Business Valuation

MEthods
Introduction
 Business valuation depends on assumptions.
 There is no one way to establish what a business is
worth.
 Business Value means different thing to different
people.
 A business owner may believe that the business
conncecrtion to the community it serves is worth a lot.
 The circustamance of a business sale also affect the
business value.
 There is big difference between a business that is shown
as part of well planned marketing effort to attract may
interested buyers and a quick sale of business assets as
an auction
Business Valuation Approach
 1) Assets Based Approach
 2) Market Based Approach
 3) Income Based Approach
Assets Based Approach
 An asset-based approach is a type of business valuation that
focuses on a company's net asset value (NAV), or the fair-
market value of its total assets minus its total liabilities, to
determine what it would cost to recreate the business.
 The purpose of this approach is to study and revaluate the
companies assets and liabilities obtaining the substance value.
 The substance value is thus estimated as assets minus
liabilities.
 The basic idea is that the company’s value could be
determined by looking at the balance sheet.
 There are two general methods for estimation of substance of
assets,eihter collective revaluation .
  Balance sheet Adjustment
1. Book value is different from the market value or
the liquidated ion value.
2. The appraiser must make certain adjustments
according to the purpose of valuation.
3. Most common is to adjust assets.
4. The items to valuate are those on the
balanchesheet include,financial assets ,tangible
propoerty,real estate,intangible real
propoerty,current liabilities, long term
liabilities,contigent liabilities and special
obligation
 The Practical application of he assets-based
model can be as following
 1.obtain or develop a cost basis balance

sheet
 2.Determine which assets and liabilities on

the cost basis balance sheet revaluation

adjustments.
Advantages of the Assets Based
Approach
 The main advantages of the assets based
approach is that it is relatively simple to apply
and does not require guesswork and
assumptions to a large extent.
 Result of the model are presented in a
traditional balance sheet format which should
be similar to anyone who has ever worked .
 Another advantages is the usefulness when
negotiating the selling or purchase price since
it is known exactly how much the assets and
liabilities of the company are worth
Diadvantges
 This model does not consider the business
idea and possibilities.
Income Based discounted Arrpoach
 The income approach is commonly called
discounted cash flow approach.
 It is accepted as an approporaite method by

business appraisers.
 This approach constitutes estimation of the

business value by calculating the present

value of the future benefits which the
company are expected to generate.
 Discounted cash flow tries to work out the
value of a company today based on projections
of how much money its going to make in
future.
 DCF analysis says that a cmpoany is worth all
of the cash that it could make available to
investors in the future
 There are several mehtods of discounted cash
flow analysis inclduing the dividend discount
model approach and cash flow to firm
approach.
 DCF analysis requires an investors /buyer to
think through the factors that affect a
company, such as future sales growth and
profit margins.
 It also makes buyer to consider the discount

rate which depends on risk free interest rate,

the company’s cost of capital and the risk its
stock faces.
Company A takover Company B
Year Cash flow Dicounted factor 10 Net present
% vale
1 100000 0.909 90900
2 200000 0.8266 165320
3 250000 0.7513 187825
4 300000 0.6830 204900
5 350000 0.6209 217315
866260
Steps in DCF analysis
1) Determination of the Forecast Period
 The first order of business when doing discounted cash flow (DCF) analysis is to
determine how far out into the future we should project cash flows.
 Free cash flow (FCF) is a measure of a company's financial performance, calculated as
operating cash flow minus capital expenditures. FCF represents the cash that a company
is able to generate after spending the money required to maintain or expand its asset
base.

 For the purposes of our example, we'll assume that The Widget Company is growing
faster than the gross domestic product (GDP) expansion of the economy. During this
"excessive return" period, The Widget Company will be able to earn returns on new
investments that are greater than its cost of capital. So, our discounted cash flow needs
to forecast the amount of free cash flow t hat the company will produce for this period. .
 FCF is calculated as:
 EBIT (1-tax rate) + (depreciation) + (amortization) - (change in net working capital) -
(capital expenditure).
The excess return period tells us how far into
the future we should forecast the company's
cash flows.
 Alas, it's impossible to say exactly how long

this period of excess returns will last.

 The best we can do is make an educated

guess based on the company's competitive

and market position. Sooner or later, all
companies settle into maturity and slower
growth.
 Excess Return/Forecast
ompany Competitive Position
Period
Slow-growing company;
operates in highly
1 year
competitive, low margin
industry
Solid company; operates with
advantage such as strong
marketing channels, recognizable
5 years
brand name, or regulatory
advantage

Outstanding growth company;

operates with very high barriers to
10 ye
entry, dominant market position or
prospects
 2. Determine of Revenue Growth Rate
 The forecast period is the time period in which the individual

yearly cash flows are input to the discounted cash flow formula.
 Cash flows after the forecast period can only be represented by
a fixed number such as the compound annual growth rate.
 There are no fixed rules for determining the duration of the
forecast period.
 We have decided that we want to estimate the free cash flow that
The Widget Company will produce over the next five years.
 To arrive at this figure, the standard procedure is to forecast
revenue growth over that time period.
 Then (as we will see in later chapters), by breaking down after-
tax operating profits, estimated capital expenditure and
working capital needs, we can estimate the cash flow the
company will produce.
 We need to think carefully about what the industry and
the company could look like as they evolve in the future.
When forecasting revenue growth.
 we need to consider a wide variety of factors. These
include whether the company's market is expanding or
contracting, and how its market share is performing. We
also need to consider whether there are any new products
driving sales or whether pricing changes are imminent.
 But because that future can never be certain, it is
valuable to consider more than one possible outcome for
the company.
Growth Current
Year 1 Year 2 Year 3 Year 4 Year 5
Rate Year
Optimi
stic:
Growth - 20% 20% 20%
20% 20%
Rate $100 $144 $172.8 $207.4
$120 $248.9
Revenu M M M M
M M
e

