1. Valuing A Business

2. 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.
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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.
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8. 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
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9. Risk and Growth: Key Factors Affecting the Earnings Multiple and Firm Value
B.1
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10. 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.
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11. 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.