This addendum to Demonstrate Your Investment Potential
is intended to provide additional theory and background
information on valuation. This material is presented as
a discussion of basic valuation principles and concepts
as well as discussion of the various methodologies and
approaches used in the valuation of the common shares
of a private company.
The addendum will describe the following:
- Fundamental Principles of Valuation;
- Valuation Concepts
- tangible asset backing
- Fair Market Value; and
- Valuation Methodologies and Approaches.
This material is presented on the assumption that you
will be assisted by a professional financial advisor.
It focuses on fundamental valuation principals and various
Fundamental Principals of Valuation
There are a number of principals of business valuation
which apply when a transaction is contemplated:
- value is relative to future expectations;
- the value of an asset is a function of its future
cash flow; and
- a higher tangible asset backing supports a higher
going concern value.
Value is Relative to Future Expectations
Value is based on future expectations if the potential
investor does not have access to historical cash flows.
The return on investment (i.e., the investment being the
purchase price) an investor will receive is wholly dependent
on the future benefits received from the acquisition.
While past earnings may indicate future earnings potential,
they do not guarantee future earnings and should not be
the only source of information used to predict a company's
future cash flow.
Value is Relative to Future Cash Flow
The benefit an investor will receive from an acquisition
is typically measured in terms of cash flow. While several
benefits may not directly pertain to cash flow, typically
they can be assessed by converting these amounts to cash
A Higher Tangible Asset Backing Supports a Higher Going
The tangible asset backing of the company is calculated
as the difference between the fair market value of all
tangible and identifiable intangible assets. The value
of intangible assets and the fair market value of the
company's liabilities can be determined separately. Tangible
assets represent the assets required in operations such
as fixed assets and working capital net of operating liabilities
such as bank debt. Identifiable intangible assets are
assets such as patents, trademarks and licences. Tangible
asset backing is determined based on a going concern assumption.
This means the estimated value of net assets should be
determined based on the assumption of continued use and
would, therefore, include installation costs but not taxes
or other costs which would result from disposition of
the net assets. Therefore, contingent liabilities and
cost of disposition (e.g., recapture, capital gains tax,
sales commissions, etc.) are specifically excluded.
Tangible asset backing provides insight into the risk
associated with the particular investment because, in
a worst case scenario, the net tangible assets of the
company could be sold. The proceeds realized could then
be used to relieve the liabilities of the company and
recoup shareholder investment. The tangible asset backing
also provides an indication of the capital investment
required to enter the market. In this case, the tangible
asset backing provides an indication of the potential
financial barrier to entry for new competitors.
Bob and Doug McKenzie were brothers who owned identical
manufacturing businesses. The companies were identical
in all respects except Bob's company owned its manufacturing
equipment while Doug's company leased its equipment. Doug
completed a sale and lease back of the equipment in 1996
with the funds generated on the transaction paid to Doug
as a dividend used to finance his personal acquisition
of a very expensive sports car. Both Bob and Doug decided
to expand operations to take advantage of the increasing
demand for their products. Operations required an additional
$500,000 to finance new product development. At dinner
one evening, Doug stated that investors considered his
company to be high risk due to the lack of supporting
assets. Investors told Doug if results did not unfold
as expected, they could lose all of their investment due
to the company's lack of assets. On the other hand, the
investors approached by Bob believed his company to be
low risk. They said even in the worst case of business
failure, proceeds from the sale of the company's underlying
net assets would repay most of their investment. Not surprisingly,
Bob received financing while Doug did not.
Tangible Asset Backing
As stated previously, the tangible asset backing is
the fair market value of all operating assets less all
operating liabilities. Most of the information gathered
to calculate the liquidation value is also necessary to
calculate the tangible asset backing.
Tangible asset backing differs from liquidation value
in three ways.
- Tangible asset backing often reflects fixed assets
at their value in use (depreciated replacement value
or realizable value plus installation costs), while
liquidation value often reflects fixed assets at fair
market value (net realizable value).
- Tangible asset backing excludes redundant assets (it
relates only to net operating assets).
