One of the central business valuation techniques under the income approach is the discounted cash flow method. It lets you calculate the business value based on three fundamentals:

• Business earnings forecast, usually annual cash flows.
• Discount rate which captures business risk.
• Long-term business value, known as the terminal value.

The standard discounting valuation formula assumes that the business cash flows occur at the end of each year. However, a business may generate a smooth income stream throughout the year.

Mid-year convention adjustment

The typical way to handle such situations is to discount the cash flows as if they occurred in the middle of the year. This calls for just one simple adjustment to your discounted cash flow valuation result, multiplication by this factor:

where D is the firm’s discount rate. You can calculate the equity discount rate by using the Build-Up model. If the company is financed by both debt and equity capital, use the weighted average cost of capital (WACC) iterative procedure.

Example: Comparing discounted cash flow valuations with and without the mid-year convention.

Consider a company with the following cash flow forecast:

Let us assume that the firm’s discount rate is 30%. The estimated long-term earnings growth rate is 5.53% which gives us the business terminal value of $5,124,129.

With these inputs prepared, we next calculate the present value of the business using the standard discounting and then adjusting the result for the mid-year convention as follows:

Business value, standard discounted cash flow method

Business value adjusted for the mid-year convention

The mid-year convention result gives the business value that is 14% higher than the standard discounting valuation.

The difference grows as the discount rate increases. This makes sense - the more risky the business, the greater the importance of receiving the cash flows as early as possible.

Of all the business valuation methods under the income approach the discounted cash flow technique truly stands out. What makes this method unique?

Its solid financial foundation, flexibility in valuing established companies and startups, businesses with steady earnings and rapidly changing profits make this method an excellent choice for appraising all types of businesses.

Earnings and risk define business value

Best of all, the discounted cash flow method lets you focus on the unique value-creating attributes of each business and show clearly the key relationship among these fundamentals:

• Business value
• Business earnings prospects
• Business risk

How business value depends on your assumptions: what-if valuation scenarios

You can create business earnings forecasts of arbitrary length, usually measured in years. Each forecast is your vision of a possible business outcome. And each outcome is associated with a certain level of business risk, captured by the discount rate. The discounted cash flow method lets you determine the business value in present day dollars for each earnings and risk scenario.

To increase the accuracy of your business valuation, consider using a number of such scenarios. For example, construct earnings forecasts and assess company risk for:

• Base case, or most likely outcome you expect going foreward.
• Best case, when the business conditions are most favorable.
• Worst case, in case the business encounters unexpected difficulties.

You can then calculate business value as a weighted average of the valuation results you get for each scenario. The weights represent the probabilities, in your judgment, of each scenario actually occurring.

Discounted cash flow valuation as a decision making tool

The power of the discounted cash flow method is that it enables you to translate expected business performance into value. This creates a number of opportunities:

• Selecting the best financial and operational plan from a number of candidates.
• Defining contingency plans.
• Verifying and refining assumptions to see how the value of the business is impacted.
• Selecting the best business investment opportunity from a number of alternatives.

In this sense, you can use the discounted cash flow method as a powerful planning tool as well as a highly effective business valuation technique.

This is no idle question - with cyber attacks on the rise the safety and security of your business computer has never been more important.

If you are a professional advisor, the last thing you need is to experience a computer crash in the middle of a time-critical project or sustain a loss of sensitive client data.

As a business owner, you may be running a number of applications on your computer. If your system is compromised or taken over by online criminals, the loss to your business could be devastating.

So how do you make sure this does not happen to you?

Your business software safeguard - digital code signing

The good news is that the reputable business software vendors already take serious steps to protect you. One of the most important defenses in their arsenal is digital code signing of the software products.

How software code signing works

If you are installing a software application on a Windows computer, the Authenticode technology is your first line of defense. Before installation is allowed to go on, the Authenticode on your computer performs two critical checks:

• It verifies the identity of the software publisher. For example, in the case of ValuAdder, your computer informs you that the publisher is Haleo Corporation (that’s us!).
• It verifies the product itself. Continuing with the above example, you are notified that ValuAdder 5 is the software product you are about to install.

Only after the above checks have been successfully done are you advised to proceed with the software installation.

What happens behind the scenes during this critical step is really important:

First, Authenticode reads the encrypted signature included in your software product. Only the software publishers whose identity has been verified, domicile established, and corporate officers contacted can have the seal, known as the code signing certificate. This seal is required to produce the software signature for verification on your computer.

Since online crooks want to conceal their identity in order to avoid punishment, they will not have access to a code signing certificate such as one granted by VeriSign.

In addition, your computer checks that the software file is intact and has not been tampered with. You can then proceed with the product installation safely.

