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Business Valuation Methods

Overview of Valuation Methods

Valuation methods are particularly important in startup ventures, as valuation affects the interest of potential investors and reflects the expectations of the firm’s future performance. Equity investors in startup ventures seek a return on their investment via a future exit event. Examples of exit events include selling one’s equity investment to a future round of investors, selling it back to the company, or selling it to the public via an initial public offering of the business’ stock. Capitalizing on a future exit event contrasts with the intentions of an investor who seeks a routine dividend from an established company. Given these expectations, startup investors will only invest in a company that has potential to achieve a certain terminal value or value at the time of exit. Specifically, investors will be concerned that the valuation reflects a terminal value that is sufficient to compensate the investor for the risk incurred by investing in the business. The terminal value will reflect the current value of the firm based upon future expectations of firm performance.

Pre-money and Post-Money Values

While the terminal value is the investor’s objective, the amount of money an investor is willing to invest depends entirely upon the present valuation attributed to the business. The present valuation is split into two categories: pre-money and post-money valuation. The pre-money valuation is the value attributed to the firm prior to infusing any new capital. The post-money valuation is the value of the firm immediately following the infusion of capital. Divide the amount of money invested in the company by the post-money valuation and the result is generally the percentage of the company (the equity interest) that the investor will own following the investment. With this in mind, the prospective investor is concerned with the method used to derive the current valuation of the firm.

Various Valuation Methods

How do the entrepreneur and investor arrive at an appropriate value or percentage of business equity to exchange for the investor’s funds? Historically, investors have used a litany of different methods to value the business, including industry or transaction comparables, net present value calculation, adjusted present value calculation, or the venture capital method. These methods are generally categorized into three approaches to valuation:

  • asset-based (or cost-based),
  • market-based, and
  • cash-flow-based methods of valuations.

Each of the above methods are addressed in individual lectures. Numerous hybrid methods exist that combine elements from these methods or employ complex financial principles based on assumptions derived from the above methods.

Overview of Asset-Based (or Cost-Based) Methods

The asset-based approach focuses on the valuation of the firm’s assets or, in some instances, the cost of replacing those assets. This approach puts emphasis on the total assets and liabilities of the firm. It therefor reflects a whole-firm valuation, rather than simply an equity valuation. To identify the equity value of the firm, one subtracts the market value of any debt held by the company. Determining the valuation may also require adjustment for the intangible assets of the firm that may be incapable of replacement. Asset-based valuation has many variables based upon the purpose or type of company being valued. Common asset-based valuations include: Book Value, Replacement Value, and Liquidation Value. Each of these methods is subsequent lectures.

Book Value (and “Adjusted Book Value”)

The book value represents the value that the company based upon the internal financial statements. Specifically, book value concerns the total value of company assets minus the total value of company liabilities. This amount will equal the owner’s equity in the firm and, likewise, equals the book value of the firm. Adjusted book value is the most common variation of the book value method. This method looks at the value of a company in terms of the current market values of its assets and liabilities. Another popular variation is the book value plus the value of the firm’s goodwill. This method focuses on the net earnings that are not attributable to a tangible asset of the firm. The firm’s earnings attributable to goodwill are multiplied by the growth rate of the firm for each year that the goodwill is expected to be present. This amount is then added to the company’s book value. Yet another variation on the book value calculation is the book value plus the capitalization of excess earnings. This method values the company by combining the company’s book value, the value of goodwill, and the capitalization of the company’s earnings. Capitalization of earnings is the average net earnings for a designated number of years, divided by a growth rate that represents the average rate of return for similar businesses. The capitalization of earnings methods is discussed in greater detail below.

Issues with Book Value

The most important detriment of the book value method is that it uses accounting numbers to derive a firm valuation. Often the book value does a very poor job of representing the value of the assets to the public. This is particularly true in companies that have lots of physical assets, such as equipment. Book value is likely most appropriate in financial holding companies where the book value represents the liquid holdings of the company.

The adjusted book value is more suitable than the book value, as it accounts for the actual value of physical assets. Both of these methods are deficient in that they poorly demonstrate the value of intellectual property, human capital, and company goodwill. While some versions of book value attempt to value intangible assets and goodwill, valuing these individual assets are very difficult due to lack of liquidity. This method is most appropriate when the individual assets are more important than the value of the firm as a going concern. This may be the case in the event of company mergers or break-up and sale transaction. Further, understanding the attributable value of each asset may assist the business in acquired loans secured by those assets. Book value is often combined with other forms of valuation (such as the capitalization of excess earnings) to arrive at a more accurate valuation of the firm as a going concern.