- Tangible asset backing does not include liquidation
costs and taxes.
The tangible asset backing must be known before goodwill
can be determined. The formula for calculating the value
of goodwill is:
Value of Goodwill
Going concern value of operations -
Tangible asset backing
Where the analysis is based on an assessment of the
company's cash flow (i.e., based on the assumption the
company is a going concern), the calculated fair market
value of the company will typically exceed the fair market
value of its underlying net assets. The excess value is
referred to as goodwill. Goodwill is an intangible asset
and represents the incremental benefit accruing from a
successful assemblage of assets.
Goodwill is a valid inclusion in the value analysis
to the extent it possesses the following attributes:
- goodwill must be of an enduring nature;
- goodwill is attributable to cash flows expected from
future business activity; and
- goodwill must have commercial value (i.e., must be
transferable to a third party).
While goodwill is an intangible asset, a basis for goodwill
can often be attributed to one or more factors particular
to the company. In general, goodwill can be derived from
one or more of the following:
- based on the notion that a company's success is,
to some extent, based on the physical location of the
- where a particular product/service offered by the
company has developed name brand recognition/reputation
in the market place, the favourable attitude of consumers
often results in incremental cash flow to the company;
- a company which has fostered a superior working relationship
with its employees and lenders, investors, suppliers
and customers, or has assembled a superior management
team, etc. is at a competitive advantage vis-à-vis
other companies in the industry. This competitive advantage
often results in incremental cash flow to the company.
In general, goodwill is classified as commercial or personal.
- Commercial Goodwill
- Commercial goodwill refers to goodwill which is sellable
and which will provide the investor/purchaser with future
economic benefits (measured in terms of cash flow).
Since the economic benefit supporting the calculation
of commercial goodwill is transferable to third parties,
commercial goodwill is a valid consideration in the
determination of value.
- Personal Goodwill
- Personal goodwill pertains to the favorable attitudes
of customers, suppliers, etc., which are derived from
the efforts of a particular individual in the business.
In many cases, personal goodwill can be transferred
to a potential purchaser through client introductions,
and so on. This is a common operating model for the
sale of service businesses, including medical practices
and accounting practices. In some cases, goodwill associated
with a particular individual may also be secured using
non-compete contracts, management contracts or other
prudent business arrangements. In these cases, personal
goodwill may be a valid inclusion in the value determination.
Fair Market Value
In a transaction-oriented valuation, the determination
of fair market value is the first step in the pricing
process. After fair market value is determined, adjustments
are made to reflect the potential benefits realized by
the seller and each prospective investor or purchaser.
Definition of Fair Market Value
There is general consensus on the underlying attributes
of the definition of Fair Market Value. In general, Fair
Market Value can be defined as:
...the highest price available,
expressed in terms of money or money's worth, in an
open and unrestricted market between informed, prudent
parties acting at arm's length and under no compulsion
Valuation Methodologies and Approaches
There are two main approaches to the determination of
value: the empirical approach and the investment approach.
The empirical approach suggests that value is best determined
by reference to open market transactions involving similar
companies. Value can be determined by referring to value
relationship implied in the stock price of similar publicly
The main advantage of the empirical approach is that
it uses information directly from the market. Therefore,
more economic factors are considered. In most cases, the
empirical approach should not be used as the primary valuation
approach in Canada. In the United States, the empirical
approach is more widely used. The differences are due
to the relatively small number of companies in Canada,
the lack of publicly available information, and differences
between an investment in a publicly traded company and
a privately held business. In addition, an investment
in a publicly traded company typically has greater liquidity
than an investment in a privately held company. If the
company is not truly comparable, how would you adjust
the purchase price to derive a meaningful value relationship
which can be applied to determine the value of your company?
Instead, the empirical approach should be used as a secondary
technique to test the reasonableness of conclusions reached
through the investment approach.
Information related to transactions involving companies
which may be somewhat comparable to your company can be
obtained from the following sources:
- Mergers and Acquisitions Digest;
- Mergers and Acquisitions in Canada published by
Crosbie and Company;
- Brokerage reports issued by securities firms;
- Industry and association publications; and
- Newspaper and financial magazine articles.
