Lecture 7

Business Valuation

 

Business valuation is, in some senses, simply a very complicated capital budgeting problem. Conceptually we could just write down the cash flows to the company being valued and then determine the present value. This is one approach to valuation, but there are others.

 

What is Being Valued?

What is the 'interest' being valued? For example, '10,000 shares of common stock of XYZ Corporation.' Does this represent a controlling interest or a minority interest in the company? Normally we will find the value of the whole firm (assets), and then subtract out debt to obtain the value of equity. Alternatively, we may find the value of equity directly. We then convert this to a per share basis. The point is, one should be careful about whether they are calculating a firm value or an equity value.

 

Benefits to Control

If the 'interest' in question is a controlling interest in the firm, then the valuation should reflect the likely set of economic benefits to be generated by those in control. In the context of mergers and acquisitions, the acquiring firm generally is valuing a set of likely benefits to be generated by the target firm under the acquiring firm's control, rather than under current target management's control.

Those in control have benefits which include the ability to:

When one is valuing a privately held firm, then a controlling interest may be worth more than the pro-rata share of the total equity of the firm because those in control can extract value from those owning a minority interest. As an example, those in control can hire themselves and pay themselves excessive salaries, in effect taking cash flow away from the minority shareholders.

 

Minority Interest

In contrast to a controlling interest, one may be valuing a minority interest. A minority interest does not have the benefits listed above. Share prices of publicly traded companies usually reflect a minority interest value. Whether an interest is a controlling interest or a minority interest is important because if affects the assumptions one makes about the cash flow stream (economic benefit stream) to be valued. The distinction between a controlling interest and a minority interest becomes most significant when one moves from a publicly traded company to a privately owned company. For example, if you own 1% of the shares in someone else's family owned business the value of your shares could be worth a lot less than 1% of the total equity of the company. There are scenarios in which one could argue they are worthless.

 

In this class we will worry about whether an interest is a control interest or minority interest only is so far as it affects our assumptions about the economic benefit stream to be valued.

Approaches to Valuation

The business valuation profession has taken an approach to valuation that closely parallels the real estate valuation. We can categorize three approaches to valuation that are similar to those used for real estate:

 

 

Cost

The first approach is the cost approach. Within the cost approach are several different methods of valuation. In general, the cost approach is not likely to completely capture the going concern value of the firm. That is, cost approaches generally do not reflect the value of the future.

 

 

Market

The market approach is the same approach we used to determine the cost of capital for a privately held firm. The market approach assumes the market is relatively efficient in valuing assets and attempts to discern how the market would value a company 'similar' to the company in question. This approach is widely used in real estate whereby to determine the value of your house you look at the prices at which similar houses have sold per square foot. (Higgins discusses the used car market where to determine the value of your car you look in the paper to see what similar cars are selling for.) The real trick to using this method is making sure that the asset in the market is truly similar to the asset in question.

 

 

Market Multiples

Using the market approach basically involves deriving what are known as 'market multiples.' Market multiples are basically ratios which relate value to some economic benefit or measure of economic performance. In real estate we would talk about price per square foot. Price is the numerator, while square feet is the denominator. For example, the most well known market multiple for businesses is the P/E ratio which relates price per share to earnings per share. We can relate price (value) to almost any economic measure. Which economic measure we use depends on the context of the problem.

 

 

As discussed above, the real trick in using the market multiple method is making sure that the asset in the market for which you can determine a value is truly comparable to the asset in question. In real estate, you would want to make sure the houses for which you have sales prices are located in the same neighborhood as yours and have roughly the same features. We can often use the word 'quality' to sum up the comparability issue.

 

To apply the market multiple approach the first step is to find a sample of publicly traded, comparable companies. Try to locate as many companies in the same industry as yours (having the same SIC code0. Then go through the list and throw out those which are too dissimilar.

 

Market Multiple, example

Problem #3 in your Higgins is an example of the market multiple approach. You are given information about four publicly traded companies which are in the same business as Timberland. (i.e., having the same business risk) You must then compare the companies with Timberland by comparing various financial ratios. Which ratios are selected depends on the industry and data availability. In the example Timberland is ultimately compared with one company. Ideally, we would like to make the comparison with the averages from a sample of companies rather than simply comparing to one company.

In this problem Timberland is assumed to be most similar to, but slightly better than Wolverine Company. Thus, we will use Wolverine's market multiples, but adjust them upward slightly.

Be careful to note that the 2nd and 4th multiples above give us values of the whole firm, while the 1st and 3rd give us values of equity directly.

The multiples are self explanatory.

Multiples:

 

Recall that the issue is whether the measures of economic performance in the denominator have the same quality as those for the company in question. One must then use judgment to determine which multiple will be given the most weight.

 

Discounted Cash Flow

The final method is the discounted cash flow approach. This approach to valuation is the one we have been using since introductory finance. We already know how to obtain the cash flows to the firm, which in the context of valuation are often called 'free cash flow.'

The only difference is that the tax number we subtract out is the tax rate times EBIT and not the income tax number from the income statement. The income tax number on the income statement reflects the tax advantage of debt. This advantage is already reflected in the cost of capital.

 

In applying this approach you need to make sure that the assumptions about NWC and capital spending are consistent with other assumptions in the problem. In particular, if you are assuming significant growth in revenues, then there would likely be capital spending required.

 

To implement the discounted cash flow approach involves projecting out future cash flows to the firm, and then discounting these back to the present. This is a two step process which involves first projecting out cash flows to the point where they are assumed to grow at a constant rate, and then finding the value of the 'constant growth' cash flows. The value of the constant growth cash flows is called a 'terminal value.' The terminal value (TV) is the present value at time t of the cash flows beginning at time t+1 and continuing forever. We use the constant growth (Gordon) model to determine this value.

Recall this model: TVt = CFt+1/(R - g)

 

The terminal value and projected cash flows are then discounted back to the present to arrive at the value of the firm. Algebraically,

The value of equity is obtained by subtracting the value of debt.

Problem #4 in Higgins is an example of the discounted cash flow approach. This problem calculates TV using both a discounted cash flow approach and a market multiple approach. (P/E ratio)

In the problem cash flows are projected out to the year 2002, after which they are assumed to either remain constant or grow at the rate of 4%. Free cash flow in year 2003 is $126. This translates into a terminal value in 2002 of $900. (126 ÷ .14) Discounting the TV and the yearly cash flows from 1999 through 2002 back to the beginning of 1999 gives a firm value of $514.60. Subtracting the value of debt of $300 results in an equity value of $214.60. Dividing this by 50 gives the per share value of $4.29.

 

Small, Privately Held Companies

Privately held firms are difficult to value because of a number of issues. In particular, the economic benefit stream as reflected on the accounting statements may not reflect the true economic benefits to the firm. As an example, consider compensation of managers who are also owners. Owners may pay themselves excessive salaries. Excessive means they pay themselves more than the economic value of the services they provide. Excessive salaries have the effect of lowering EBIT and ultimately free cash flow, which would lead to a reduced value of the firm. If valuing a controlling interest, then one should adjust salaries to reflect the economic benefit of the service provided. That is, what would it cost in the marketplace to replace the position in question. Another example involves perquisites. It is not uncommon for small business owners to run personal expenses through the company. This has the effect of lowering EBIT and hence firm value, implying the firm is worth less than it really is.

Discount rate higher for smaller co's => value

Return to Home Page