Startup ventures are often focused on growth and have little physical assets outside of investment capital. The growth nature of the firm means that these assets will be depleted to sustain its intended growth (e.g., continuing customer or user acquisition). Therefore, the measure of asset value in relationship to outstanding debt is a poor indication of a startup’s value. This calculation will only really be useful when applying for a line of credit or other debt arrangement, as lenders often look to unencumbered collateral to secure a loan to the business.

Intangibles and the Asset-Based Valuations

In addition to the failure of asset-based approaches to consider the entity value as a going concern, a salient deficiency of the asset-based approaches is the inability to accurately determine the value of intangible assets. This is particularly important is many startup ventures. These assets are difficult to value and often only have value within the business as a going concern. Examples of valuable intangibles include: on-going business relationships, industry reputation, brand recognition, human capital (knowledge or experience), and intellectual property (trade secrets, trademarks, patents, copyrights, etc.). All of these are intangible assets that serve to increase the value of the firm. In other instances a firm may have intangible assets that put the company at risk. For example, the firm may be the subject of intellectual property litigation.

Replacement Value (or Substantial Value) of Assets

A second, asset-based valuation method looks at the operating assets of a business and assigns a value based on what it would cost to replace them. This approach evaluates the cost of replacing the assets to achieve a commensurate output given the current state of technology in the industry. This is important as industry innovations may offer better or cheaper methods of achieving the purpose of the company’s assets. This is particularly common in technology-based businesses, as the available technology changes rapidly. This may cause the book value of the assets to differ considerably from the actual or market value of those assets.

Like the book value method, the replacement value method considers the value of each asset independently of the operations or productive capacity of the whole business. The values of the individual assets of the firm are added together to arrive at a valuation. The replacement value is often subdivided into gross substantial value and net substantial value of the assets. Gross substantial value refers to an asset’s replacement value at market price. Net substantial value is the gross substantial value reduced by the liabilities owed that have recourse against the asset.

Issues with Replacement Value

The replacement value method is not very useful in valuing a startup that has value as a going concern. This is particularly true when the venture has already achieved high growth rate. Replacing the physical assets of a startup is often quite easy. The intangible factors, such as human capital, first-mover advantage and early brand recognition, intellectual property, etc., are the drivers of value in the startup venture. In summary, this approach does a poor job of valuing the intangible assets of the firm, as many of these assets are not capable of replacement. The importance of intangible assets is discussed further below.

The replacement value is, however, useful for certain internal valuations. Entrepreneurs or managers may be concerned with the replacement cost of key operational assets. Understanding the replacement cost serves as a risk assessment. This method can also be useful to individuals determining the cost of entering a given market. While there are numerous intangibles that are incapable of replacement, an aspiring entrepreneur or new firm can use this calculation to determine the upfront and long-term asset costs associated with entering the market.

Intangibles and the Asset-Based Valuations

In addition to the failure of asset-based approaches to consider the entity value as a going concern, a salient deficiency of the asset-based approaches is the inability to accurately determine the value of intangible assets. This is particularly important is many startup ventures. These assets are difficult to value and often only have value within the business as a going concern. Examples of valuable intangibles include: on-going business relationships, industry reputation, brand recognition, human capital (knowledge or experience), and intellectual property (trade secrets, trademarks, patents, copyrights, etc.). All of these are intangible assets that serve to increase the value of the firm. In other instances a firm may have intangible assets that put the company at risk. For example, the firm may be the subject of intellectual property litigation.

Liquidation Value

Liquidation value is an asset-based method based upon the value that the business would immediately receive upon selling the asset on the open market. Immediately means selling the asset within a six to twelve month period. This method takes into consideration the age, wear, and technological innovations associated with this type of asset. The liquidation value is notably different from the book value, as assets with no book value may still have a liquidation value. This is common with assets that are expensed or subject to accelerated depreciation. Further, assets of the company may appreciate, the value of which is not accounted for on the company’s books. This is common with real estate assets.

