Archive for January, 2012

If you plan to value a business using methods under the income approach, the discounted cash flow technique us likely to be high on the list.

Using this venerable business valuation method requires that you forecast the business earnings over some future period, usually measured in years. In addition, you would also need to assess the business risk and calculate the discount rate. Finally, you would compute the residual value, also known as the terminal value of the company, based on your expectation of earnings growth.

The Financial Accounting Standards Board (FASB) has issued interesting recommendations on the use of the discounted cash flow valuation in its Concept Statement No 7.

Business valuation problem: earnings forecast uncertainty

The basic idea is that any cash flow projection you create is at best speculative. After all, who knows whether the company will really win the customer acceptance it anticipates or how the competitors will react to the introduction of a new product line. Overall market conditions could suddenly deteriorate limiting the customers ability to buy the company’s products or services. All this could fall outside the management’s expectations and significantly change the actual earnings for the business.

Given this uncertainty, FASB has suggested a somewhat different approach to business valuation. Instead of a single cash flow projection, they recommend that you create a number of possible cash flow forecasts.

Use multiple cash flow forecasts to improve your valuation

Each forecast can be assigned a probability of occurrence. Let’s say, you foresee a possible best case scenario where the firm lands a number of major customer contracts. You can create a cash flow forecast that reflects this outcome. On the other hand, unexpected problems may crimp the earnings going forward. You capture this situation by creating an alternative worst case cash flow projection.

To round out your analysis, you may put together yet another earnings forecast that is somewhere in the middle of these two extremes.

You then assign a probability to each scenario. For example, the best case gets a weight of 30 percent, worst case 20 percent and the middle or most likely case 50 percent.

Finally, you calculate the business value as the weighted average of the above scenarios, using the risk free rate as the discount rate. Usually, the yield of long-term US Treasuries is selected for the risk free rate.

While this approach to business valuation has some merits, most business appraisers prefer to capture the company risk directly and calculate the discount rate based on the full assessment of the subject business risk profile.

Match earnings forecast and discount rate to increase valuation accuracy

One way you can combine both methodologies for a highly effective business appraisal is to use the multiple cash flow projections each with its own discount rate. The idea here is that each outcome is associated with its unique business risk. This should be reflected in the scenario specific discount rate.

If you use the build-up model for discount rate calculation, one element that is likely to vary a lot is the company specific risk premium. This makes sense – in each possible outcome the company management can make decisions that change such factors as the capital structure, customer concentration, and earnings stability.

The result is a different level or risk and different discount rate. These key inputs will in turn affect your business value calculation.

Business Valuation based on Cash Flow and Risk

Looking back at the first decade of the 21st century, you can see the investor psychology at work in setting the valuations of businesses and other income producing assets. Once the frenzy sets in, business valuations can rise to lofty levels rather quickly, at least in the short term. This is often driven by market comparisons: if one company sells for 10 times the gross revenues, then a similar firm should trade at about the same price.

This is the essence of the market approach. At any point in time, investors tend to compare the current prices of similar businesses to see what a given company is worth. And it can happen despite the fact that such prices may well fly in the face of historic reality. After all, how often have companies sold at 20 – 50 times their revenues?

Investor excitement aside, your business valuation must pass two key tests:

  1. the market comparison should make sound financial sense
  2. and the business sale comps must be truly similar to the subject business.

One of the most accessible and reliable sources of business sales data is the public company transactions. These are usually available based on well established financial reporting standards and cover practically every industry sector. However, there is little comparison between a seasoned public company and an emerging start-up.

To make market comps work, you would need to consider a number of adjustments:

Company size risk premium

Smaller companies tend to be riskier. As a result, investors will demand higher returns to put their money into such firms.

Earnings track record

Start-ups with a limited track record are inherently more risky. Only future will show how successful the company is at executing its business plan.

Lack of marketability discount

Investments in private companies are essentially illiquid. This means considerable risk to the investors should they try to sell their shares of the business. Such lack of marketability can lead to considerable discounts on the company’s value.

Company specific risk premium

Private business owners are notoriously under-diversified. Their entire capital may be tied up in a single company. Unlike public company investors, owners of small to mid-size firms incur additional risks associated with the company itself. Examples are company capitalization, management team quality, market concentration and competitive position.

Reliable business valuation uses all three approaches

Your business appraisal should account for these factors to be defensible. To come up with a solid business valuation, consider using methods under all three approaches. Pick up an income-based method, such as the Discounted Cash Flow, to sanity check your market comparisons. Look at the asset base of the business using the Capitalized Excess Earnings method. This could be very valuable in cases where the company has built up considerable goodwill.

This combination of valuation methods may give you a range of business values. If your market comparison was based on sound reasoning, the income and asset based appraisal results should be close. If not, it is likely that the assumptions made in your business sales data selection or adjustments are the source of error.

Company Valuation using Multiple Methods