Valuing A Business

The Need to Compute Firm Value Situations call for a firm valuation when: An entrepreneur decides to buy a business, rather than starting one from scratch. An owner needs an annual value in order to contribute the appropriate number of shares to an ESOP. A value is needed to set the percentage of ownership that the new investors receive in the company. One partner wants to buy out another partner or the interest of a deceased partner. An owner wants to exit (harvest) the business by selling the business or transferring it to family members. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Valuation Methods Firm Value (or Enterprise Value) The value of the entire business, regardless of how it is financed Firm value – Outstanding debt = Equity value Equity Value (or Owner’s Value) The value of the firm less the debt owed by the firm Basic Valuation Methods Asset-based valuation Valuation based on comparables Cash flow–based valuation Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Valuing the Business Asset-Based Valuation Market-Comparable Valuation Estimates the value of the firm’s assets; does not reflect the value of the firm as a going concern Market-Comparable Valuation Considers the sale prices of comparable firms; difficulty is in finding comparable firms Cash-Flow-based Valuation Compares the expected and required rates of return on the amount of capital to be invested in the business Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Asset-Based Valuation Modified Book Value Technique Historical value of firm’s assets is adjusted to reflect current market values Replacement Value Technique Value of firm’s assets is adjusted to reflect current costs to replace the assets Liquidation Value Technique Value of firm’s assets is adjusted to reflect their value if the firm ceased operations and disposed of the assets Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Market-Comparable Valuation Earnings Multiple (Value-to-Earnings) Ratio A ratio is determined by dividing the firm’s value by its earnings that can be compared to representative ratios of recently-sold similar firms. Normalized Earnings Earnings that have been adjusted for unusual items, such as fire damage, and all relevant expenses, such as a fair salary for the owner’s time Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Market-Comparable Valuation (cont’d.) Risk and Growth in Determining a Firm’s Value: The more (less) risky the business, the lower (higher) the appropriate earnings multiple and, as a consequence, the lower (higher) the firm’s value. The higher (lower) the projected growth rate in future earnings, the higher (lower) the appropriate earnings multiple and, therefore, the higher (lower) the firm’s value. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Market-Comparable Valuation (cont’d) Earnings Type of Firm Multiple Small, well-established firms, vulnerable to recession 7 Small firms requiring average executive ability but operating in a highly competitive environment 4 Firms that depend on the special, often unusual, skill of one individual or a small group of managers 2 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Risk and Growth: Key Factors Affecting the Earnings Multiple and Firm Value B.1 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Wholesaling Industry Valuation Multiples B.2 Source: Pratt’s Stats from BVR, as reported in Randall Lane, “What Is Your Company Worth Now?” Inc., July 2003, p. 76. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Cash Flow-Based Valuation Determination of the value of a business by estimating the amount and timing of its future cash flows Step 1. Project the firm’s expected future cash flows. Step 2. Estimate the investors’ and owners’ required rate of return on their investment in the business. Step 3. Using the required rate of return as the discount rate, calculate the present value of the firm’s expected future cash flows, which equals the value of the firm. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.