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CHAPTER 12Business Valuation

EBD-301Accounting and Finance For Entrepreneurs

Dr. david P. Echevarria


INTRODUCTIONOne of the most difficult questions to answer is how to value a small or relatively new business.

Large corporations have publicly traded stocks and bonds whose values are published daily – their market values can be easily computed.

The same is not true with small privately held businesses - valuation of small businesses is more an art form than one of mathematical certainty



The Fundamental Value QuestionsA. What are things worth?B. How can we determine value?C. How are price and value related?D. Does price always equal value?E. Can value be created?



Dr. Stanley Feldman: Five prevailing myths surrounding the valuation of businesses

Myth 1: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process.

Businesses should or ought to have their value calculated on a regular basis:

For estate planning purposesFor partnerships: knowing the current buyout valuesIf charitable donations of part of business is intendedValuation method must be acceptable to the IRS




Myth 2: Businesses in my industry always sell for two times annual revenue (the revenue multiple). So why should I pay someone to value my business?

Multiples of sales or earnings as a basis for valuation is fraught with significant problems.

Multiples may not adequately represent the riskiness of the businessUsing median or average values may over- or under-value a business such as that available from Pratt’s StatsThe problem of uniqueness adds to the difficulty of using medians or averages




Myth 3: A local competitor sold his business for three times revenue six months ago. My business is worth at least this much!

What happened six months ago is hardly relevant todayWe are always buying future performanceExpected return on investment is very much influenced by expectations relative to the national economyChanging interest rates will affect valuations of projected operating revenues




Myth 4: How much a business is worth depends on what the valuation is used for!

The value of every business is its fair market value (FMV)IRS: FMV is driven by what people are willing to payThere may be motives for under- or over-valuing the business

Sale to family member may motivate a lower valuationDonation to charity may motivate a higher valuationIncorrect valuation may invite an IRS audit




Myth 5: Your business loses money, so it is not worth much.

Many privately held businesses tend to lose moneyWell-managed business will generate a significant amount of cash flow as well as expensesNon-Cash expenses reduce taxable income but are still available for distribution to the owner(s)Owner-managers have significant discretion over how they classify the cash flow



PROBLEMS IN THE VALUATION OF SMALL BUSINESSES

The first and probably the biggest problem is that these businesses are not subject to periodic external valuationsValuation events may be limited to when the assets of the business may be used as collateral for loansMotives for Valuation

Contemplation of selling the businessDone for purposes of estate planningDetermine buyout valuesPartnerships may buy insurance policies to buy a deceased partner’s share from the estate




A second problem in valuing a small business is the naive assignment of a multiple to sales or earnings

Multiples used depend on a variety of valuation factorsHistoric valuations of similar companiesProblems in fixing value of future benefits

A major valuation factor is the uniqueness of each small business




A third problem in valuation is when we allege comparable valuations to what similar businesses have sold for in the past

The reality of valuation is that we do not sell the past.What a similar business sold for six or nine months ago is largely irrelevant.Value is based on expected future performance

The valuation of any business should focus on what our best estimates are of how much cash the business will generate tomorrowExpected rates of growth will influence value




A fourth problem in the valuation of a business addresses the objective of the valuation exercise

The primary objective of the valuation exercise is to determine a fair market value (potential selling price) for the businessThe fair market value is validated when a buyer is willing to pay that price for the businessThere is a second blade to the valuation problem: IRS requirements

When businesses are sold, the IRS has specific requirements regarding depreciable property and other property sold in the same transaction. Forms 4797 and 8594 are germane to the allocation and valuation of assets conveyed in a sale.




The fifth and final problem concerns businesses that are losing money; for example, not generating any significant taxable income

Lesson #1: Businesses that don’t generate taxable income can still be generating a positive cash flow to the owner• A significant amount of gross profits can be written off as

legitimate expenses such as regular pay to owner as well as bonuses are legitimate business expenses

• It is also possible that some cash may be withdrawn from the business as a [non-taxable] return of capital

• Every careful owner-manager will minimize the taxable profits the business would have to report on a Form 1040 (personal return) or a Form 1120 for a corporation



Valuation of Relatively New Businesses

There are several techniques in use for valuing relatively new ventures; businesses with 5 years or less of operating historyThe first and most popular technique is the asset-valuation technique• What are the assets of the business worth? • The balance sheet of the business is the primary source

document for this information. • Assets are generally carried at the cost or market value,

whichever is the lowest – This conforms to the accounting principle of conservatism.




A second valuation technique is accomplished by estimating the earnings potential of the business

Earnings potential is in many ways driven by supply and demand

The population base served by the business is the most frequently utilized proxy for demandThe number of similar businesses competing for customers proxies for supply• The amount of competition suggests thinner profit margins

Barriers to entry affects the valuation• Technically qualified personnel• Expensive equipment• Need to have a physical location




The third technique for valuing a relatively new business is based on capitalizing the potential future earnings of the business at some appropriate risk-adjusted discount rate.

[Refer to Equation 11-1]

Value = the sum of the present values of expected cash flowsk = discount rateN = number of years of expected cash flows to be discounted




Capitalizing the potential future earnings method (DCF) cont.