The liquidation value method is similar to the adjusted book value method in that it provides a market value for the assets of the business. The difference in these methods is that liquidation value provides an additional context to the valuation. The liquidation approach assumes that the business has failed and has to immediately sell the asset. One context may be the sale of the assets in an organized process such as bankruptcy liquidation. The adjusted book value approach does not account for the immediacy of sale or the possible effect of the company’s failure on the ability to receive a market price.

Issues with Liquidation Value

The liquidation value method, like other asset-based methods, fails to capture the value of the business as a going concern. Further, it is incapable of attributing relevant value to intangible assets that lack an immediate comparable value in an immediate market. This method, however, does provide useful information to creditors of the business. Also, prospective lenders may use this method to determine the creditworthiness of a business for future capital. Creditors and lenders will often be forced to liquidate debtor assets in the event of default on a secured loan. As such, creditors will need to understand the value of assets based on an immediate sale in the present market. This method is effective when determining a creditor’s position or priority in the event of the debtor’s chapter 7 bankruptcy.

Intangibles and the Asset-Based Valuations

In addition to the failure of asset-based approaches to consider the entity value as a going concern, a salient deficiency of the asset-based approaches is the inability to accurately determine the value of intangible assets. This is particularly important is many startup ventures. These assets are difficult to value and often only have value within the business as a going concern. Examples of valuable intangibles include: on-going business relationships, industry reputation, brand recognition, human capital (knowledge or experience), and intellectual property (trade secrets, trademarks, patents, copyrights, etc.). All of these are intangible assets that serve to increase the value of the firm. In other instances a firm may have intangible assets that put the company at risk. For example, the firm may be the subject of intellectual property litigation.

Overview of Market-based Approaches

Market-based approaches value the business based upon the productive characteristics of the business in a given market. These methods focus on comparisons of like businesses, transactions, or industries (known as comparables or comps). Most of these methods focus on identifying a value-based, characteristic of the comparable and comparing it to the total price or value of the firm (i.e., Value-based Characteristic / Total Value of Outstanding Share). The ratio of this value-based characteristic to price is used to value businesses with similar productive output, involved in similar transactions (the reason for valuation), or operating within the same industry. In summary, these methods attribute a value to a business by using ratios (value characteristic to price) to compare the firm being value with other firms whose value is readily determined.

Using market-based valuation methods raises numerous questions, including: What type of comparable is available and most accurate? Under what circumstances will the assets of the comparable and subject firms sell for the same multiple?

Types of Comparables

A company may be valued using any number of characteristics about the business. In general, the price of that company’s total equity is compared to some value characteristic of the company, such as the before or after-tax earnings, cash flow, or revenue of the company. This ratio may then be used to value comparable companies by simply multiplying the target company’s value characteristic by the similar company ratio. Of course, this valuation is adjusted to account for differences between the two firms.

Transaction Comparables

Transaction multiples are used to estimate the value of the target company based on purchase prices of companies that were recently involved in similar transactions (sales, merger, funding, etc.). The performance characteristics of the companies are compared against the price at which the company is sold. These ratios are used as a starting point for valuing the present company. The ratios are adjusted to account for differences between the transactions and companies. For example, the acquisition of a given company always includes a premium in valuation to account for the level of control afforded the investor.

Industry Comparables

Industry comparables are used to estimate the value of the target company based upon a ratio of price to a value characteristic of companies within a given industry. For example, companies in the industry may have a price to revenue value ratio of 5 to 1, or five dollars in company valuation to one dollar of annual revenue. It is important to note that the term industry has a loose definition. An investor may consider any number of characteristics about a company’s operations when classifying it as operating in a given industry.

Company Comparables

The comparable company method calculates the market value of the company’s equity by employing a value-characteristic ratio derived from companies with some comparable features that justify the comparison. Companies from any industry may have characteristics about operations, mission, market segment, strategy, etc., that makes it a good source of comparison when valuing a business. As with transaction and industry comparables, a value-characteristic ratio is derived from the comparable company and used to determine a value of the subject business.

Common Characteristic-Based Ratios or Multiples

The following subsections contain a non-exclusive list of characteristic-based ratios used to value a business. These ratios are derived from a comparable transaction, firm, or industry. Sometimes, multiple ratios are used to derive a single valuation for a target business.

