Business Valuation - Part 2

Topics : Types of Business Valuation Approach

1) The Market Approach

- the basic theory is based on the economic principle of substitution;

- looking for valuation guidance from prices of other similar companies or industries.

The market comparable approach using public market data is a market based approach
whereby we estimate the price that would be paid for the common stock of a closely held
company, as if its common stock were traded in an active market or over an exchange.

We do this by analysing the prices of stocks of publicly traded companies that operate in
the same industry as the company we are appraising (the subject company), since their
stock prices most adequately reflect investor’s expectations of return for an investment
of similar risk to the subject company.

To the extent that the riskiness of an investment in the subject company’s common stock
is different from that of the similarly publicly traded company group, the appraiser will
make subjective adjustments to the market ratios to reflect these differences (e.g.
adjustment for non-marketability).

The advantages of this approach are:

i) There is a lot of financial and other data available on publicly traded companies.

ii) Market prices represent arms-length transactions of many buyers and sellers.

iii) The market prices represent minority interest transactions and, therefore, this
approach is particularly appropriate in minority interest valuations.

iv) Larger subject companies could often be publicly traded and, therefore, this approach
is also very applicable for these types of companies.

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The disadvantages of this approach are:

i) It is often hard to find publicly traded companies that are truly similar to the subject
company, particularly when the subject company is very small.

ii) Proper interpretation of stock market data (both the price and financial data) may be
difficult.

iii) The stock market has an emotional aspect to it.

iv) There is disagreement on how to apply this approach in the valuation of a

controlling interest.

Different market ratios that can be used

i) Price/Earnings (P/E) ratio

- This ratio indicates the number of years requires to earn the amount invested in the
shares.
- A high ratio indicates investors have strong confidence in the company, so they are
willing to pay a higher price.
- However, an unreasonably high P/E ratio may be the result of speculation in the
stock market.

ii) Price/Cash Flow Ratio

- This market ratio is especially relevant for companies with high noncash charges,
like depreciation and amortization, in relation to net income.
- As a result, it is often used for manufacturing companies, as well as other asset
heavy companies.
- Cash flow is typically defined as net income plus depreciation and amortization.

iii) Dividends/Price ratio

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- This ratio measures the rate of return obtained from dividends on an investment in
shares.
- Investors can compare the dividend yield with the returns on other share of
investment opportunities.
- If a company can maintain a high dividend yield, it will be considered more
successful and efficient.

iv) Price/Revenues Ratio

- This market multiple is primarily used for service and asset light companies, where
the subject company is homogeneous to the comparative companies in terms of
operating expenses.
- Insurance agencies, employment agencies and other service companies often sell in
relation to their revenues, because there is an implicit assumption that a certain
level of revenues will generate a certain level of earnings.

Limitations of Ratio Analysis

Ratios can only be used as references but not as conclusive indicators. The usefulness of
accounting ratios may be limited due to the following factors:

1. Financial statements are prepared by using different accounting policies and

techniques in different companies. They may have different valuation methods or
depreciation methods. It is difficult to compare the performance of different
companies.
2. Differences in the backgrounds of the companies may also weaken the validity of
inter-firm comparison. It is difficult to compare a firm which hires its plant with a
firm which purchases its own plant.
3. The environment and external factors can affect the performance of a company.
Differences in these factors may affect the inter-period comparison.
4. Differences in the basis of data recording may also weaken the comparison of the
return on capital employed between different periods. Most of the assets are recorded
at historical cost, but the profit is recorded at the current price.
5. Accounting ratios act as indicators for financial assessments. However it is difficult
to establish a proper standard for determining which result is good and which result
is bad.

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2) The Income Approach

This approach is based on a review and analysis of a company’s income generating

capability. The diversity of techniques within this broad approach is primarily a
result of the various measures of income that can be used. The measures range from
broad-based indicators such as gross revenues used in a gross revenue multiplier to
detailed and complex figures such as net free cash flow, which is the integral
component of discounted cash flow(DCF) analysis and accounts for all expenses,
taxes, working capital needs, and capital expenditures.

This approach is that the value of a company is equal to the present value of
all future benefits (cash flows) discounted at the company’s weighted average
cost of capital (WACC). It is an intrinsic valuation approach that assesses a
company’s value based on the cash flows inherent to a company and the riskiness
of those cash flows. (Business Valuation and Bankruptcy, Ian Ratner, Grant T.
Stein and John C. Weitnauer)

“In the simplest sense, the theory surrounding the value of an interest in a business
depends on the future benefits that will accrue to the owner of it. The value of the
business interest, then, depends upon an estimate of the future benefits and the
required rate of return at which those future benefits are discounted back to the
valuation date.” (Valuing a Business, Pratt, Reilly and Scheihs)

“Value today always equals future cash flow discounted at the opportunity cost of
capital.” (Principles of Corporate Finance, Richard A. Brealey and Stewart C.
Mybers)

“A sum of values based on physical factors and assigned to separate units of the
property without regard to the earning capacity of the whole enterprise is plainly
inadequate.” (Consolidated Rock Products Co. v. Du Bois, 312 U.S. 510, 525-526
(1941))

The value of most going-concern entities is a function primarily of income or cash flow.
The ability of a company to generate positive cash flows accruing to the owner into the
future is the most influential determinant of value. In lay terms, the value of a business

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 generally is a function of its ability to create or generate income for the owner. The
essence of the income approach thus is found in the evaluation of a company’s historical
and probable future ability to generate income or cash flow for the owners in light of the
actual or perceived riskiness of the company’s future operations.

- the basic theory is based on the value of a business / investment which is computed
as the present value of future benefits discounted at a rate of return that reflects the
riskiness of the business / investment.

