Valuation for Entrepreneurs

Concept of Valuation

• Business valuation refers to the process used to determine the economic value of an owner’s interest in a business.

• Business valuation is determining the present status as well as the prospects of a company, how to maximize the value of a company.

• The creation and development of corporate value is the single most important long – term measure of the performance of an entrepreneur.

Valuation Approaches

• Different valuation approaches are as following:

1. Discounted Cash Flow Valuation2. Asset-based Approach3. Relative Valuation

Choice of Approach

• In determining which of these approaches to use, the valuer must exercise discretion as each technique has advantages as well as drawbacks. It is normally considered advisable to employ more than one technique, which must be reconciled with each other before arriving at a value conclusion.

1. Discounted Cash Flow Valuation

• This approach is also known as the Income approach, where the value is determined by calculating the present value of FCF (Free Cash Flow) of explicit forecast period and value of venture at the end of explicit forecast period. Thus, the DCF approach equals the enterprise value to all future cash flows discounted to the present using the appropriate discount rate which reflects the present value of the stream of benefits generated by the business.

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Useful Terms

• Explicit forecast period:two- to ten-year period in which the venture’s financial statements are explicitly forecast

• Terminal (or horizon) value:value of the venture at the end of the explicit forecast period

• Stepping stone year:first year after the explicit forecast period

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Useful Terms

• Capitalization (cap) Rate:spread between the discount rate and the growth rate of cash flow in terminal value period (r – g)

• Reversion value:present value of the terminal value

• Pre-Money Valuation:present value of a venture prior to a new money investment

• Post-Money Valuation:pre-money valuation of a venture plus money injected by new investors

Illustration 1

• The TecOne Corporation is about to begin producing and selling its prototype product. Annual cash flows for the next five years are forecasted as:

Year Cash Flow 1 -$50,000

2 -$20,000 3 $100,000 4 $400,000 5 $800,000

1. Discounted Cash Flow Valuation

two basic parameters :A. Assessment of venture’s future FCFB. Finding out a discount rate

A. Assessment of future free cash flows

• Assessment of venture’s free cash flow distribution among all the securities holders, equity holders, debt holders, preferred stock holders, convertible security holders, and so on.

A. Assessment of future free cash flows

• When Net profit and Tax rate applicable are given, it can be calculated by taking:

[EBIT*(1-Tax Rate)] + [Interest * Tax Rate] + Non Cash Expense (i.e. Depreciation etc.) – Capital Investment – Working Capital Investment________________ Venture’s Free Cash Flow_ ______________

Illustration 1

• The Sanford Software Co. earned $ 40 million before Interest and tax on revenues of $ 120 million last year. Investment in fixed assets was $24 million and depreciation was $16 million. Working capital investment was $ 6 million. Calculate free cash flow of Sanford if interest paid is $10 million and tax rate is 40%.

Solution

Am. (in million $)[EBIT*(1-Tax Rate)] 24Add: [Interest * Tax Rate] 4Add: Depreciation 16Less: Capital Investment 24Less: Working Capital Investment 6Free Cash Flow 14

Illustration 4

• The Sanford Software Co. earned $ 40 million before Interest and tax on revenues of $ 120 million last year. Investment in fixed assets was $24 million and depreciation was $16 million. Working capital investment was $ 6 million. Sanford expects earnings before interest and tax, investment in fixed and working capital, depreciation and sales to grow at 12% per year for next five years. After five years, the growth in sales, EBIT and working capital will decline to a stable 4% per year

Illustration 4

• and investments in fixed capital and depreciation will offset each other Sanford’s tax rate is 40%. Calculate free cash flow for explicit planning period and stepping stone year if interest paid is $10 million and tax rate is 40%.

SolutionPeriod 1 2 3 4 5 6[EBIT*(1-Tax Rate)] 24 26.88 30.11 33.72 37.76 39.3Add: [Interest * Tax Rate] 4 4 4 4 4 4Add: Depreciation 16 17.92 20.07 22.48 25.18 0Less: Capital Investment 24 26.88 30.11 33.72 37.76 0Less: Working Capital Investment 6 6.72 7.53 8.43 9.44 9.82Free Cash Flow 14 15.2 16.54 18.06 19.74 33.46

Illustration 5

• The Anderson Pvt. Ltd. earned $ 20 million before Interest and tax on revenues of $ 60 million last year. Investment in fixed assets was $12 million and depreciation was $8 million. Working capital investment was $ 3 million. Anderson Pvt. Ltd. expects earnings before interest and tax, investment in fixed and working capital, depreciation and sales to grow at 15% per year for next five years. After five years, the growth in sales, EBIT and working capital will decline to a stable 6% per year

Terminal value

• With the firm growing at a constant rate and maintaining its operating ratios and providing a growing stream of payments to its investors, formula:

gr

VCFValuealTer T

min

VCFT =Venture’s Free Cash Flow for Terminal Value (Free Cash Flow of Stepping Stone Year)r = required rate of returng = normal growth rate

Value of Venture

Where: r = required rate of return VCF = Venture’s Free Cash Flow

t

n

t tt

r

ValuealTer

r

VCFVentureofValue

)1(

min

)1(

)(1

Advantages of DCF

a. As DCF valuation is based on asset’s fundamentals.

b. DCF valuation is the right way to think when buying an asset.

c. DCF valuation forces an investor to think about characteristics of the firm and business.