The investment approach suggests value should be determined
by reference to a detailed investment analysis using the
techniques of financial statement analysis and risk measurement
theory. The investment approach is used by sophisticated
buyers and sellers in open market transactions.
There are two basic approaches to valuing a business:
earnings/cash flow-based approaches, and asset-based approaches.
The use of a specific approach is generally determined
by the operations of a business and whether or not it
is a going concern.
Going Concern Analysis
The assessment of fair market value begins with the
determination of the economic viability of the company.
Economic viability can be assessed by determining if the
company has realized a reasonable return on investment
in the past. This assessment is based on the inherent
risk associated with the industry and the particular company.
Economic viability should also be based on whether a reasonable
rate of return is expected in the foreseeable future.
Consider the circumstance where a company is earning a
fair return on employed capital (i.e., the return to owners
resulting from continued operation is expected to exceed
the proceeds which would be received on the liquidation
of the net assets). In this case, fair market value can
be determined using one of several methodologies based
on future expected cash flows. In some cases, this will
be based on the fair market value of the underlying employed
Now, consider the case where a company is not earning
a fair return on capital employed. The prospects for earning
a fair return in the foreseeable future are remote. Fair
market value will now be based on the liquidated value
of the company's net assets, based on the assumption this
value will exceed the value calculated on a going concern
basis (i.e., based on cash flow). The liquidation approach
to value focuses on a determination of the net realizable
value of the company's net assets and, therefore, includes
costs associated with winding up the company (e.g., latent
tax costs, sales commissions, severance packages, etc.).
Assuming entrepreneurs would not seek investment capital
for a business which should be wound up, the information
as set out in this course will concentrate on going concern
methodologies. A description of the liquidation approach
and examples of its application can be found in the Canada
Valuation Service published by DeBoo.
An asset-based approach is appropriate under the going
concern assumption where the underlying value of the company
relates to its assets (as opposed to operating cash flow).
An example of this type of company would be a real estate
holding company, which not only derives cash flow from
rents, etc., but also realizes value from capital appreciation
of the buildings it owns. The asset based approach requires
the calculation of the fair market value of the company's
individual assets and liabilities. Fair market value of
the company is calculated as follows:
Fair market value of the company
= Fair market value of the assets
Fair market value of the liabilities
Capitalization of Earnings Method
The capitalization of earnings method is based on a
simple premise. The future benefits derived from the acquisition
of a particular company can be measured based on the after-tax
maintainable earnings expected to be realized by the company
in the future. Maintainable earnings represent the average
level of earnings expected to be achieved in the future.
This approach is appropriate in circumstances where the
future financial performance of the company is expected
to be relatively stable and can therefore be estimated
by a single earnings figure. The capitalized earnings
approach assumes the earnings are distributed to the shareholders
each year (not reinvested in the business).
The following general formula calculates the fair market
value of all issued and outstanding shares of the company:
Maintainable after-tax earnings from
Going concern value of the operations
Fair market value of the shares
Note: This formula may require modification depending
on your circumstances.
Assessment of Indicated Value
To assess the reasonableness of the calculated fair
market value using the above methodology, a common approach
is to calculate the number of years of after-tax maintainable
earnings that will be required to pay back the indicated
value of goodwill. Goodwill pay back is a relevant consideration
since goodwill represents an intangible asset which would
not be recoverable in the worst case scenario where the
purchaser has to wind up the company's operations. Therefore,
the purchase price pertaining to goodwill represents a
higher risk than the purchase price pertaining to fixed
assets and other tangible assets. The following is a general
Going concern value of the operations
(i.e., fair market value)
Tangible asset backing
Annual future maintainable earnings from operations
Number of years of earnings in goodwill
The "number of years of earnings in goodwill"
calculation is then assessed relative to the nature of
the business. In certain industries (e.g., pharmaceuticals),
a high degree of goodwill may be evident given the relatively
low tangible asset backing typical in this industry. However,
in other cases, the calculated amount may indicate an
unusually high value in which case the value calculations/assumptions
employed in the analysis should be revisited. The calculated
"number of years of earnings in goodwill" can
also be viewed in relation to the general business risk
in the industry.