Realisti
c:
Growth - 20% 15%
20% 15% 10%
Rate $100 $144 $190.4
$120 $165.6 $209.5
3.Forecasting Free Cash flows

 Free cash flow is the cash that flows through

a company in the course of a quarter or a
year once all cash expenses have been taken
out.
 Free cash flow represents the actual amount

of cash that a company has left from its

operations that could be used to pursue
opportunities that enhance shareholder value
-
Calculating Free Cash Flow
Sales Revenu:__________
Less :Operating Cost
Less: Tax
Less: Net investment
Less : Changes in working Capital
=Free Cash flo
A) Company’s Sales Revenue
B) Determining future operating costs
 When doing business, a company incurs
expenses-such salaries, cost of goods sold,
selling and general administrative expenses,
and research and development cost.
 A good place to start when forecasting
operating costs is to look at the company’s
historic operating cost margins
C) Determining Taxation Rate:
 The Widget Company paid 30% income tax.

We will project that the company will continue

to pay that 30% tax rate over the next five
years.
 Companies with high capital expenditure

receives tax cuts. so it makes sense to

calculate the tax rate by taking the average
annual income tax paid over the past few
years divided by profits before income tax.
d) Determining Net investment
 Companies need to keep investing in capital
items such as property, plants and
equipment.
Particula Year0 Year 1 Year 2 Year 3 Year 4 Year 5
r
Revenue - 20% 20% 15% 15% 10%
1.Sales 100000 120000 144000 165600 190440 209484
revenue
2.Operat 65000 78000 93600 107640 133308 146639
ing
costs
Operatin 35000 42000 50400 57960 57132 62845
g profits
Tax (30 10500 12600 15120 17388 17140 18854
%)
PAT 24500 29400 35280 40572 39992 43995
Net 7 7.6 8.2 8.8 9.4 10
investm (7000) (9120) (11808) (14573) (17901) (20948)
ent
e) Changes in working capital
 Working capital refers to the cash a business

require for day to day operations, or more

specifically ,short term financing to maintain
current assets such as inventory.
 The faster business expand the more cash it

will need for working capital and investment.

 Working capital is calculated as current assets

minus current liabilities

Calculating the discount rate

 A wide variety of methods can be used to determine

discount rates, but in most cases, these calculations
resemble art more than science. Still, it is better to be
generally correct than precisely incorrect,
 so it is worth your while to use a rigorous method to
estimate the discount rate.
 A good strategy is to apply the concepts of the
weighted average cost of capital (WACC). The WACC is
essentially a blend of the cost of equity and the after-tax
cost of debt.
 Cost of Equity
1. Unlike debt, which the company must pay at a set rate of interest, equity
does not have a concrete price that the company must pay.
But that doesn't mean that there is no cost of equity
2. From the company's perspective, the equity holders' required rate of
return is a cost, because if the company does not deliver this expected
return, shareholders will simply sell their shares, causing the price to
drop.
3. The cost of equity is basically what it costs the company to maintain a
share price that is satisfactory (at least in theory) to investors.
4. The most commonly accepted method for calculating cost of equity
comes from the Nobel Memorial Prize-winning
capital asset pricing model (CAPM),
 Cost of Equity (Re) = Rf + Beta (Rm-Rf).

 Rf - Risk-Free Rate - This is the amount obtained

from investing in securities considered free from
credit risk, such as government bonds from
developed countries.
 ß - Beta - This measures how much a company's
share price moves against the market as a whole.
A beta of one, for instance, indicates that the
company moves in line with the market. If the
beta is in excess of one, the share is exaggerating
the market's movements; less than one means the
share is more stable.
 (Rm – Rf) = Equity Market Risk
Premium - The equity market risk premium
(EMRP) represents the returns investors
expect, over and above the risk-free rate, to
compensate them for taking extra risk by
investing in the stock market. In other words,
it is the difference between the risk-free rate
and the market rate.
 Cost of Debt
 Compared to cost of equity, cost of debt is fairly
straightforward to calculate.
 The rate applied to determine the cost of debt (Rd) should be
the current market rate the company is paying on its debt.
 If the company is not paying market rates, an appropriate
market rate payable by the company should be estimated.

As companies benefit from the tax deductions available on

interest paid, the net cost of the debt is actually the interest
paid less the tax savings resulting from the tax-deductible
interest payment. Therefore, the after-tax cost of debt is Rd
(1 - corporate tax rate).
Weighted Average cost of Capital
The WACC is the weighted avreagae of the cost
of equity and cost based on the proportion of
debt and equity in the company’s capital
structure.
WACC:( Re*E/V)+(Rd*(1-corporate tax)*D/V)
Market Based Approach
 A market approach is a method of determining the appraisal
value of an asset based on the selling price of similar items.
 The market approach is a business valuation method that can
be used to calculate the value of property or as part of the
valuation process for a closely held business.
 Additionally, the market approach can be used to determine the
value of a business ownership interest, security or
intangible asset.

 Regardless of what asset is being valued, the market approach

studies recent sales of similar assets, making adjustments for
differences in size, quantity or quality.
 Market capitalization means number of
outstanding equity share multiplied by
market price of shares.
 Market value of an assets or a security is the

price at which is currently being traded in the

market.
Dividend Discounted Model
 Dividend discount model begin with the
arguments that the value of an equity share is
net present value of dividends that investor
would receive over the holding period plus
net present value of the price of the price he
will realize at the end of the holding period.