ValuAdder products - designed with your protection in mind

All ValuAdder business valuation software products are digitally signed by a VeriSign certificate. This authoritative third party endorsement is your assurance that your ValuAdder products will perform their functions while protecting your computer system.

When it comes to valuing a business, size matters. The main reasons for this is that companies of different sizes face very different risks. Most investors believe that large companies are less risky than their small counterparts. Other things being equal, the smaller firms need to generate higher returns to compensate their investors for the extra risk they take.

How much more risk? The largest Fortune 500 firms with market capitalizations approaching $500M are about as risky as the overall market. On the other hand, for businesses that are valued well below $150M, the investors currently demand the additional risk premium of around 9.5%. That’s the bracket where most small businesses fit in.

Here are some reasons for this risk perception difference:

• Large companies have better access to debt and equity capital.
• Larger firms tend to be more diversified in their product and service offering.
• Small companies usually have a relatively limited market reach.
• Large firms with deep pockets are often preferred by customers who look for a stable, long-term vendor.
• Large companies have an easier time attracting top management and skilled talent.

How company size affects its value

To illustrate, we will use the well-known Build-Up model to calculate the capitalization rate for a fictitious Fortune 500 company and a small business. We will assume that both firms are debt-free and their earnings grow at 5% per year. Both companies are in the general merchandize retail industry, SIC 5399.

In this example we have included the company specific risk premium of 4% for both firms.

The valuation multiples above tell a remarkable story: the large company commands the valuation ratio that is almost twice as high as its small business counterpart!

In other words, it takes almost $2 of business earnings for the small company to contribute as much to its value as $1 for the Fortune 500 firm.

One of the key factors that affects the value of a company is the industry in which it operates. The question is why and by how much?

The answer is risk. In fact, the industry-specific risk premium is one of the elements that make up the discount and capitalization rates for your business. Here are the key factors that define the industry-specific risk:

• Overall industry growth prospects.
• Barriers to competitive entry such as initial capital investment, licensure requirements or unique know-how.
• Consolidation trends and degree to which large competitors dominate the industry segment.
• Technological changes that may require considerable investment to stay competitive.
• Regulatory compliance requirements that can suddenly drive up the costs of doing business in the industry.
• Emergence of new competitive threats domestically and internationally.

How much can the industry-specific risk affect the company valuation?

In 2009 the lowest risk industries such as the educational services under the SIC code 82 showed negative industry specific risk premia of around -4%. This means that the companies in this industry sector faced risks below the overall market!

On the other hand, the high risk industry segments, for example the transportation services under SIC code 47, called for the risk premia on the order of 4.3%.

Given the typical discount rates of some 25% for privately owned firms, this could make a difference of more than 8% and greatly affect the valuations of companies in these industries.

Example: effect of industry specific risk on company valuation

To demonstrate the effect of industry risk on company valuations, we will pick two firms with identical earnings forecasts for the next 5 years.

One of the firms is in the educational services sector, the other is a transportation company. To make the comparison easier, we will assume that both firms have the same company-specific risk profile that adds another 4.1% to their discount rates.

Here is the earnings forecast:

• Year 1: $150,000.
• Year 2: $175,000.
• Year 3: 185,000.
• Year 4: 200,000.
• Year 5: $225,000.

Using the well-known Build-Up model, we calculate the discount rates for the two companies as follows:

• Educational services: 18.94%
• Transportation services: 27.47%

We apply the Discounted Cash Flow business valuation method to calculate the value of both companies. Here are the results:

The business value difference is amazing: with the same earnings prospects the educational services firm is worth almost twice as much as its transportation industry counterpart!

If you own a software firm, plan to start one or acquire an existing company, here are some interesting facts to consider:

The two main segments of the software industry are custom software services and pre-packaged products.

Software development services firms

Classified under the SIC code 7371, the firms in the software service industry concentrate on creating solutions for clients, usually other businesses.

The industry segment as a whole counts over 49,500 establishments in the US alone. These software companies employ around 572,000 people and generate over $57.7B in annual sales. The average contract software development company makes about $1.3M in annual revenues and employs a staff of 12.

Software product development companies

Software companies that develop and sell their own products are classified under the SIC code 7372. The pre-packaged software industry has just under 19,000 firms operating in the US market with a total employment force of some 264,000.

The segment generates an impressive $152B in annual sales. An average company does about $9.2M in revenues per year with a staff of 14.

One interesting observation you can make is that the software services industry creates fewer dollars with more people. One reason is that the software services are more labor intensive. However, the service companies have an easier time establishing a loyal customer base and recurring business.