Calculation of Maintainable After-Tax Earnings
The maintainable after-tax earnings is determined as
- Assess historical pre-tax earnings realized by the
company. Depending on the circumstances, the number
of years to review will vary. However, as a general
rule, five years of historical results is a useful benchmark.
Clearly, this analysis will not be available if the
company is in the start-up phase.
- The review of historical information is only useful
to the extent it provides insight into the expected
future financial performance. Therefore, consider whether
or not each of the historical years is relevant to determine
future maintainable earnings. This analysis may be influenced
by the stage the business is in (e.g., start up) and
the industry in which it operates (e.g., cyclical industries
such as real estate). The years prior to a change in
operations may not be relevant if the change did not
have a material impact on profitability.
Past earnings are only a guide to determining future
maintainable earnings. View them in combination with
earnings projections to achieve optimal results.
- Historical financial results and those projected for
the future of the company may include unusual and non-recurring
expenses. These should be excluded for purposes of determining
annual future maintainable earnings. Examples of such
items include one-time fees, start-up costs or property
damage relating to floods/fires, etc. Adjustments should
also be made for revenue and expense amounts which do
not reflect fair market value. Examples of such expenditures
would include favourable terms provided or given to
a non-arm's length party and other items which, although
they provide economic benefit, will not be available
indefinitely in the future. Examples of such items include
salaries paid to relatives, guaranteed supply contracts
from related parties at favourable prices, etc. Furthermore,
historical results may be adjusted to reflect the inflationary
effects between the date the financial results were
reported and the valuation date.
- Determine the future maintainable pre-tax earnings
based on past and projected adjusted earnings. A simple
average or weighted average can be used to determine
the maintainable pre-tax earnings based on the use of
judgment after analysing earning trends and future expectations.
In some situations, the most current year, or forecast
earnings, may be the most appropriate indicator of future
maintainable pre-tax earnings. The ultimate objective
of this analysis is to project the annual earnings which
probably will be realized by the company in the future.
- Apply the appropriate tax rate to determine the after-tax
The following is an example of the determination of
maintainable after-tax earnings.
Historic Financial Information
- The president used to pay his wife a salary of $20,000
per year, although she performed no corporate function.
This practice was stopped in 1999.
- Pre-tax income for 1999 included a severance payment
of $30,000. Further severance payments are not anticipated.
- The income tax rate is 40%.
- In 1996 and 1997, the company's primary competitor
was experiencing labour problems. Labour relations are
now excellent and no further work stoppages are expected.
- No forecast has been prepared for 2001, but management
does not anticipate significant growth in sales.
Determination of Maintainable After-Tax Earnings
Reported pre-tax income
Adjust pre-tax income
Maintainable pre-tax earnings
Income tax @ 40%
Maintainable after-tax earnings
Rounding off to -
- The president's wife's salary and severance payment
are considered non-recurring and have been added back
to reported income.
- Results for 1996 and 1997 have been weighted less
heavily due to the belief that labour problems at the
main competitor during 1996 and 1997 make these results
less representative of future earnings.
- 2000 results weighted most heavily due to recency.
Strengths and Weaknesses of the Earnings Method
- It has greater acceptance and is better understood
than cash flow methods.
- It is easier to obtain information on comparable earnings
multiples than for cash flow multiples.
- Earnings do not reflect the actual benefits to the
owners (i.e., cash flow).
- Net income often fluctuates significantly from the
indicated cash flow amounts due to such items as depreciation
expense and other non-cash expenses.
- Depreciation, particularly in inflationary environments,
is an inadequate measure of the asset's usage.
Cash Flow-Based Approaches
In general, cash flow-based approaches are the preferred
methodology where the company is viewed as a going concern.
In general, there are two cash flow-based methodologies
- the capitalized cash flow approach and the discounted
cash flow approach.
