Business valuations

Why do we need a valuation?

A share valuation may be needed for any of the following:

• For any sale or purchase of shares
• As a price for a merger or acquisition
• For tax purposes - e.g. capital gains, inheritance tax
• For disclosure purposes - e.g. if directors are given shares as part of their remuneration
• For other legal purposes, such as divorce settlements 

How to value a business

There are three basic ways of valuing a business

• cash based methods - the theoretical premise here is that the value of the company should be equal to the discounted value of future cash flows.
• market based methods - where we assume that the market is efficient, so use market information (such as share prices and P/E ratios) for the target company and other companies. The assumption is that the market values businesses consistently so, if necessary, the value of one company can be used to find the value of another.
• asset based methods - the firm's assets form the basis for the company's valuation. Asset based methods are difficult to apply to companies with high levels of intangible assets, but we shall look at methods of trying to value intangible as well as tangible assets.

Cash based methods

The free cash flow method

Free cash flows can used to find the value of a firm. This value can be used:

• to determine the price in a merger or acquisition
• to identify a share price for the sale of a block of shares
• to calculate the "shareholder value added" (SVA) by management from one period to another.

Calculating the value

Technically, in order for the value of the business to be accurately determined, free cash flow for all future years should be estimated. However rather than attempting to predict the free cash flows for every year, in practice a short cut method is applied.

Future cash flows are divided into two time periods:

• Those that occur during the "planning horizon".
• Those that occur after the planning horizon.

The planning horizon

In competitive industries, a business may have a period of competitive advantage where it can earn excess returns on capital by maintaining a commercial advantage over the competition. However this period is unlikely to last indefinitely. Returns are likely to reach a steady state where the business earns on average its cost of capital but no more.

The planning horizon (which may last up to ten years or more) is the period during which the returns are expected to be higher than the cost of finance.

In period beyond the planning horizon it is usually assumed that the returns earned will continue at their current rate for the remainder of the investors' time horizon. This may be a given number of years or in perpetuity. Alternatively the value of the cash flows may be expressed as a lump sum using a P/E ratio.

Calculating free cash flows from accounting information

Identifying free cash flows for an entire company or business unit is a complex task and is usually determined from the already prepared accounting information and is found by working back from profits as follows:

This method gives the level of free cash flow to the firm as a whole.

Free cash flow to equity

The above approach calculates free cash flows before deducting either interest or dividend payments.

The free cash flow to equity only can be calculated by taking the free cash flow calculated above and:

• deducting debt interest paid
• deducting any debt repayments
• adding any cash raised from debt issues.

In practical terms, the free cash flow to equity determines the dividend capacity of a firm i.e. the amount the firm can afford to payout as a dividend.

Forecasting growth in free cash flows

The methods above have identified a figure for the free cash flow of the business based on its current financial statements. In order to value the business, the future free cash flows need to be forecast and then discounted.

To forecast the likely growth rate for the free cash flows, the following three methods can be used:

• Historical estimates - For example, if the business has achieved growth of 5% per annum each year for the last five years, 5% may be a sensible growth rate to apply to future free cash flows.
• Analyst forecasts - Particularly for listed companies, market analysts regularly produce forecasts of growth. These independent estimates could be a useful indicator of the likely future growth rate.
• Fundamental analysis - The formula for Gordon's growth approximation (g = r × b) can be used to calculate the likely future growth rate, where r is the company's return on equity (cost of equity) and b is the earnings retention rate. The formula is based on the assumption that growth will be driven by the reinvestment of earnings.

Use of free cash flow to equity (FCFE) in valuation

The previous calculations have found equity value by:

• discounting free cash flow to present value using the WACC, and then deducting debt value.

Alternatively, the value of equity can be found directly by:

• discounting free cash flow TO EQUITY at the cost of equity.

In the simplest case (if FCFE is assumed to be growing at a constant rate into perpetuity), the following formula can be applied:

FCFE₀(1 + g) / (k_e - g)

The formula is based on the dividend valuation model theory

Economic value added (EVA^TM)

The economic value added (EVA^TM) valuation model was developed by a firm called Stern Stewart. It combines:

• the logic of the NPV model
• the use of accounting data produced by a firm.

EVA^TM is an estimate of "economic" profit - the amount by which earnings exceed the required minimum rate of return that investors could get from other securities of comparable risk.

It follows the same principles as residual income by deducting from profits a charge for the opportunity cost of the capital invested.

EVA^TM is defined as:

NOPAT - rC

where:

NOPAT = Net operating profit after tax

r = WACC

C = firm's invested capital

The EVA^TM is then "capitalised". Assuming the earnings will continue in perpetuity, the capitalised value is EVA^TM / WACC

Then, the value of the firm = C + capitalised EVA^TMand the value of equity = value of the firm less value of the total debt outstanding.

EVA adjustments

The NOPAT and C figures are not simply taken from the company's financial statements. There are over 160 different adjustments that maybe required to bring the figures into closer alignment with the true underlying profitability and level of capital invested - i.e. to remove the distortions caused by conforming to the governing GAAP - although in practice only between 5 and 15 of them are usually needed to achieve a meaningful result.

The dividend valuation model (DVM)

Theory: The value of the company/share is the present value of the expected future dividends discounted at the shareholders' required rate of return.

Assuming a constant growth rate in dividends, g:

P₀ = D₀(1 + g) / (K_e - g)

If the growth pattern of dividends is not expected to be stable, but will vary over time, the formula can be adapted.