Key value drivers for software companies

Regardless of which market segment your software company is in, these key factors make the major difference to its value:

Earnings growth prospects

Software products can be highly profitable if focused on the right market segment with significant demand. Product firms especially can experience significant revenue growth quickly with the right product mix.

Profitability

Keeping costs under control is not an easy task for a software company. The costs of developing and marketing software products are very high. The firms that manage growth while keeping their cost from escalating are far more valuable than their unprofitable counterparts.

Stability of earnings

Maintaining consistent level of sales and profitability can be very difficult especially for pure product software companies. Competition can introduce an alternative product and sudden market changes can make a star product obsolete very quickly.

This is where the service companies tend to do better - the customer loyalty tends to translate into repeat business, stable prices and steady earnings. The costs of entering the new market segments are also lower for software services companies as they tend to rely on  existing customers and referrals to do so.

Business valuation methods for software companies

As with any business, you can value a software company three ways, known as appraisal approaches:

• Asset - based on the company’s asset base.
• Income - based on the firm’s earning power and risk.

Established software firms tend to be frequent acquisition targets. Hence, there is solid evidence of their market value as shown by the actual business selling prices. Thus, you can use the market valuation methods quite effectively to appraise your software business.

At the same time, the growth potential is a key element of value in any software company. Income-based business valuation methods, such as the Discounted Cash Flow technique, are an excellent choice to value a software firm.

Combined Market and Income approach: First Chicago Method

For a highly accurate business appraisal, you can combine the two approaches. This technique is often referred to as the First Chicago method. Under this method, you can assess the value of your software business using the Discounted Cash Flow method. This requires that you create a set of earnings forecasts and assess the business risk.

Since the future is never certain, you can improve the accuracy and validity of your business appraisal by repeating the Discounted Cash Flow analysis under a couple of possible scenarios, such as the worst case and best case outcomes. You can average the results to come up with an estimate of what your company is worth.

The market comparisons serve as the objective proof to back your income-based valuation results. Since the market valuation is based on the actual data on similar business sales, it tends to act as a sanity check on your forward-looking income-based valuation.

Again, combine the income and market-based valuation results for a highly defensible, comprehensive estimate of what your software company is worth.

If you want to get a top quality business appraisal, consider using several well-known business valuation methods.

Such a multi-method business valuation is standard in professionally prepared appraisals. Since each method represents a different view of how business value is measured, reviewing the results from several different methods gives you a comprehensive picture of what the business is worth.

In practice, you can choose some valuation methods over others because they are more suitable for your specific situation. Here are the typical method choices used for valuing established service firms:

• Valuation multiples based on comparable business sales
• Multiple of Discretionary Earnings valuation method
• Discounted Cash Flow method
• Capitalized Excess Earnings method

Using market comps to value a service business

Successful companies in the services industry sell often. Hence you can do valid market comparisons to recent business sales to see what your business is worth.

The valuation multiples are ratios that help you estimate the market value of a business based on the actual selling prices of similar firms and your company’s financial performance measures. Business value is usually measured against the firm’s revenue, profits, cash flow, EBIT, EBITDA, business assets or owners equity.

Valuing a company by direct capitalization of earnings

Smaller service businesses, especially those with mostly recurring revenues, can be valued using the Multiple of Discretionary Earnings method.

Discounting cash flows to determine business value

For larger firms or those experiencing significant earnings fluctuations over time, the Discounted Cash Flow method may be more appropriate.

Valuation of business assets: tangibles and goodwill

Business goodwill can be a big part of the total asset base for service companies. To determine the value of goodwill, consider using the Capitalized Excess Earnings method, also called the Treasury Method.

Establishing business value

The results you get by using the various business valuation methods may differ. This is quite normal since each method uses a different set of rules to determine business value.

You can use your results to establish a range of business values, from low to high. On the other hand, you can average your business value results and come up with a single number. Both techniques are very common in professional business appraisals.

One of the most challenging tasks you are likely to face when considering an outside investment is how to determine the value of your company.

Referred to by venture capitalists as the post-money valuation, this key step gives you a number of strategic decision data points:

• What the entire company is worth, known as the enterprise value.
• How the business ownership interests are split between the founding team and external investors.
• Whether the founders retain the controlling ownership of the company after the investment has been made.
• Is the investment worth taking given its effect on business value?

Business valuation of a high growth firm - First Chicago Method

Since the infusion of outside capital is likely to change the business earnings prospects going forward, the Discounted Cash Flow method is the standard choice for investment-driven business valuation.

This income-based valuation method lets you focus on the company’s earnings prospects and risk directly. The result is the “present value” of the firm - what it is worth today.