Capitalized Cash Flow Approach
The capitalized cash flow is similar to the capitalized
earnings approach, except it capitalizes cash flows as
opposed to earnings.
The capitalized cash flow approach is a more precise
methodology than the earnings approach, particularly in
cases where the company is capital-intensive, and depreciation
and other accounting estimates may not accurately reflect
cash flow expenditures.
Capitalized Cash Flow Formula
The following formula calculates the fair market value
of all issued and outstanding shares of the company:
Maintainable net income before tax
Cash flow before taxes
Taxes based on cash flows
Sustaining capital reinvestment
Maintainable future cash flows
Capitalized cash flows
Going concern value of operations
Tax shield on available UCC
Fair market value of shares
This methodology is very similar to the capitalized
earnings approach. The main difference is the substitution
of estimated average sustaining capital reinvestment for
The key components of this methodology are described
- Maintainable Future Cash Flows
- The adjustments made to normalize earnings also apply
to this cash flows methodology. Non-cash items (e.g.,
depreciation) are added back to earnings to determine
the company's cash flow.
- Sustaining Capital Reinvestment
- As indicated previously, the cash flow methodology
requires an add back for non-cash items including depreciation.
However, the company will incur capital expenditures
on fixed assets necessary to maintain the viability
of the company. To reflect this cash outflow, an estimate
of the required sustaining capital reinvestment is made
and deducted from the cash flow calculated above. Depending
on the jurisdiction, these capital expenditures may
have preferential tax treatment which should be reflected
as a reduction to the expenditure on these items. While
sustaining capital reinvestment may fluctuate from year
to year, the capitalized cash flow methodology requires
one estimate of the annual expenditures; it is assumed
this expenditure will be incurred on an annual basis
- Tax Shield on Available Undepreciated Capital Cost
- The income taxes calculated to arrive at maintainable
future cash flow were based on cash flows without adjustment
for the deductions available from existing undepreciated
capital cost (UCC) balances (i.e., tax depreciation).
Accordingly, the present value of the tax shield arising
from the existence of available UCC must be added to
the capitalized cash flow value prior to arriving at
the fair market value of the shares.
The present value of the tax shelter provided by existing
UCC balances can be calculated using the following formula:
UCC x Rate of income tax x Rate of
Rate of return + Rate of capital cost allowance
In calculating the capitalized cash flow value, you
have assembled the following information:
Rate of income tax
Rate of capital cost allowance
Rate of return
The present value of the tax shelter provided by existing
UCC balances is approximately $64,000 calculated as follows:
250,000 x 45% x 20%
15% + 20%
Strengths and Weaknesses of the Capitalized Cash Flow
- The capitalized cash flow approach is based on your
company's cash flows and, therefore, is a more relevant
analysis since potential purchasers assess the future
expected cash flows (as opposed to earnings).
- This methodology is more precise than the earnings
methodology because cash flows pertaining to capital
reinvestment are quantified. The earnings approach assumes
depreciation is an appropriate estimate of the required
- This methodology provides a better measurement of
cash return on capital.
- Annual fluctuations in cash flow are not considered.
- Irregular required capital reinvestment is also not
Discounted Cash Flow Approach
The discounted cash flow (DCF) approach requires the
projection of cash flows for a specified number of years
in the future. The DCF then discounts these amounts by
an appropriate discount rate (based on an assessment of
the risk associated with realizing the projected future
cash flows). Future cash flows are discounted to determine
the value today of amounts which will be received at some
point in the future. Discounting future cash flows recognizes
that a dollar received today is worth more than a dollar
received at some point in the future. A dollar received
today can be invested, earn income and grow. Furthermore,
a dollar received today has greater value. There is a
risk a dollar received in the future will not be received.
The dollar received today, by definition, does not have
this risk of realization.
The DCF approach is based on a projection of the company's
future cash flows. You should base projected future financial
performance on an analysis of the economy in general,
the industry in which the company operates and the particular
attributes of the company itself.
