Refer To: Chapter 4, Franchising and Buyouts

Valuation of the Business:

Basic Approaches Expanded

Refer to: Chapter 4, Franchising and Buyouts

Market-Based Valuation

The market-based valuation approach relies on financial markets in estimating a firm’s value. This method looks at the actual market prices of firms that are similar to the one being valued and have been recently sold, or that are traded publicly on a stock exchange. For instance, as a prospective buyer, you might find recently sold companies having growth prospects and levels of risk comparable to the firm you wish to value. For each of these companies, you could calculate the price-to-earnings ratio, measured as follows:

You then apply this ratio to estimate the prospective company’s value as if it had the same price-to-earnings ratio as the similar firms that were recently sold.

The market-based valuation approach is not as easy as it might appear, because it is often difficult to find even one company that provides a good comparison in every way. It is not enough simply to find a firm in the same industry, although that might provide a rough approximation. Instead, the ideal company is in the same or a similar type of business and has a similar growth rate, financial structure, asset turnover ratio (sales/total assets), and profit margin (profits/sales). There is little published information about company purchases; however, many large accounting firms have departments that can sometimes provide information about the selling prices of comparable companies. Most major real estate companies also have an “ICI,” (industrial, commercial, investment) department that can provide information.

As an example, assume that you are considering the purchase of the Aberdeen Company, which has after-tax earnings (net income) of $80,000. You are interested in determining a fair price for the company and have located three comparable firms that recently sold, on average, for six times their earnings after taxes. That is,

Using this information, you estimate the market value of Aberdeen’s equity as follows:

Aberdeen’s market value =6(Aberdeen’s after-tax earnings)

Given Aberdeen’s after-tax earnings of $80,000, you estimate its equity market value (the owner’s value) to be $480,000:

Thus, it could reasonably be argued that the market value of Aberdeen Company’s equity ownership, a price you might be willing to pay for the firm, is about $480,000.

Earnings-Based Valuation

We now provide a different perspective, in which the value of a firm is not determined by historical or replacement costs or by market comparables, but by future returns from the investment. That is, the estimated value of the firm is based on its ability to produce future income or profits—thus, the name earnings-based valuation approach.

Different procedures are used in valuing a company based on its earnings, but the underlying concept is generally the same: (1) determine normalized earnings and (2) divide this amount by a capitalization rate. That is,

Normalized earnings are earnings that have been adjusted for any unusual items, such as a one-time loss in the sale of real estate or as the consequence of a fire. Also, the buyer should be certain that all relevant expenses are included, such as a fair salary for the owner’s time.

The appropriate capitalization rate is based on the riskiness of the earnings and the expected growth rate of these earnings in the future. The relationships are as follows:

The more (less) risky the business, the higher (lower) the capitalization rate to be used, and, as a consequence, the lower (higher) the firm’s value.
The higher (lower) the projected growth rate in future earnings, the lower (higher) the capitalization rate to be used and, therefore, the higher (lower) the firm’s value.

In practice, the capitalization rate is determined largely by rules of thumb; that is, it is based on conventional wisdom and the experience of the person performing the valuation. For example, some appraisers assign capitalization rates for different types of firms as follows:

Small, well-established businesses, vulnerable to recession / 15 percent
Small companies requiring average executive ability but operating in a highly competitive environment / 25 percent
Firms that depend on the special, often unusual, skill of one individual or small group of managers / 50 percent

Assume that the normalized earnings for a company are $130,000 (before deducting anything for the owner’s salary) and that fair compensation for the owner’s time would be $50,000. Using the earnings-based valuation technique, the appraiser would capitalize the $80,000 in earnings that remains after the owner’s salary is deducted ($130,000  $50,000). If the appraiser uses a 25 percent capitalization rate, the firm would be valued at $320,000, calculated as follows:

Cash Flow–Based Valuation

Although not popular, a cash flow–based valuation approach in which a company is valued based on the amount and timing of its future cash flows, makes a lot of sense. The earnings-based valuation approach, while used more often in practice, presents a conceptual problem. It considers earnings, rather than cash flows, as the item to be valued. From an investor’s or owner’s perspective, the value of a firm should be based on future cash flows, not reported earnings—especially not a single year of earnings; valuation is just too complex a process to be captured by a single earnings figure. For one thing, there are simply too many ways to influence a firm’s earnings favourably (even when using generally accepted accounting principles) while having no effect on future cash flows, or, even worse, reducing cash flows.

Buying a business is in one sense similar to investing in a savings account in a bank. With a savings account, you are interested in the cash (capital) you have to put into the account and the future cash flows you will receive in the form of interest. Similarly, when you buy a company, you should be interested in future cash flows received relative to capital invested. In a cash flow–based valuation, a comparison is made between the expected rate of return on investment (the interest rate promised by the bank) and the required rate of return to determine whether the investment (savings account) is satisfactory.

Two steps are involved in measuring the present value of a company’s future cash flows:

Estimate the firm’s future cash flows that can be expected by the investor.
Decide on the investor’s required rate of return.

The first step—projecting cash flows—is no simple matter and is beyond the scope of this book. However, anyone serious about valuing a company would be well advised to develop an understanding of the technique or to seek assistance from someone who can help in this regard.

The second step involves selecting a discount rate to be used in bringing the firm’s future cash flows back to their present value. This rate is not the same as the capitalization rate used for earnings. The capitalization rate is used to convert a single-point estimate of the current or normalized earnings into value. A required rate of return is used as a discount rate that is applicable to a stream of projected future cash flows. The required rate of return is, therefore, the opportunity cost of the funds: An investor must think, “If I do not make this investment (buy this company), what is the best rate of return that I could earn on another investment having a similar level of risk?” The answer to this question provides the appropriate discount rate to be used in valuing future cash flows.

The required rate of return also equals the existing risk-free rate in the capital markets, such as the rate earned on short-term Canadian government securities, plus a return premium for assuming risk (risk premium). In other words,

Required rate of return = Risk-free rate of return + Risk premium

For example, assume the current rate on Canadian treasury bills, a short-term government security, is 4 percent. If, for a given investment, such as buying a company, the risk premium is 15 percent, then the required rate of return should be 19 percent (4 percent + 15 percent).

How the risk premium is estimated is clearly an important factor in determining the required rate of return. Although there are no hard-and-fast rules that can be used in determining the required rate of return, the smaller companies listed on the Toronto Stock Exchange have provided investors an average risk premium of 15 percent. So if the rate of return on a government security is 6 percent, an investor should expect at least a 21 percent rate of return on his or her investment (6 percent risk-free rate + 15 percent risk premium)—and even more if the firm being valued is riskier.

In fact, for most very small firms, the rate should be significantly more than 21 percent. The risk premium—the rate above the risk-free rate—should, according to one experienced appraiser, be at least 16 percent, and possibly as much as 30 percent, depending on the riskiness of the firm being valued. Given the required rate of return for valuing a company, an appraiser can then use the rate to calculate the present value of the firm’s future cash flows.

Valuation of the Business: Basic Approaches Expanded

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