area locations.
• The franchise is well-known throughout the region and has a strong
customer base, ranging from professionals on the go to retirees and local
college students.
• XYZ's five area locations are organized as individual corporations which
are, in turn, owned and operated by ABC Holdings, Ltd, a local company
that also owns several other franchise restaurants, ice cream shops, and
gourmet coffee houses.
• Mr A, Mr B, and Mr C own ABC Holdings, Ltd and are seeking to sell two of
the XYZ locations that are outside their immediate territory.
• They had started the two locations about eighteen months ago as part of
an expansion plan incentive offered by XYZ’s parent company.
• Since then, ABC Holdings, Ltd declined the rights to additional franchises
in those outlying locations.

The financial aspect

• The two XYZ locations that ABC Holdings Ltd is seeking
to sell had revenues of roughly $750,000 each in the
last fiscal year as compared to the other locations that
each generated revenues in excess of $1 million pa.
• Both locations have had trouble maintaining quality
staff, and the managers have been largely unsuccessful
in running the business and controlling costs.
• However, the locations are in high traffic strip malls
where rent is roughly $10,000 per month.
• These two locations experienced net losses for the last
fiscal year of roughly $50,000 each.

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Investing Proposition
• MJ and DJ both work at one of the XYZ's more profitable
locations. Upon hearing rumors that ABC Holdings is
contemplating a sale of the two underperforming locations,
they approach Mr A to discuss the possibility of purchasing
the franchises.
• All parties agree that this would be an ideal situation, given
MJ and DJ’s background with the XYZ and their
commitment to increasing the franchises' revenues through
additional marketing and cost cutting initiatives.
• ABC Holdings offers to sell the two franchises for an
aggregate price of $1,000,000. Mark and Diane agree, in
principle, on the price. The deal is contingent upon their
ability to secure financing for the acquisition.

Investors’ Projections
• MJ and DJ consult ASC, a local business consultant and former head of the
state's Small Business Development Center who has extensive experience
in negotiating deals and working with entrepreneurs to develop a viable
business plan.
• After reviewing the tax return (which lacks a balance sheet) provided by
ABC Holding's accountants, ASC has several concerns over the viability of
the plan.
• MJ and DJ believe that they will be able to:
– increase sales by over $200,000 at each of the locations within twelve months.
– In subsequent years, they anticipate sales to increase by 8% annually.
– accomplish this through increased advertising initiatives having a marginal
cost of $10,000.
– employee retention and training programs will help to reduce their turnover
expenses by roughly $20,000 per location
– will be able to reduce their cost of sales from 35% to 30%, saving $50,000 at
each location, through better employee training and inventory management.
• The other XYZ locations have cost of sales of roughly 32%.

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Valuation of the locations

• As a way of assessing the acquisition of the XYZ locations and in
order to facilitate the lending process, ASC suggests that MJ and DJ
engage a business valuation firm to provide an estimate of the fair
market value of the firm.
• They agree to this and feel this is an excellent way of obtaining an
impartial opinion on the value of the business relative to the price
being paid.
• The valuation analyst receives the tax returns for the XYZ locations.
• The valuation analyst utilizes an income approach and a market
approach to value these two locations.
• Within these approaches, the valuation analyst employs the multi-
period discounted earnings method (income approach) and the
direct market data method (market approach). The final value
estimate for each of the XYZ locations is $300,000 for a total value
of $600,000 for the two locations.

Valuation Report
• In arriving at this indication of value, the valuation analyst suggests
the following:
– There is little to suggest that MJ and DJ will be able to reduce the cost of
sales at each location to 30%, a level that is below that of the other XYZ
locations, particularly given that the cost of sales is now in excess of the
average.
– The growth expectations for the two locations are higher than the current
and historic growth rates of the more established XYZ locations. The 8%
growth rate is unlikely to be sustained indefinitely into the future.
– The valuation analyst states no opinion as to the likelihood of the marginal
increase in advertising to increase sales by such a disproportionate
amount.
– After a visit to both locations, the valuation analyst does not believe that
the local traffic is sufficient to support any dramatic increase in sales.
– Further, the analyst does not believe that the locations are conducive to
the business.
– The break-even point for each of the XYZ locations is roughly $1.1 million.

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Valuation Report (Contd..)

– The ability of the firm to reach this level of sales is possible only under highly
optimistic projections.
– In addition, MJ and DJ would likely be forced to make additional capital
contributions to the business in order to maintain operations until they reach
break-even.
• In light of the comprehensive valuation report, MJ and DJ begin to reassess
their acquisition of the two XYZ locations.
• ASC is glad that he arranged for the valuation to be conducted.
• The bank is also glad to have the insight on the business in order to more fully
assess the loan request.
• ABC Holdings is not pleased with the results of the valuation and its role in
killing the deal that would unload these two unprofitable assets that are a
drain on the resources of the other XYZ locations. The ABC owners realize,
however, that it is the job of the valuation analyst to provide an objective
opinion of value, not to work toward a particular value that would get the deal
done.

Indications of the Case Study

• The value-added nature of business valuations when entrepreneurs are
assessing the acquisition of an existing business.
• The prospective owners benefit from the valuation of the firm which
reveals, in this case and in many others, that the companies being
acquired are underperforming assets that warrant a lower valuation than
the contemplated transaction price.
• The valuation report may also serve as a reality check to the prospective
buyers by providing an independent assessment regarding the future
earnings potential of the firm and the errors or overreaching in their
assumptions regarding future operations.
• In addition, the bank benefits from not making a loan to the prospective
buyers whose business venture would likely be doomed from the start.
• Finally, ABC Holdings could also benefit by considering its options for the
two underperforming locations—close the locations and liquidate the
limited assets, maintain existing operations that drain the other resources
of the company, or sell the locations to MJ and DJ at a lower price that is
more reflective of fair market value.

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Thank You

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