Ke = cost of equity.

g = constant rate of growth in dividends, expressed as a decimal.

D₀(1 + g) = dividend just paid adjusted for one year's growth.

The model is highly sensitive to changes in assumptions:

• Where growth is high relative to the shareholders' required return, the share price is very volatile.
• Even a minor change in investors' expectations of growth rates can cause a major change in share price contributing to the share price crashes seen in recent years.

DVM is more suitable for valuing minority stakes, since it only considers dividends. In practice the model does tend to accurately match actual stock market share prices.

Market based methods

Stock market value (market capitalisation)

For a listed company, the stock market value of the shares (or "market capitalisation") is the starting point for the valuation process.

In a perfectly efficient market, the market price of the shares would be fair at all times, and would accurately reflect all information about a company. In reality, share prices tend to reflect publicly available information.

The market share price is suitable when purchasing a minority stake. However, a premium usually has to be paid above the current market price in order to acquire a controlling interest.

The price-earnings ratio (P/E) method

The P/E method is a very simple method of valuation. It is the most commonly used method in practice.

Value of equity = PAT × Suitable industry PE ratio.

Value of a share = EPS × Suitable industry PE ratio.

PE ratio

The PE ratio applied should be that of a company (or average of several companies), that are similar with respect to:

• business risk - i.e. in the same industry
• finance risk - i.e. have approximately the same level of gearing
• growth - are growing at about the same rate.

In practice this may be difficult to find, and the parties involved in the acquisition will then negotiate the applied PE ratio up or down depending on the specific company circumstances.

In particular, if using a quoted company's PE to value an unquoted business, a substantial discount is often applied to reflect the lower marketability of unquoted shares (around 25% in practice).

Profit figure

The PAT must be:

• maintainable earnings going forward - some adjustment will be needed for changes anticipated as a result of the acquisition or future trading conditions (e.g. forecast synergies)

Weaknesses of the model

• It is applied to accounting earnings which are more subjective than cash flows.
• It assumes that the market is actually valuing earnings rather than some other aspect of the company's output - dividends, earnings growth, risk etc.
• It assumes that the market does accurately value shares

Earnings yield approach

The earnings yield is simply the inverse of the PE ratio:

Earnings yield = EPS/Price per share

It can therefore be used to value the shares or market capitalisation of a company in exactly the same way as the PE ratio:

Value of company = Total earnings  / Earnings yield

Value per share = EPS  / Earnings yield

Market to book ratio (based on Tobin's Q)

Market value of target company = Market to book ratio × book value of target company's assets

where market to book ratio = (Market capitalisation/Book value of assets) for a comparator company (or take industry average)

This method assumes a constant relationship between market value of the equity and the book value of the firm.

Problems with the model

• Choosing an appropriate comparator - should we use industry average, or an average of similar firms only?
• The ratio the market applies is not constant throughout its business cycle, so strictly the comparator should be taken only from other companies at the same stage.

Asset based methods

The basic model

The traditional asset based valuation method is to take as a starting point the value of all the firm's balance sheet assets less any liabilities.

Asset values used can be:

• book value - the book value of assets can easily be found from the financial statements. However, it is unlikely that book values (which are based on historic cost accounting principles) will be a reliable indicator of current market values.
• replacement cost - the buyer of a business will be interested in the replacement cost, since this represents the alternative cost of setting up a similar business from scratch (organic growth versus acquisition).
• net realisable value - the seller of a business will usually see the realisable value of assets as the minimum acceptable price in negotiations.

However:

• replacement cost is not easy to identify in practice, and
• the business is more than just the sum of its constituent parts. In fact the value of the tangible assets in many businesses is minimal since much of the value comes from the intangible assets and goodwill (e.g. compare a firm of accountants with a mining company).

Intangible asset valuation methods

Definition of intangible assets

Intangible assets are those assets that cannot be touched, weighed or physically measured. They include:

• assets such as patents with legal rights attached
• intangibles such as goodwill, purchased and valued as part of a previous acquisition
• relationships, networks and skills built up by the business over time.

A major flaw with the basic asset valuation model is that it does not take account of the true value of intangibles.

Basic intangible valuation method

The simplest way of incorporating intangible value into the process is by the following basic formula:

Firm value = [book or replacement cost of the real assets] + [multiplier × annual profit or turnover]

The multiplier is negotiated between the parties to compensate for goodwill.

Effectively, some attempt is being made to estimate the extra value generated by the intangible assets, above the value of the firm's tangible assets.

This simple formula provides the basis for the two main intangible valuation methods: CIV (Calculated Intangible Value) and Lev's method.

Calculated intangible value (CIV)

This method is based on comparing (benchmarking) the return on assets earned by the company with:

• a similar company in the same industry or
• the industry average.

The method is similar to the residual income technique. It calculates the company's value spread - the profit it earns over the return on assets that would be expected for a firm in that business.

Method

(1) A suitable competitor (similar in size, structure etc.) is identified and their return on assets calculated:

(2) If no suitable similar competitor can be identified, the industry average return may be used.

(3) The company's value spread is then calculated.

(4) Assuming that the value spread would be earned in perpetuity, the Calculated Intangible Value (CIV) is found as follows:

• Find the post-tax value spread.
• Divide the post-tax value spread by the cost of capital to find the present value of the post-tax value spread as a perpetuity (the CIV).

(5) The CIV is added to the net asset value to give an overall value of the firm.

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