The additional capital can make a major difference to the business’s earnings prospects. Since the future is uncertain, it is best to create a number of forecasts and run your Discounted Cash Flow valuation for each:

1. Best case - under the most favorable assumptions of business performance.
2. Base or most likely case.
3. Worst case - if the business encounters unexpected “head winds” in the near term.

You can view the results as a range of possible business values or average them to come up with a single valuation number.

Business Valuation based on Cash Flow and Risk

Note that this valuation analysis is inherently forward looking and involves a number of subjective assumptions on your part. It is a very good idea to check the market in order to confirm your valuation results. Recent sales of comparable businesses give you an objective evidence of selling prices.

If you relate the business selling prices to the the firms’ financial performance, you can see how the market values these companies. More importantly, using the valuation multiples derived from the market comps you can estimate the market value of your own business.

Valuing a Business based on Market Comps

This combination of the comparative market value analysis and Discounted Cash Flow valuation is known as the First Chicago Method.

The method’s power is in combining the theoretically precise yet subjective business valuation based on its income prospects with a highly objective “reality check” of business market value based on the actual business sales.

You can easily implement the First Chicago method using the ValuAdder business valuation software:

• Select the Market Comps tool for your market-based valuation.
• Create a number of Discounted Cash Flow valuation tools, one for each valuation scenario.
• Calculate your business valuation results.

Are you using a modern 64 bit computer system? Or do you work on both 32 and 64 bit machines?

Now you can use ValuAdder business valuation software on both types of computers - and get identical performance and accurate business appraisal results.

What makes this magic possible? ValuAdder leverages the Java 6 computing platform to give you the business valuation system that automatically detects your computer’s capabilities to give you top performance.

Tools to determine business value - and maximize your return on investment

You can save time and money by using the same ValuAdder program on your Windows XP as well as the state-of-the-art Windows 7 and Vista 64 bit systems.

Business valuation software that gives you peak performance

On a MAC computer, you can take full advantage of the MAC OS X.6 Snow Leopard system performance, or run ValuAdder on a MAC OS X.5 Leopard or X.4 Tiger systems.

All this makes your ValuAdder business valuation tools a highly economical investment - you can run the same tools on any computer system and exchange your appraisal results across your entire network - or with clients who work on completely different computers - Windows, Mac OS, Linux or Unix!

For example, you can prepare a business appraisal for a client, then package the entire project using a ValuAdder Scenario, and email it to your client for review. While you may be doing your work on a Windows computer, your client can open and edit the scenario on an Apple MAC.

To make this possible, ValuAdder uses the standard XML format for data exchange.

Our customers ask us often: “what computer systems can I run ValuAdder software on?”

Our answer: any computer you like! This is no exaggeration - you can conduct your business appraisal using ValuAdder software on all versions of Windows, Apple MAC OS, Linux or Unix computer systems.

Industry-standard environment for business valuation software

How is this possible? The short answer is: Java. All ValuAdder software products are built on top of the industry-standard Java 6 computing platform. Invented by Sun Microsystems, Java has become the de-facto standard for enterprise quality software applications world-wide.

Enterprise valuation software quality for businesses large and small

It is used and supported by the Fortune 500 industry leaders including IBM, Oracle, HP, CISCO, Google, eBay and many others. Through the Open Source Java Community Process, Java stays on the cutting edge of software innovation and runs on millions of computers throughout the globe.

What does this mean to you? In short, the proven track record and quality business appraisal software that you can depend on regardless of your choice of a computer system to use.

Business valuation software quality you can rely on

The fact that Java is used by millions of business people gives you a proven platform on which to run your ValuAdder business valuation software tools. Thousands of software engineers contribute to continuous innovation to make Java the most secure, reliable and high performance way to do your business valuation analysis.

You get the same consistent performance and dependable results from ValuAdder whether you run the software on a leading edge Windows 7 machine or earlier versions such as Windows XP.

On a MAC OS X computer ValuAdder looks and behaves as a true Apple application - just as you would expect. And, of course, this includes the latest MAC OS X.6 Snow Leopard systems. Thank you, Apple engineering team, for making this possible!

Immediate help as you do your business valuation

State of the art software is nothing unless it offers help right when you need it. Your ValuAdder comes equipped with an extensive integrated Learning and  Information Center that leverages the power of the Java Help system.

This gives you two tools in one - a powerful business valuation analysis tool and a flexible learning system. Whether you are new to business appraisal or a seasoned veteran, ValuAdder adapts to make your task of valuing a business easier and more time efficient.

As computer systems evolve so does Java. We already have full Windows 7 support - on the eve of the release of this new Windows system.

Business valuation tools that capture the spirit of innovation

As you work on a business appraisal using ValuAdder you are benefiting from the talent and dedication of a global community of software engineering professionals that made the Java software possible.

Tools for Business Valuation