Price/Earnings Ratio (P/E Ratio)

The price/earnings (P/E) ratio is most commonly used with public companies. It represents the ratio of the earnings of company equity to the number of shares of equity outstanding. It generally involves a public company’s stock price divided by the average earning per share during four quarters. As such, the ratio varies based upon the quarters used in the ratio. The trailing P/E ratio is the current stock price divided by the average earnings per share during previous four quarters of earnings. The forward P/E is current stock price divided by a forecast of the next four quarters earnings. The forward P/E ratio is often used when past earnings are negative or are seriously distorted due to extraordinary losses or gains. The straddle P/E ratio is the current stock price divided by the average earnings per share during the past two quarters of earnings plus a forecast of the next two quarters.

Price/Earnings Growth Ratio

A variation of the P/E ratio is the price/earnings to growth (PEG) ratio. This ratio is used to value a company that has (or is assumed to have) a constant growth rate. PEG is calculated by dividing the company’s P/E ratio by the expected annual growth rate in the company’s earnings. This technique provides an efficient method for adjusting the P/E ratio to compare firms with different growth rates.

Price/Cash Flow Ratio

Price to cash flow uses the total value attributable to a company compared to the annual cash flow that the firm generates. The definition of cash flow may vary between companies. A common definition of cash flow includes all earnings plus any non-cash charges by the company. Firms may use the earnings before interest and taxes (EBIT) or interest, taxes, depreciation, or amortization (EBITDA) to represent the company’s cash flow.

Price/Sales Ratio

The price/sales ratio compares the total price of the company to the total sales. Sales may include all sales with or without regard to bad accounts. In any event, the Price/Sales ratio excludes other forms of revenue not directly related to the company’s primary service(s) or product(s).

Price/Operating Characteristics

In some events, using value characteristics other than accounting variables may provide a more accurate valuation of the target business. Operating characteristics are a common metric for closely-held businesses, cross-border deals, and specialty businesses. For example, a social media firm may be valued based upon the number of users; as opposed to focusing on firm revenue or assets. Cellphone companies may be valued based upon a dollar value for each individual in a population served.

Market/Book Ratios

Another method that may provide an accurate depiction of the value of a firm’s equity is the market/book ratio. This method is used to in conjunction with a P/E ratio. The market/book ratio is the total value (market value) of a company’s equity divided by that company’s net worth as recorded on the balance sheet. This method is common specialty industries, such as banks and large retailers.

Issues Associated with Market-Based Valuation Methods

As will all valuation methods, market-based valuation methods have negative aspects - particularly when they are used to value startup ventures. Some of the notable issues with market-based approaches are discussed below.

Comparable Companies, Transactions, Industries

The primary difficulty associated with using market-based, comparables to value the firm is the inability to identify truly comparable companies. For example, two companies may have very similar operational and structural characteristics, but the comparable ratios may be affected by the position of either company in its lifecycle. That is, one company may still be growing, while the other company has a flatter growth curve. These simple differences can lead to distortion of the comparable ratios. Also, the information leading to the valuation of other private companies is difficult to locate and the lack of transparency can lead to valuations that are unjustified by the relevant cash flow.

Characteristics that make a company comparable include: similar markets, capital structures, operational characteristics, and market size. Identifying comparable companies is easier when the comparable company is publicly traded, as publicly traded firms must make more thorough public disclosures. Transactions or companies within an industry may be too distinct from the firm being valued to offer a valid method of comparison. Transaction and industry multiples should only be used as additional criterion in identifying comparable companies.

Discounts and Premiums

Another important issue is that comparable company valuations do not include the same discounts or premiums. Discounts and premiums are particularly important when valuing startups or closely-held businesses, as there are inevitably specific variables that either increase or decrease a target valuation. The most common discounts are result of limited marketability for the business equity and the control afforded to the investor. Consequently, the valuation must be adjusted for the anticipated premium in order to estimate accurately the actual purchase price. Another source of discount or premium may be the trapped capital gains or losses associated with a firm. Still other premiums unique to a company may be the synergies attributable to the combination of two firms. These synergies can greatly distort the valuation attributable to any individual firm. Discounts and premiums are relevant when using both market-based and income-based approaches.

Ratio Valuation Considerations

The next issue for market-based, valuation is the potential for widely-divergent, valuation ratios. Issues that commonly arise in ratios includes: using ratios from non-comparable businesses (size, financial structure, management, philosophy, growth-path, regulatory environment, location, etc.), using ratios based on accounting numbers, and irrational exuberance surrounding an industry. As such, the ratios produced by similar firms, in like industries, or in similar transactions often are poor points of comparison when valuing a firm.

