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Business Valuation DeMYSTiFieD
By Edward Nelling
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
Commonly Used Valuation Methods
There are many useful applications of business valuation. If we are faced with the need to value a business, how do we get started? In this chapter, we introduce the valuation methods that are used most often and describe when each method is appropriate.
After completing this chapter, the student should have an understanding of
The motivations for valuing a business
The discounted cash flow valuation method
Business valuation using price multiples
The liquidation valuation method
Applications of Business Valuation
Are you buying or selling a business? If the answer is "yes" to either, then you certainly have an interest in valuation. After all, the transaction is likely to have a significant effect on your financial situation. If you're a buyer, you don't want to pay more than necessary; if you're a seller, you want to receive as much as possible. However, the need to understand the valuation process is not limited to buyers and sellers. Consider the situations faced by the individuals below:
Mary Simpson graduated from college 10 years ago and has been working in the small software business started by her father in Boston. Mary's father just received an offer for the business and has asked Mary for her opinion. Mary is trying to decide if it is time to sell the business, or instead expand by buying one of her company's main competitors in California.
Victor Martinez is the owner and chef at one of the most popular restaurants in New Orleans. He feels that the time is right to expand and is planning to contact a group of potential investors for financing.
Arthur Robinson and his son established a successful painting business over 20 years ago. Arthur is nearing retirement and is planning for his son to run the company.
Tom Young owns a small chain of hotels. He is considering the creation of an employee stock ownership plan to give his employees a stake in the business.
Ramesh Patel is an executive running a division of medium-sized chemical company. His division has been performing well, but Ramesh feels that it could do even better if it was spun off into a stand-alone company.
All the situations above involve business valuation. In addition, other events that prompt a valuation include the death of an owner, divorce, a lawsuit, or a decision to file for a public stock offering. Aside from these major events, analysts, portfolio managers, and investors perform valuation calculations every day for public companies, to make decisions about whether to buy or sell their securities. We begin to develop our knowledge of valuation by reviewing the basic methods.
The Discounted Cash Flow Valuation Method
Why would anyone buy a business? Presumably, because they think that by doing so they can "make money." But what does this phrase mean? In other words, what are the financial benefits of buying a business? Simply put, the financial benefits to the owner are in the form of the cash flows generated by the business. These cash flows come in two forms. First, by operating the business, the owner is entitled to keep the cash flows that are generated by the business over time. Second, at some point in the future, the owner is entitled to sell the business and keep the proceeds from the sale.
As a simple example, let's consider the purchase of a fictitious business called Johnny's Sandwich Shop. We assume that the shop produces a cash flow of $50,000 in one year and $75,000 in two years (for the sake of simplicity, we assume that these cash flows occur at the end of each year, even though the shop will really generate cash flow every day). In addition, let's assume that after two years, we can sell the shop for $300,000, buy an island in the Caribbean (it will be a small island), and retire (in this simple example, let's ignore taxes–a small pleasure that we seldom get to enjoy in real life).
The total cash flow generated by the business is then $425,000 ($50,000 plus $75,000 plus $300,000). Does this mean that we are willing to pay $425,000 to buy it? Not exactly, because we won't get all our cash back at the time of purchase?it will be spread out over time. Since a dollar received in the future is worth a little less to us than a dollar today, we will pay something less than $425,000. In the terminology of finance, we will be willing to pay the present value of the future cash flows generated by the business.
This example illustrates the essence of the discounted cash flow (DCF) approach: we determine how much we are willing to pay for a business today by forecasting the cash flows we expect to receive in the future and by discounting them back to the present. In other words, the value of a business is the present value of its expected future cash flows. Mathematically speaking, the discounted cash flow estimate of the value of a business is
Value = C1/(1 + r) + C2/(1 + r)2 + C3/(1 + r)3 + ...
where C1 is the cash flow we expect the company to generate one year from today, C2 is the expected cash flow in two years, C3 is the expected cash flow in three years, and so on. [As a small mathematical note, we can write the denominator of the first term in the above expression as (1 + r) or (1 + r)1, as they are equivalent—we omit the superscript in our notation.] The variable r represents the discount rate (similar to an interest rate) used to determine the present value of a future cash flow. We discuss cash flows and discount rates in more detail in later chapters. For now, let's just focus on the basic approach.
Based on the information above, our DCF estimate of the value of the sandwich shop is computed by discounting the cash flow we expect to receive each year, along with the expected proceeds from the sale. For illustration purposes, we use a discount rate of 10 percent.
Value = $50,000/(1.10) + $75,000/(1.10)2 + $300,000/(1.10)2 = $355,372
From our DCF calculation, we'd be willing to pay $355,372 today for a business that would provide the expected cash flows noted above. Valuation experts might refer to this number as the fair value of the business. Of course, if we are the buyer in the transaction, we hope to pay less, and if we are the seller, we hope to receive more.
The Price Multiple Valuation Method
Another popular method of business valuation is the use of price multiples. With this approach, we assume that two or more companies that are in the same line of business should receive about the same valuations in the marketplace. In other words, we are valuing our company relative to other similar companies.
With price multiple valuation, we assume that the value of a company is closely tied to one of its key financial characteristics. There are several possibilities, but let's illustrate with one of the most popular—a company's earnings, or net income, and the price/earnings (P/E) multiple. Mathematically, this approach is a snap:
Value = (net income) x (price/earnings multiple)
Of course, looks can be deceiving, so don't let the apparent simplicity of this method fool you. A lot of analysis has to go into the estimate of net income and the appropriate multiple for this estimate to have any reliability.
To illustrate the application of price multiples, let's return for a second helping
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