In determining the number of years to project future
cash flows (the projected period), an assessment of the
reliability of the projections is performed. The projected
period is limited to the period for which reliable projections
are available. For years subsequent to the projected period,
a maintainable annual cash flow is estimated and assumed
to be realized on an annual basis in perpetuity. This
annual amount is discounted back to the valuation date
and is referred to as the residual value of the company.
The DCF methodology is generally viewed as the most
accurate methodology in cases where a company is considered
as a going concern and value is based on future cash flows.
A benefit of this methodology is that it allows for annual
fluctuations in cash flows which may occur in the future.
In contrast, the capitalized cash flow methodology is
based on an average cash flow to be received in perpetuity.
In many cases, the future annual cash flows of a company
are not expected to fluctuate significantly. The added
level of precision offered by the DCF methodology may
not be required. The DCF methodology does require a more
in-depth analysis, and this level of precision may not
be worthwhile in certain circumstances.
Discounted Cash Flow Formula
The DCF methodology is based on the following formula:
- Step #1
- Calculate units sold.
- Step #2
- Calculate gross revenues.
- Step #3
- Calculate gross margin.
- Step #4
- Deduct cash outlays per income statements.
- Step #5
- Deduct other future costs.
To Determine Net Operating Cash Flow
- Step #6
- Deduct income taxes at stipulated rate.
To Determine After-Tax Cash Flow
- Step #7
- Deduct capital expenditures (net of tax benefits).
- Step #8
- Deduct working capital requirements.
To Determine Net Cash Flow in Each Year
- Step #9
- Apply discount factor to each year of projected cash
flows and a multiple to the last year of projected cash
flow which is then discounted to the valuation date.
- Step #10
- Add redundant assets.
Components of the Discounted Cash Flow Formula
Projected cash flow from operations
Projecting future financial performance is a speculative
process which becomes less precise as the projection period
is increased. In general, financial projections beyond
a five year forecast period are not typically used in
the DCF methodology. However, the projection period will
depend to a large degree on the industry in which the
company operates and the ability to develop reliable projections.
For example, in a regulated industry such as utilities,
cash flow may be accurately projected for up to 10 years
or more. Financial projections can include consideration
of inflation or can be stated in constant dollars (i.e.,
excluding inflation). The methodology employed in either
case should be clearly stated and will have a significant
impact on the discount rate which is described below.
Working capital changes
Working capital is defined as the current assets less
current liabilities of the company. The analysis should
include a determination of additional investments required
in working capital because the DCF methodology permits
cash flows to be estimated on a year by year basis during
the projected period. As a company continues to grow,
it will be required to reinvest some of the cash flow
in current assets such as inventory and a larger accounts
receivable balance. Part of these investments can be funded
through increased debt (e.g., accounts payable and operating
loans). This represents a cash outflow, to the extent
cash flow generated by the business is used for this purpose.
You should then reduce the projected cash flows of the
As previously discussed, capital additions may be required
to maintain the ongoing viability of the company. To the
extent capital acquisitions are required, these expenditures
should be reflected as deductions to the company's cash
flow in the year in which you expect to incur them. In
certain circumstances, capital additions may have a beneficial
tax advantage which will reduce the ultimate taxes payable
by the company. In such circumstances, this tax benefit
should also be reflected in the cash flows as a reduction
to the taxes payable.
Debt principal payments are a cash outflow to the company.
However, principal repayments are typically excluded from
the DCF valuation. This deduction is based on the assumption
the principal repayment can be replaced by new debt. Therefore,
the net effect on cash flows is nil.
Income taxes are applied to the cash flows based on
the prevailing income tax rates. This analysis is based
on the assumption income tax rates will continue into
the future. If the government announces income tax changes
which will affect the future taxes payable in a given
year, you should reflect these adjustments in the cash
flows in that particular year.
The discount rate is similar to the capitalization multiple
discussed in the capitalized cash flow methodology described
above. In essence, the discount factor recognizes the
fact that a dollar received today is worth more than a
dollar received a year from now. A dollar received today
can be invested, earn interest and grow. Therefore, a
dollar received in the future must be discounted (i.e.,
reduced) to reflect its value today. The determination
of the appropriate discount rate (and capitalization rate)
are discussed in a later section.