Businesses with a few years of operating experience will pose the most difficulty in projecting future revenues. Older more established business will be somewhat easier, especially if the business still has the potential for significant future growth in sales and the potential for implementing operating efficiencies that will boost current operating profitability.



Valuation using Discounted Cash Flow Method

Discounted Cash Flow (DCF) analysisPrimary method for;• Valuing businesses, • Determining the attractiveness of potential investments, or• the value (price) of income producing assets

The basis for DCF is the time value of money (TVM)Dollars to be received tomorrow are worth less than a dollar todayA dollar invested today should be worth more than a dollar tomorrow




Net Present Value AnalysisThe objective of NPV analysis is to determine whether or not future benefits are worth the price paid today.Keep in mind that the reason we invest is to have more tomorrow

NPV considers the relationship of 3 important factors in determining the attractiveness of an investment

1. The required upfront investment or price of the business2. A suitable risk-adjusted discount rate3. Estimates of future net cash flows




Present Value Analysis (refer to Equation 11.2)

PV(CFn) = + + + . . . +

PV (CFn) = the present value of a series of n-yearly cash flows(1+i) = the discount interest factori = the equivalent of the weighted average cost of capital (wacc)




The Weighted Average Cost of CapitalA metric used in corporate financeThe method can be adopted for privately held businesses

WACC = wdkd (1-tx) + weke

Where: w = relative weight of debt and equity kd (1-tx) = the after tax cost of borrowing

ke = the cost of equity proxied by the average ROE for the business



Present Value Example #1

The present value of the cash flows for years 1 through 5, discounted at 10.5%, suggests that the value of assumed [future] cash flows is $197,062. A little more analysis of the CF values reveals that cash flows have grown an average of 18.32% per year. However, the rapid growth of the first two years declined to about 6.35% in year 5

Increase $ $ 12,000 $ 9,000 $ 6,000 $ 4,000 Year 1 2 3 4 5CF $ 36,000 $ 48,000 $ 57,000 $ 63,000 $ 67,000

0.105 WACC 0.105 0.105 0.105 0.105 0.105PV $ 32,579 $ 39,311 $ 42,246 $ 42,256 $ 40,669 S PV = $ 197,062



Present Value Example #2If we assume that cash flows will continue to grow at a constant 7.5% per year, the business will have a current value of $154,288.

Increase % 0.075 0.075 0.075 0.075Year 1 2 3 4 5CF $ 36,000 $ 38,700 $ 41,603 $ 44,723 $ 48,077

0.105 WACC 0.105 0.105 0.105 0.105 0.105PV $ 32,579 $ 31,695 $ 30,834 $ 29,997 $ 29,183 S PV = $ 154,288



Implications of Present ValuesWe assumed different rates of operating revenue growth in the previous two examples. The difference in values suggests the breakeven purchase price of this business

Example 1: $197,062 represents the maximum price we would pay to earn a 10.5% return on our investment assuming an average growth rate of 18.32% over he five years, but at declining rates from year to year so that from year 4 to year 5 the growth rate is 6.35%

Example 2: $154,288 represents the maximum price we would pay to earn a 10.5% return on our investment assuming an average growth rate for operating revenue of 7.5% year over year for five yearsDr. david P. Echevarria


Implications of Present ValuesThe previous examples demonstrate the effects of different assumptions regarding revenue growth over a 5-year period on the price we would pay to earn 10.5% on our investment in the business to be bought.If we required a greater rate of return, based on the level of perceived risk in this business we might use a wacc proxy of 14%. The impact on example 2 is:CF $ 36,000 $ 38,700 $ 41,603 $ 44,723 $ 48,077

WACC 0.14 0.14 0.14 0.14 0.14PV $ 31,579 $ 29,778 $ 28,081 $ 26,479 $ 24,970 S PV = $ 140,887



VALUATION OF INCREMENTAL INVESTMENTS

Every successful business will at some point in its growth require additional investments in new assets. New assets will be used to support additional sales or new product lines or both. The projected net revenues from these additional investments should provide an adequate return on investment; a positive net present value.

Where: DCF = the present value of increment cash flowsIo = Investment outlay requiredSubject to: NPV ≥ 0



A Simple Rule of Thumb for Business Valuation

Many business brokers like to use simple rules of thumb to estimate selling prices. The most popular is the Earnings Multiplier.

The earnings multiplier really reflects a sustainable rate of return on investmentSome Examples:

If you are looking for a 10% ROR: the EM is 10 (= 1 / .10)If you are looking for a 15% ROR: the EM is 6.67If you are looking for a 20% ROR: the EM is 5

We use EBITDA as the preferred measure for cash flow since it represents the best estimate of the cash generated by the business after covering all the operating expenses.



SummaryThere are several approaches to estimating the value of a business. There are also a variety of considerations such as ease of entry and the number of competitors. Finally there is the problem of selecting an appropriate discount rate when using the DCF method. Business valuations are more art than science. For the business owner, the recommendation is to value the business on a regular basis taking into account changes in conditions and opportunities. For the prospective business buyer the task is much more difficult. Besides trying to decide on what type of business is the decision whether to start a business from scratch, buy a franchise, or buy an established business and work to make certain your investment will yield the expected rewards.


dr. david p. echevarriaall rights reserved1. dr. david p. echevarriaall rights reserved2

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