Archive for December, 2013

If you are valuing a business by using capitalization of income methods you may have to be extra careful in selecting the right capitalization rate. The cap rate is just the difference between the discount rate, which captures the company’s risk profile, and the earnings growth rate over the long term.

Sounds simple enough, but yet the incorrect choice of the cap rate is the most common source of mistakes. Say, for example, your discount rate is 35% and you use the 5 year earnings forecast to come up with an earnings growth rate of 55%. The cap rate, being the difference between the two is a negative -20%! What gives?

While negative cap rates are mathematically possible, they make no financial sense. The calculated business value becomes a negative number – an impossible result. The reason for this confusing situation is that the earnings growth rate is overstated, given the company’s discount rate.

To address this problem, carefully review your earnings growth expectations. A company may go through a period of rapid earnings growth on occasion. Perhaps you have acquired new technology, access to a protected market for a while, or favorable customer contracts.

These types of advantages may lead to business earnings rising rapidly in the short term. However, market forces eventually balance this situation. New competitors become attracted to the market place. The overall market saturation occurs where existing customers are no longer buying as much or new customers become harder to find.

The result is your earnings growth rate over the long haul is bound to drop below the discount rate, or the business risk factor. The result is that the cap rate is a positive number.

So it is important to figure out what the sustainable long term earnings growth is likely to be. For guidance, look to your industry sector. What is the historic sector growth rate? How are the major established competitors growing?

If your industry sector is growing at 5% annually on average, and you predict a 20% increase in earnings, this is likely to be due to short term opportunities. Sooner or later competitive forces in the market will bring your growth rate down to about the market average.

One of the best valuation methods to use for a company going through a rapid growth spurt is the discounted cash flow technique. You can forecast annual earnings for the entire super growth period. Then calculate the so-called terminal business value using the long-term earnings growth rate that is more in line with the industry prospects.

Valuing a Rapidly Growing Business

See how to use the discounted cash flow method to value a company going through a growth spurt.

See Example »

If you look at the public capital markets such as NYSE or NASDAQ, the day-to-day prices are for non-controlling business ownership interests, usually a small number of shares. In other words, these per share prices represent the minority price.

If you want to acquire a controlling share of the company’s stock, you will have to pay a premium over the market price per share of stock. This is what usually happens in a tender offer.

Statistics on control premia paid are readily available by industry sector. Usually, these premia fall somewhere between 30% and 40% over the market share price. This means that the buyers have to pay about 35% over the per share price on average to get a majority stake in a public company.

The minority discount is the opposite of control premium. If you know the value of the entire business, then a minority interest is worth less than its pro rata share of the total.

Why is this so? Let’s say you are a private company co-owner who has, say, 10% of the total company stock. You don’t control the company operational or financial policy. You can’t set management salaries or benefits by yourself. The board can decide to distribute the money to other owners who work in the business as bonuses so you can can miss on dividend payouts. In other words, you have little say in the company.

So your position in the company with the minority ownership stake is not very strong. This affects how much your ownership interest is worth in relation to the overall business value.

Private companies are usually valued on a business enterprise basis. That makes sense if you consider the fact that private companies usually sell as a whole, not piecemeal.

Let’s say you gather some data on the business selling prices for companies similar to yours. You can develop valuation multiples from these prices and known financial performance factors for sold firms, such as revenue, EBIT or EBITDA, assets and owners equity.

Using the multiples you can calculate an estimate of the business value for your company. This gives you the total business enterprise value. Now to evaluate a minority interest in the business you would apply a discount. For example, if a pro rata share of the business is worth $1,000,000 based on the total business value of $10,000,000; then a 10% minority stake at 35% discount would be worth $650,000.