Chapter 17 Business Valuation

Valuation approaches (This text assumes an acquisition context) Valuation closely related to cash flows ≈ net present value of future cash flows Regardless of methodology, valuation steps: Strategic analysis of target for fit, etc. Financial analysis, using ratios, etc. Projection of future performance Application of valuation approach Chapter 17 © Philip O’Regan 2016

Valuation approaches ctd. Cash flow Most commonly used method Determine/estimate future cash flows DCF (discounted cash flow): apply discount factor to reflect risks, etc. Discount factor uses WACC This reflects risk threshold and capital structure Assess value in context of net present value (NPV) Chapter 17 © Philip O’Regan 2016

Worked example p.561 Year Amount Discount Factor NPV 1 £100,000 0.952 £95,200   2 £110,000 0.907 £99,770 3 £120,000 0.864 £103,680 4 £200,000 0.823 £164,600 5 £250,000 0.784 £196,000 Totals £780,000 £659,250 Chapter 17 © Philip O’Regan 2016

Book value Less common approach Limited perspective Adopts historic cost basis of financial accounts Does not allow for up-to-date market value Limited application Zombie banks of recent years have used it! Chapter 17 © Philip O’Regan 2016

Market value (capitalization) Takes stock exchange valuation as proxy MV = Share Price x Market value per share Intuitively appealing But fails to take account of: fluctuations inspired by bid process premium demand by key stakeholders other stakeholders Nevertheless, good approximation of value Chapter 17 © Philip O’Regan 2016

Price (earnings) multiples Reflects role of profits in determining value P/E ratio can be used as multiplier Already captures market expectations (p.357) But based on EPS which is unsound Best used to: establish initial valuation and/or in tandem with other DCF approaches Chapter 17 © Philip O’Regan 2016

Enterprise value (EV) Combines strengths of other approaches In particular, it is sensitive to capital structure of acquirer and acquiree Allows for different debt/equity structures Recognizes that acquiring equity not always sufficient Value = “sum of all claims on the business” = MV + Debt – Cash Chapter 17 © Philip O’Regan 2016

Economic value added (EVA) Not based on “accounting profits” Adopts opportunity cost perspective Highlights cash flow increments above WACC = Operating Profit after Tax and WACC Changes focus onto “economic profit” Useful as non-accounting approach Chapter 17 © Philip O’Regan 2016

Altman’s “Z-score” Insights on viability of acquisition target May inform strategy and/or timing Composite model that draws on financial information to predict bankruptcy Not a valuation model per se: More useful in determining viability Only used as one element of process Chapter 17 © Philip O’Regan 2016

Financial Information Analysis Summary Various valuation approaches possible Valuation one step in acquisition process Most valuation approaches use DCF Credibility of cash as valuation basis But difficulties posed by estimation/WACC, etc. Alternatives includes “earnings” as basis Enterprise value sensitive to structure Acquisitions often more to do with ego! Chapter 17 Financial Information Analysis