In many circumstances, a company will accumulate various
assets which are not essential to the ongoing operations
of the core business. For example, successful corporations
may have large cash balances or investments in marketable
securities. In most circumstances, these assets can be
removed from the company without adversely affecting the
operations of the business. These assets are commonly
referred to as redundant assets.
How do you determine the fair market value using a cash
flow approach? The cash flows of the company will exclude
consideration of any income/expenses earned on these redundant
assets. Therefore, you must then adjust the calculated
fair market value based on cash flow to reflect the value
of these redundant assets which have been assumed to be
removed from the company. The fair market value of a redundant
asset should reflect the fair market value of the asset
less any costs associated with removing it from the corporation.
For example, cash is easily valued and removed from the
corporation so that the fair market value may be the face
value reported in the company's financial statements.
However, marketable securities are typically recorded
at historical costs and there may have been a significant
fluctuation in the value of these investments. The fair
market value of the marketable securities should reflect
the current market value less any costs of disposition
(i.e., sales commissions, etc.).
You should be cautious to ensure the assets which appear
to be redundant are in fact not necessary for the operations
of the business. For example, large cash balances may
be required by the business if the business is seasonal
and the large cash balance has been set aside to invest
in inventory. Furthermore, marketable securities and other
investments may be required due to debt covenants, etc.
Hidden Redundant Assets
A review of the company's balance sheet may indicate
a hidden redundant asset if the company does not fully
use available financial leverage. Many companies operate
with a very low level of debt financing. Basic valuation
principals assert that due to tax benefits being afforded
interest expense, it is advantageous to introduce some
level of debt financing into a company's operations. By
doing this, the fair market value of the company will
be maximized. If a company does not have debt financing,
you should adjust the cash flows and balance sheet to
reflect the appropriate level of imputed debt financing.
The net effect is to reduce the cash flows by the imputed
interest expense and to introduce additional cash available
for distribution to the balance sheet. The amount borrowed
(imputed) is treated as a redundant asset. Therefore,
it is added to the fair market value calculated based
on a cash flow methodology.
Strengths and Weaknesses of the Discounted Cash Flow
- This method focuses solely on the future (see principles
- It takes into account fluctuations in annual cash
- It offers the highest level of precision.
- This method is generally not well understood and
is more difficult to apply than other methods.
Multipliers, Capitalization Rates and Discount Rates
The selection of a discount rate is required to calculate
the risk adjusted present value of expected future cash
flows of your company. The rate selected is based on an
assessment of general and prevailing economic market conditions,
trends and conditions within the industry, the financial
condition and prospects of the company, and the overall
risk attached to the cash flow of the business.
In this regard, the discount rate is composed of the
- risk free rate of return;
- risk associated with equity investments;
- risk associated with the industry in particular; and
- risk associated with the company in particular.
In general, a premium is added to the risk free rate
of return to reflect an investor's required rate of return
from that investment. The investor's required rate of
return is based on the perceived risk of realizing the
projected cash flows and the security of the investment.
The risk free rate of return can be estimated by long-term
government bonds based on the assumption the risk of default
is virtually nil. This risk free rate of return has two
- a real rate of return (excluding inflation); and
- an inflation premium to reflect future expectations
concerning changes in prices.
If the market anticipates increases in future inflation,
the risk free rate of return would increase accordingly.
Investors view investments in companies as longer term.
You should then base the risk free rate on long-term government
bonds. The rate of return on these instruments represent
the market's expectation regarding long-term inflation.
An equity risk premium is the premium return an investor
in equities will require over and above the rate of return
which that investor would realize from a risk free investment.
The equity risk premium is typically determined relative
to historical market return relationships. Recent studies
indicate after-tax equity risk premiums are generally
in the range of 4% to 5%.
After determining the required rate of return on equity
investments in general, the analysis then focuses on the
risk pertaining to the industry in which the company operates.
