Valuation for Entrepreneurs

Concept of Valuation
Business valuation refers to the process used to determine the economic value of an owners 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 Valuation 2. Asset-based Approach 3. 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.

Useful Terms
Explicit forecast period:
two- to ten-year period in which the ventures 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

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
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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 1 2 3 4 5 Cash Flow -$50,000 -$20,000 $100,000 $400,000 $800,000

1. Discounted Cash Flow Valuation

two basic parameters : A. Assessment of ventures future FCF B. Finding out a discount rate

A. Assessment of future free cash flows

Assessment of ventures 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________________ Ventures 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
[EBIT*(1-Tax Rate)] Add: [Interest * Tax Rate] Add: Depreciation Less: Capital Investment Less: Working Capital Investment Free Cash Flow Am. (in million $) 24 4 16 24 6 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 Sanfords 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%.

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

VCFT =Ventures Free Cash Flow for Terminal Value (Free Cash Flow of Stepping Stone Year) r = required rate of return g = normal growth rate

Value of Venture
Value of Venture t 1
n

(VCF ) t Ter min al Value t (1 r ) (1 r ) t

Where:

r = required rate of return VCF = Ventures Free Cash Flow

Advantages of DCF
a. As DCF valuation is based on assets 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

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.

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3. Relative Valuation Approach

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

Why Use Multiples?

A careful multiples analysiscomparing a companys multiples versus those of comparable companiescan be useful in improving cash flow forecasts and testing the credibility of DCF-based valuations. Multiples address three important issues:

1. How plausible are forecasted cash flows?

2. Why is one companys 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.

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. Lets examine a standard multiples analysis of Home Depot and Lowes:
Market capitalization $ Million $74,250 $39,075 Estimated Earnings per share (EPS) 2004 $2.18 $2.86 2005 $2.48 $3.36 Forward-looking multiples, 2004 EBITDA 7.1 7.3 P/E 13.3 14.4

Company Home Depot Lowes

Stock price July 23, 2004 $33.00 $48.39

To find Home Depots P/E ratio (13.3x), divide the companys end of week closing price of $33 by projected 2005 EPS of $2.48. Since EPS is based on a forwardlooking estimate, this multiple is known as a forward multiple. But which multiple is best and why are some multiples misleading?

Commonly Used Multiples

P/E Multiple P/B Multiple EBITDA Multiple

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 business operations Cash Marketable securities $1500 $200 $150 $1850 Debt Equity $650 $1200 $1850

Enterprise Value

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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)

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.

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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 history 2. 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