Raising Entrepreneurial Capital

Chapter 5: Valuation

Valuation Methodologies

Asset based valuation Market comparables Capitalization of earnings Excess earnings approach, and Discounted cash flow (DCF) valuation

or present value of the firm's “free” cash flows.

Finance theory

would argue that only the discounted cash flow method is theoretically correct.

the value of any asset is the present value of cash flows that the asset will generate over its useful life, adjusted by the risk of achieving those cash flows.

The problem for new ventures

is that the information that provides the basis for the free cash flow estimates is generally so speculative that the more sophisticated DCF method may not be perceived as worth the effort it takes to generate a value.

Asset-based approaches

Assume that the value of a firm can be determined by examining the value of its underlying assets:

Liquidation value of the assets Replacement value of the assets Modified book value of the assets.

Liquidation value

Neglects that part of the firm’s value that would be contingent upon the business continuing in operation.

This does provide a lower bound estimate for a valuation, however.

Replacement value

Estimates the cost to replace each of the firm's assets. The value of the business is the sum of the replacement costs of the individual assets.

Based not on what a willing buyer would pay for the assets, a market value test, but rather what it would cost to replicate the company by buying the assets in the open market.

Problems with replacement value

There are likely to be large discrepancies between book value and replacement cost for assets like land, plant and equipment.

Often ignores value adding assets such as human capital and intellectual property, potentially seriously understating the value of the business.

Modified book value approach

Assets and liabilities are restated to their current fair market values.

Items not found on the balance sheet, but that add to firm value, are included.

On the liability side, the value of any pending lawsuits or tax disputes are disclosed.

Market multiple approach

Most common method of valuation; sometimes called guideline company approach.

Value of a firm is based on the observed market value of a comparable company relative to some metric.

Comparison factors

Capital Structure Credit status Depth of management Personnel experience Nature of the competition Maturity of the business

Valuing service businesses

Multiples are usually applied to sales or earnings.

Sales is better for a service business because sales drive profits and cash flows and expenses are more controllable than they are in an asset intensive business.

The implicit assumption is that a certain level of revenue will result in a certain level of profit.

Discounted cash flow

Vt = CFt (1 + g)

(r-g) Vt = the value of the firm at time t

CFt = the cash flow at time t g = the constant growth rate of cash

flows in perpetuity r = the appropriate risk-adjusted

discount rate.

Appropriateness of methods

Value a firm from earnings? Some contend that markets value a firm based on future cash flows, and not reported earnings. Also, there are many ways to influence the firm's reported earnings.

Proponents of the market multiple method argue that companies are more similar than they are different at various stages of fundraising and therefore standard multiples can be applied to companies at each stage of their financing.

Capitalization rate

Inverse of market multiple. A multiple of 5 would correspond to a

“cap” rate of 1/5 or 20%. Cap rates are typically applied to the

next year’s earnings forecast, and chosen to reflect the risk of the investment.

Excess earnings aproach

An interest rate reflective of current returns on tangible assets (plant, equipment, land) is used to determine a fair return on the business' assets.

This rate is relatively low, reflecting the low risk of investing in tangible assets.

The dollar return on tangible assets is calculated by multiplying the fair market value of the assets by this risk-adjusted rate.

Excess earnings - calculated

An imputed return is subtracted from the forecasted normalized earnings for the next year to calculate excess earnings.

Tangible assets are forecast to return the risk-adjusted rate for tangible assets. Excess return is then due to some intangible factor left off of the balance sheet.

Excess earnings - goodwill

The excess earnings are capitalized at a higher rate than the rate on tangible assets to determine the present value of the company's goodwill.

The sum of the present value of goodwill and the firm's tangible assets equals the total firm value.

Problems in implementation

Excess earnings, cap rate and DCF methods all require the use of a risk-adjusted discount rate.

The excess earnings method requires the use of two risk adjusted rates which doubles the opportunity for error in the valuation.

Free cash flow valuation

Defines the value of the firm as the present value of the expected future cash flows in excess of those needed to operate the company.

A firm's economic or intrinsic value is then equal to the present value of its “free cash flows” discounted at the company’s cost of capital, plus the value of the firm’s non-operating assets.