Limitations of DCF

a. DCF valuation is estimate intrinsic value, so it requires far more inputs and information.

b. Difficult to estimate the inputs and information

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2. Asset Based Valuation

• Asset Based Valuation is recommended for certain types of companies e.g. for investment companies.

• The method relating to asset basis may take various forms depending upon circumstances:

• Break-up Value Method• Appraised Value Method• Book Value Method

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Advantages asset-based valuations

• The main strengths of asset-based valuations are:

1. Valuations are fairly readily available; 2. Provide a minimum value of the entity.

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Limitations of asset-based valuations

• The main limitations of asset-based valuations are:

1. Based on historic information 2. Difficult to allow for the value of intangible assets such as intellectual property rights.

3. Relative Valuation Approach

• This is also known as the market approach. It requires a multiple valuation such as PER

Why Use Multiples?

Multiples address three important issues:

1. How plausible are forecasted cash flows?

2. Why is one company’s valuation higher or lower than its competitors?

3. Is the company strategically positioned to create more value than its peers?

Multiple analysis is only useful when performed accurately. Poorly performed multiple analysis can lead to misleading conclusions.

A careful multiples analysis—comparing a company’s multiples versus those of comparable companies—can be useful in improving cash flow forecasts and testing the credibility of DCF-based valuations.

What Are Multiples? Multiples such as the Price-to-Earnings Ratio (P/E) and Enterprise-Value-to-EBITDA

are used to compare companies. Multiples normalize market values by profits, book values, or nonfinancial statistics.

Let’s examine a standard multiples analysis of Home Depot and Lowes:

To find Home Depot’s P/E ratio (13.3x), divide the company’s end of week closing price of $33 by projected 2005 EPS of $2.48. Since EPS is based on a forward-looking estimate, this multiple is known as a forward multiple.

Company

Home Depot

Lowe’s

Stock priceJuly 23, 2004

Market capitalization$ Million

Estimated Earnings per share (EPS)

Forward-looking multiples, 2004

2004 2005 EBITDA P/E

$33.00

$48.39

$74,250

$39,075

$2.18

$2.86

$2.48

$3.36

7.1

7.3

13.3

14.4

But which multiple is best and why are some multiples misleading?

Commonly Used Multiples

• P/E Multiple• P/B Multiple• EBITDA Multiple

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Valuation: P/E multiple

• If valuation is being done to estimate firm value: – Value of firm = Average P/E multiple in industry

EPS of firm• This method can be used when

– firms in the industry are profitable (have positive earnings)

– firms in the industry have similar growth (more likely for “mature” industries)

– firms in the industry have similar capital structure

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Valuation: Price to Book multiple

• The application of this method is similar to that of the P/E multiple method. If valuation is being done to estimate firm value: – Value of firm = Average P/B multiple in industry Book Value

per Share of firm• book value of equity is essentially the amount of equity

capital invested in the firm, this method measures the market value of each dollar of equity invested.

• This method can be used for– companies in the manufacturing sector which have significant

capital requirements.– companies which are not in technical default (negative book value

of equity)

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Valuation: Value to EBITDA multiple

• This multiple measures the enterprise value, that is the value of the business operations such as

• investment in treasury bills or bonds, or investment in stocks of other companies, is excluded.

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Enterprise Value

Economic Value Balance Sheet

PV of future cash from businessoperations

$1500

Cash $200 Debt $650

Marketable securities $150 Equity $1200

$1850 $1850

Enterprise Value

Valuation: Value to EBITDA multiple

• If valuation is being done to estimate firm value: – Value of firm = Average EBITDA multiple in

industry EBITDA (From Business Operations Only)

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Value to EBITDA multiple: Example

• Suppose you wish to value a target company using the following data:– Enterprise Value to EBITDA (business operations only)

multiple of 5 recent transactions in this industry: 10.1, 9.8, 9.2, 10.5, 10.3.

– Recent EBITDA of target company = $20 million– Cash in hand of target company = $5 million– Marketable securities held by target company = $45 million– Interest rate received on marketable securities = 6%.– Sum of long-term and short-term debt held by target = $75

million

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Value to EBITDA multiple: Example

• Average (Value/ EBITDA) of recent transactions=(10.1+9.8+9.2+10.5+10.3)/5 = 9.98

• Interest income from marketable securities=0.06 45 = $2.7 million

• EBITDA – Interest income from marketable securities=20 – 2.7 = $17.3 million

• Estimated enterprise value of the target=9.98 17.3 = $172.65 million

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Valuation: Value to EBITDA multiple

• Appropriate for valuing companies with large debt burden: while earnings might be negative, EBIT is likely to be positive.

• Gives a measure of cash flows that can be used to support debt payments in leveraged companies.

Advantages of Relative Valuation

1. Relative valuation is more reflect market perceptions than DCF valuation.

2. Relative valuation requires less information than DCF valuation.

Value Creation

Factors that can affect the value of a venture:1. Recent profit history2. Market demand for a specific type of business 3. The general condition of the company: This

includes the accuracy and completeness of company records, condition of facilities and equipment, and an evaluation of the human resources

Value Creation

4. Regional and national economic conditions: F RAC Consider the cost and availability of capital and other economic factors that can affect the business

5. Competitive climate: Includes issues of market share and ease of substitution for the companies product or service

6. Ability to transfer the benefits of the intangible assets to the new owner

7. Future growth and profit potential