P/E ratios, for example, are generally only useful in comparing public companies. In startup companies, this ratio offers little insight to the value of the firm. Other ratios fail take into account key aspects of the comparable firm. For example, Price/Sales ratios fail to adequately consider the expense ratios of the comparable company. This ratio should only be used when the entire capital structures of the two firms are comparable. Other examples include the Market/Book ratio, which is subject to distortion from accelerated depreciation and differences in asset purchasing history of companies. A company with more recent purchases or newer assets will have a drastically different ratio than an otherwise similar company with older assets. Further, the book value may distort the value of goodwill on the balance sheet. For these reasons, ratios should be employed in combination when used to value a firm. Above all, however, one must work to find truly comparable firms from which to derive the characteristic-based ratio.

Overview of Income-Based Approaches

Income based approaches value a business based upon the past, current, or expected future cash flows of the business and the risk that the business will not produce the desired return. Estimating and valuing flows of income is done through a process called capitalization. Capitalizing the income streams will produce a so-called present value. Risk is incorporated into this valuation through a discounting process. An applicable valuation formula will discount the present value of cash flows based upon the probability that the firm will not achieve the desired cash flows in the future. The discount rate uses many factors relevant to the individual firm that make the firm’s projections more or less likely. Below are multiple income-based valuation approaches.

Issues with Income-Based Valuation Methods Generally

Income-based valuation approaches depend on a number of criteria in valuing a firm, such as a capitalization rate, risk-related discount factors, and the projection of future cash flows. Capitalization rates are often determined from historical transactions, the market rate of return, and other indefinite factors. Discount factors are based largely upon the perception of risk and the identification of possible risk factors. Various methods, such as the build-up method and CAPM, take into consideration the systemic risk associated with investing in a firm. These methods, however, often do little to account for the firm-specific risk. The projection of future cash flows is very imprecise and rarely accurate due to the tenuous nature of startup operations. The usefulness of these projections is further distorted when they are discounted to present value.

Earnings Capitalization Model

The earnings capitalization model values the company based upon the company earnings. To determine normalized earnings, you calculate a weighted average of earnings over a period of years. The earnings reported on financial statements or tax returns are normalized through several steps. These modifications include the deduction of extraordinary gains or additions for losses, large employee salaries. Earnings are weighted based upon when earned. The most recent earnings are weighted more heavily than older amounts. The weighting value depends on the stage of life of the company and the company’s growth over the time period. A mature company will have more consistent earnings and will be weighted less than startup ventures with rapidly changing annual earnings.

The earnings are assumed to continue in perpetuity. The business is valued by dividing the normalized earnings by a capitalization factor. The capitalization factor is generally expressed as a percentage of the earnings. In the case of growing businesses (such as startups), the firm is assumed to have a constant growth rate. The growth rate is then subtracted from the discount rate to obtain a capitalization rate. This is an adaptation of the Gordon model (discussed further below). The discount rate is determined by identifying the value that the marketplace gives to comparable publicly traded companies or through a process known as the "buildup method."

Earnings Capitalization Model (and Buildup Method)

The earnings capitalization model faces the difficulty of weighting the cash flows attributable to the business and identifying an adequate discount rate (or cap rate) for the projected cash flows. While the concept of weighting more recent cash flows more heavily is a sound practice, there is not set rule on the weight attributable to a given cash flow. Further, the capitalization rate is difficult to determine is startup ventures, due to the early stage of growth.

Build-Up Method of Valuation

In the "buildup method" valuation begins with the risk-free rate. The individual valuing the firm then makes the subjective determination of what percentage to add to the risk-free rate. The amount added depends upon the amount of risk associated with the business’ earnings. The value of the firm is calculated by dividing the adjusted earnings by the determined capitalization rate. The buildup method is frequently used in small and medium-size businesses where comparisons to publicly traded company betas are not deemed to be applicable or it is felt they should be supplemented. The equation for this method can be written as follows:

Re = Rf +ERP + Rs + Rc

where

Re = Expected rate of return of the company

Rf = Risk-free rate of return

ERP = Equity risk premium

Rs = Size premium

Rc = Specific company risk

The risk-free rate is generally the U.S. Treasury note rate. The equity risk premium may be obtained through a number of professional publications. The size risk premium accounts for the increased risk associated with investing in smaller firms. The company-specific risk is a subjective determination based upon the characteristics of the subject firm. The types of items usually considered include: Management depth, Management expertise, Access to capital, Leverage, The five Porter threats, Product diversification, Geographic distribution, Demographics, Availability of labor, Employee stability, Economic factors, Fixed asset age and condition, Distribution system, Location, Technological risk, Socio-cultural risk, Political risk, Global risk, Size.

