Valuation Techniques

1. Valuation Techniques What is a business worth

2. Value is not absolute but a function of the individual’s perception of risk, opportunity, the nature of financial resources available to the buyer, the strategy for operation, the time horizon for analysis, alternatives available for time and money and the prospective methods for harvesting.

3. Three methods of valuation Asset Value Earnings Value Cash Flow Value

4. Asset Valuation

5. Asset Valuation What are the underlying value of the assets? Asset valuation indicates the entrepreneur’s tolerance to risk Four approaches to asset valuation Book value Adjusted book value Liquidation value Replacement value

6. Book Value It provides a tangible starting point Value is affected by the accounting practices of the firm Reserve for bad debts Accounting treatment of research costs, marketing costs, etc.

7. Adjusted book value Adjust the book value to bring stated value in line with market value of tangible assets Buildings, land, Adjust intangible assets e.g. covenents not to compete, to zero.

8. Liquidation Value Value based on selling the assets in a quick sale. Assumes the company will not continue Discounts the value and includes costs of the sale itself Represents a floor value below which the seller would not be willing to go-he could liquidate the assets himself.

9. Replacement Value The cost of starting a new company rather than buying this one. Replacing the tangible assets Not normally used except as a reference point.

10. Earnings Valuation

11. Earnings Valuation Capitalize earnings by multiplying earnings by a capitalization factor or price/earnings ratio. What earnings to use? What multiple to use?

12. Earnings options Historical earnings Future earnings under present ownership Future earnings under new ownership

13. Historical Earnings Assumption that past earnings reflects the company’s future earnings is not logical. Rarely used directly without extrapolation Study each cost and income elements and understand the relationships and trends. Random and non recurring items factored out Salaries of owners and relatives adjusted. Depreciation rates evaluated Federal and State Taxes paid.

14. Future earnings under present ownership If the future owner were to stay and impose his strategic plan, management abilities, marketing philosophy, etc., what would the earnings stream look like? Value based on future earnings should give an indication of the current economic value of the company to the current owner. Might be used to develop a bargaining position. Rarely a meaningful assessment of value to an investor or buyer.

15. Future earnings under future ownership Used when evaluating turnaround or dying companies. Includes performance estimates based on new strategy, management, and possibly the nature of the business. The question of paying for your own skill and abilities comes into play Significant levels of uncertainty Range of values

16. Which earnings and what period Deciding what periods are valid in your evaluation. What earnings to use After tax or before tax earnings Operating income EBIT EBITDA What are you trying to measure? Consistency is important-use the same measures.

17. Price Earnings Multiple Given the anticipated pattern of earnings of the company, anticipated market conditions, nature of the industry etc, etc.,….. What will the public or some acquiring company pay for my holdings? What prices paid for similar holdings in similar industries? Difficult task for small companies

18. Uncertainty of estimating both future earnings and future market conditions for the stock in part explains why ROI requirements are so high.

19. Cash Flow Valuation

20. Cash Flow Valuation The entrepreneur is interested in what he can earn from the business rather than the inherent value of the business itself

21. Cash Flow Valuation In the purchase process or subsequently, the entrepreneur gives up value to others. Investors get shares of the business Lenders get values in terms of notes payable Suppliers get claims on the company value The entrepreneur must acquire resources from others and must give up a portion of the value of the business in order to attract those resources.

22. Cash Flow Valuation The entrepreneur values what he will extract from the business during its operation Return on capital he invests Return on his time invested Cash flow out of the business from operations Cash flow out of the business when it is harvested.

23. Operating Cash Flows Perks-cars, country club memberships etc. Cash equivalents Not normally taxed Return of Capital via debt repayment Payments are tax free Entrepreneur retains equity value in the company Interest payments on Investment Tax free to the company Taxable to the entrepreneur Salary Tax free to the company Taxable to the entrepreneur Dividends Double taxed

24. Terminal Value Return of Capital via Sale Tax free Equity not retained Capital Gain No tax to the corporation

25. Summary Valuation is based on a variety of approaches No single approach will provide the “right” answer There is an inherent risk involved which must be borne. You have to make a decision. The true purpose of analysis Identify critical assumptions Evaluate the interrelationships among elements and determine which are crucial Develop realistic scenarios Surface and understand potential outcomes and consequences, good and bad How is the value being carved up to satisfy needs of suppliers of resources

26. Value is not absolute but a function of the individual’s perception of risk, opportunity, the nature of financial resources available to the buyer, the strategy for operation, the time horizon for analysis, alternatives available for time and money and the prospective methods for harvesting.