VALUATION ANALYSIS by Oleksiy Nesterenko

1. VALUATION ANALYSIS by Oleksiy Nesterenko In my work at OLEKSIY NESTERENKO STARTUP FINANCE, I often get asked “how much is my business worth?” Indeed, valuation is significant and fundamental to many areas of finance. Broadly speaking, valuation analysis is the process of determining the value of a business. As we go through this valuation overview, it should become apparent that this process of valuation is by no means an exact science, and there are several approaches and methodologies commonly used. Additionally, it is important to recognize that while there is a discrete set of tools available to professionals for performing valuation analysis, different groups need to assess value for different reasons and have different objectives. All valuation techniques are broadly based on two basic methods: Intrinsic valuation (absolute valuation):the value of a business is based on the sum of all the cash flows it will generate, discounted to the present value using a discount rate that reflects the riskiness of the business. Relative valuation (comparable valuation): The value of a business is based on the values assessed by the market for similar or comparable businesses. When discussing valuation, it always helps to use an example to illustrate how both methods are applied. So, let us assume you own an ice cream stand and would like to sell it. Before disposing of the stand, you decide to determine its value in order to set the price for the business. Ice cream stand generated cash flows of $10,000 this year, and cash flows are expected to grow 5% next year and each subsequent year. Additionally, you assume a discount rate, which reflects riskiness of the estimated cash flows, of 10%. Intrinsic valuation: Whenever we value a business, we assume that the firm will continue functioning for a foreseeable future (so called going concern).Thus we would need to make various assumptions to forecast business’ future cashflows, including short, mid, and long-term

2. growth rates, reinvestments rates, etc. However, for the sake of simplicity we’ll assume that the ice cream stand’s cashflows will grow 5% in perpetuity (ie forever). As such, the value of a business with a perpetual growth rate is equal to next year’s cash flows divided by the discount rate minus the growth rate (well-established perpetuity formula in mathematics).Using the growth in perpetuity formula, we can arrive at a value for the ice cream stand as illustrated: Value = $10,500 / (10% - 5%) = $210,000 In real life, OLEKSIY NESTERENKO. STARTUP FINANCE and other analysts use a lot more elaborate models to determine the intrinsic value of a business, yet the underlying concept of discounting future cashflows remains the same. Relative valuation: Continuing with our example. Now that you have established intrinsic value for your business, you want to be sure that the derived valuation is at least less than or equal to what you can really expect to receive for the stand. Given that our valuation involved making growth and risk assumptions about the business, it is quite possible that the value the market will come up with is different. You do some research and find out that an ice cream stand nearby was sold last year to an ice cream chain for $300,000. However, you learn that acquired stand generated cash flows of $20,000 in the year prior to purchase, compared to your cash flows of $10,000 this year. Since the chain paid 15x as much as the stand’s cash flow, you assume they will pay 15x your profits or $150,000. And that’s the crux of relative valuation analysis – you look at the value of comparable business, typically relative to an operating measure of profit and apply the derived multiple to estimate an appropriate value for your business. Intrinsic vs relative valuation In theory, both intrinsic and relative valuation methods should yield the same value. So how could the discounted cash flow valuation of the ice cream stand yield $210,000, while the relative valuation yielded $150,000? There are several reasons we observe differences in value derived from different methods. One obvious possible explanation is in the reliance on estimates and projections to arrive at intrinsic value – it is quite possible that the market’s estimate of your asset’s cash flows, growth rate, and discount rate is different form your own. Another obvious possibility is that the nearby ice cream stand group was not really 100% comparable, or that the seller was not behaving rationally (i.e. in-line with fundamentals). As a result, valuation is not a clear-cut science, and is sensitive to assumptions and uncertainties. This does not, however, mean that there is no correct methodology. Because of the shortcomings in both methods, OLEKSIY NESTERENKO STARTUP FINANCE looks at a variety of valuation methods to quantify value. Click here for more details