The analysis also focuses on the risk associated with
realizing the cash flows of the company in particular.
In general, this is a qualitative analysis and the specific
considerations will depend on the specific circumstances
of the case under review. In general, the analysis may
consider the following:
- Size of the business
- generally, larger businesses will have lower business
risk since they are more diversified and well established
in the marketplace.
- Economic considerations
- uncertainty regarding the market in which the company
operates will lead to higher business risk and increase
the risk the investor will not realize the projected
- Earnings trends
- as previously indicated, historical earnings can
provide an indication of future financial performance.
However, the value determination will be based on an
assessment of future financial performance. To the extent
financial projections are speculative, the risk of realizing
future cash flows is increased. The relative risk associated
with financial projections will depend on the company
and the industry in which it operates.
- Industry assessment
- companies operating in high technology industries
or other industries with significant and rapid changes
in products/services are more vulnerable to downturn,
and therefore, the investor faces an increased risk
the company will not attain future financial performance.
However, these industries also represent opportunity
since market leaders can significantly outperform companies
is more stable industries.
In general, the financial projections should reflect
the best estimate of future financial performance. The
discount rate can then be adjusted to reflect qualitative
factors (in addition to the risk free rate of return)
- an equity risk premium. An example of the qualitative
analysis used to determine the premium over the return
on equity investments is provided here.
1.The company was entering a period marked by
several new product introductions and significant
2.The financial forecasts predict significant
growth in cash flows.
3.The financial forecasts do not reflect additional
opportunities the company may realize, which have
not been specifically identified.
4.Many of the company's product lines have relatively
small sales volumes and may not attract competition.
5.The company is projecting an increased diversification
of its product line, reducing its reliance on its
current product line.
6.The company has a low tangible asset backing,
which is not uncharacteristic of companies operating
in the industry.
7.There is a trend toward increasing price sensitivity
8.The general outlook for the industry is relatively
9.The company has exhibited a willingness and
desire to undertake research and development, a
critical success factor in the industry.
10.The industry is fragmented with no dominant
competitors (in terms of market share).
11.Product introduction can be delayed due to
government regulation, etc.
12.Given the nature of the industry, it is difficult
to assess comparable transactions.
13.Corporate management has exhibited the ability
to adapt to change, and there appears to be no dependence
on one or two key individuals.
14.There are significant barriers to entry in
This required rate of return should be consistent with
the cash flow forecast in terms of inflation — both
should either include or exclude inflation.
Investor Rates of Return
The investor will want to ensure the project or business
will provide a sufficiently high level of return on investment
to compensate for the perceived risk the investor will
assume. The required rate of return will vary greatly
depending on the nature of the opportunity and on the
structure of the investment (i.e., debt or equity). The
higher an investor perceives the risk to be, the higher
the rate of return the investor will require. Your investor
may be looking for a rate of return of 15% to 25% on a
subordinated debt instrument and as much as 25% to 40%
on an equity investment. These high rates of return are
driven by the substantial risks associated with private
equity investment. These risks include high rates of business
failure, long periods of time before capital is returned
to the investor, the investor's likely inability to control
or influence the operations of the company, and the general
lack of liquidity associated with an investment in a privately
Rules of Thumb
Closely related to the "comparable transaction"
methodology is an analysis involving rules of thumb in
the industry. Rules of thumb pertain to quick and general
analyses which apply a basic multiple to a measure of
cash flows or asset values. For example, a general valuation
rule of thumb within the industry may be a multiple of
revenues, multiple of the number of repeat customers,
gross margin or book value. In general, rules of thumb
are not a primary valuation technique but can provide
useful insight into how the industry views a particular
company. In this case, it can provide a useful reasonableness
check on the value determined using a primary valuation
technique. The analysis is further complicated by the
fact that rules of thumb are not regularly adjusted to
reflect the fluid nature of value (recall that value reflects
a particular point in time). Furthermore, rules of thumb
do not provide insight into the specific characteristics
of a particular company, and therefore, should be considered
general estimates only.