- Capitalization Model and DCF Model: based on a stream of prospective economic

income which is any inflow into an economic unit in exchange for goods, services,
or capital.

Capitalization Model:
PV = E= E
(i-g) C

where: PV = Present Value

E = Expected amount of income immediately ahead
i = Discount rate (WACC)
g = Expected growth rate of E (sustainable income growth rate)
C = Capitalization Rate

Remark : not taking into account of the timing of future changes in expected economic
income

DCF Model:

Value = (a) The sum of the present value of each year’s projected income for a projected
period (e.g. 5 years) + (b) The present value of Terminal Value.

Terminal Value = The projected income for the year following the projected period divided
by the capitalization rate.

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Capitalization Rate = WACC – Growth Rate.

( see example)

3) The Asset-Based Approach

This approach focuses on a company’s assets and liabilities, so it is sometimes called a

balance sheet approach. This approach is generally based on the process of adjusting a
company’s asset and liability book values to their corresponding Full Market Value (FMV).
The key to successfully applying the cost approach lies in being able to determine the
existence of and FMV of all assets and liabilities, including intangible assets and those that
are not listed on a typical balance sheet.

The approach is to estimate the value of the equity of a business by examining the assets and
liabilities of the business at a point in time – generally using the most resent balance sheet
data prior to the valuation date. These amounts are then restated to market value by
estimating the current cost to purchase or replace the asset on the balance sheet. This
approach is based on the theory that an investor would not pay more for an asset, company,
or business interest than the cost of obtaining a substitute asset of similar economic utility
(principle of substitution). (Business Valuation and Bankruptcy)

Once the asset side (including tangible and intangible assets) of the balance sheet has
been restated to market value, liabilities can be subtracted to derive the market value.
Various adjustments may be required. (Business Valuation and Bankruptcy)

The Asset Approach is typically used for asset-heavy or capital-intensive companies.

This approach should not be used for companies with limited hard assets and significant
intangible assets, such as service companies or technology companies. In many cases, the
asset approach provides a safe floor value of a company. (Business Valuation and
Bankruptcy)

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A major difficulty in this approach is found in the search for and recognition of assets and
liabilities that are not listed on the balance sheet and the act of excluding assets and liabilities
that are of a personal nature or that will be excluded from the sale. Examples of hidden assets
include fixed assets that have been fully depreciated or were fully expensed at the time of
acquisition or any relevant intangible assets such as a customer list, a trade name, or
goodwill.

This approach is particularly useful or relevant for companies that are shut down or are not
earning profits or generating positive cash flow from operations. If a business is not
functioning properly or operating at only a portion of capacity, its value typically is
diminished to a point where the market value of the tangible asset is the primary source of
value. Overall, this approach gives the valuer a low-end result for the typical business that is
actively generating revenue and profits.

In summary:

- the basic principle is to adjust the companys’ balance sheet accounts from book
valued base to market value base.
- from the valuation perspective, the book value is not related to economic value
where therefore adjustments are required.

Basic adjustment procedure:

i) Adjust items
- adjust each asset, liability, and equity account from book value to estimated
market value
ii) Adjust for items not on the balance sheet
- value and add specific tangible and intangible assets and liabilities that were
not listed on the balance sheet
iii) Tax affecting
- any deferred taxes on the balance sheet should be eliminated
- consider any tax issue affecting the adjustments to the balance sheet

Result :

- A balance sheet is prepared that reflects all items at market value. From this
amount, determine the adjusted value of invested capital or equity

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4) The need for using multiple valuation approaches

When valuing a business as a going concern, all three approaches should be considered
prior to choosing the most appropriate valuation approach (or approaches) to use.
Market Approach and/or income approaches are normally used. However, depending on
the industry, the Asset Approach may also be appropriate. For example, asset-intensive
business with low profitability relative to their invested capital may be more
appropriately valued using the asset approach. The use of more than one methodology is
encouraged when developing a valuation opinion. (Business Valuation and Bankruptcy)

The courts generally agree with the use of weighting in concluding the value:

“The standard valuation practice to calculate value using all three methodologies, and
then reach an ultimate opinion by assigning weight to the value associated with each
method, based on the methods suitable to the case at hand.”

“Each method should be weighted and then all methods should be considered together.”

“In many situations, multiple methodologies are used to eliminate outliers and derive as
accurate an estimate of values as possible given that valuation is an inexact science.”

(Business Valuation and Bankruptcy)

5) How to value an equity interest

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Apple Company is a privately owned one with the projected sales and net income in the next
period are $8,765,000 and $3,579,000 respectively. The total Ordinary Shares issued are
5,000,000 and there is no preference shares issued as at the date of valuation.

Adjusted indicated Price-to-Sales ratio of the comparable companies: 2.5

Adjusted indicated Price-to-Earning ratio of the comparable companies: 18.3 Marketability
Discount: 45%

Valuation Model:

I) Theoretical market capitalization

i) P/S ratio basis:

Projected Sales in next period $8,765,000

Adjusted indicated Price-to-Sales ratio 2.5
Indicated market value before marketability adjustment $21,912,500

ii) P/E ratio basis:

Projected Net Income in next period $3,579,000

Adjusted indicated Price-to-Earning ratio 18.3
Indicated market value before marketability adjustment $65,495,700

Reconciliation:
In our valuation, we have adopted the average value of the above indicated market values
for the theoretical market capitalization, and the result is given as $43,704,100.

II) The Market Value per share of Apple Company

Theoretical market capitalization as at 31 December 2007 $43,704,100

Total Ordinary Shares 5,000,000
Market Value per share if freely tradable in stock market $8.74
Marketability discount 45%
Market Value per share of non-freely tradable $4.81

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Therefore, the Market Value per share of the Apple Company is $4.81.

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