The individual valuing the firm will assign values to each of these aspects in developing a risk factor. Taken together, these considerations allow for the determination of a discount rate. As previously stated, the estimated growth rate is subtracted from the discount rate to determine the capitalization rate.

Discount Future Cash Flow Method

The Discounted Cash Flow (DCF) method uses the projected future cash flows of the business after subtracting the operating expenses, taxes, changes in working capital, and capital expenditures. This figure is known as the free cash flow of the business because it accurately represents the cash available to interested parties, such as investors or debt holders. These cash flows are then discounted to bring them back to present value. The discount rate is the cost of capital or the required return by investors given the risk associated with the venture.

DCF formula is as follows:

 

where V0 is the value today (time 0),

E0 denotes expectations at time 0,

FCFt is the free cash flow at time t, and

r1, r2, … are the discount rates of the first, second, and so on to all future periods.

If the discount rate does not change over time so that r1 = r2 = r3 … the DCF formula can be stated as:

 

The DCF approach may be used to value both the debt and equity of the company or just the company equity. When the formula is used to value the whole company, it is important to determine the weighted average cost of capital (WACC) associated with that business. The WACC will account for the capital structure (the percentage of debt and equity used to finance the company). The WACC will serve as the discount rate for the future cash flows. If, however, the FCF is determined net of interest to debt holders, the discount factor should simply be the rate of return required by all stockholders.

The debt and equity in the company can be valued pursuant to the following steps. Estimate the future revenues of the company and subtract the operating expenses (including depreciation and amortization). This will yield the Earnings Before Interest and Taxes (EBIT) for each year. Now subtract the taxes from this amount (which is generally a percentage of the EBIT amount). This yields the Net Operating Profit After Tax (NOPAT) for each annual cash flow. Add back any operating expenses that did not result in an outlay of cash. This is generally depreciation and amortization. This is important, as these expenses do not reduce the actual free cash flow of the business. Then subtract amount amounts attributed to capital expenditures. Also subtract any necessary increases in net working capital (NWC) required by the business in that year. Subtracting capital expenditures and increases in NWC is not an expense, but it does reduce the FCF available for the business in a given year. This amount is the projected FCF available to the business in that year.

Now you have a FCF for each year until the date of an intended exit event (such as sale or public offering). The last year is obviously not the final year that the business can bring in revenue. So, for the last year, you will need to obtain a terminal value. The terminal value of cash flows is derived from the assumption that the last year of cash flows will remain equal into perpetuity. The formula for determining a future cash flow in perpetuity is as follows:

 

where “g” accounts for any stable growth rate of the cash flows over time. The result is the terminal value attributable to the intended year of exit.

Now you should discount each years FCF, including the terminal value in the year of exit, using the WACC. This requires you to calculate the individual firm’s WACC based upon the capital structure (debt and equity). This is important as the required return from debt holders if far less than the required return from equity holders. Further, debt provides tax advantages (deductions) to the business based upon the interest paid to debt holders. Equity financing, on the other hand, does not provide tax benefits for the dividends distributed to equity holders. Therefore, it is necessary to account for these discrepancies when valuing the business. The benefit of interest payment deductions is incorporated for in the WACC calculation. The calculation is as follows.

,

where,

kd is the required rate of return for debt holders,

ke is the required rate of return of stock holders,

tx is the marginal tax rate, and

D/A represents the firm’s debt to total assets, and

E/A represent the firm’s Equity to total assets in the firm’s capital structure.

D/A and E/A represent the total capital structure, and therefore must add up to one. Think of it as all assets are either obtained via debt or shareholder’s equity (capital contribution or retained earnings). The kd figure relates to the available return on similar bonds (time and risk level) in the market. The ke figure is determined by the required rate of return from shareholders given the level of risk of similar equity in the market.

Since the level of risk associated with equity is unique to the firm, the capital asset pricing model (CAPM) is used to calculate the ke amount. The CAPM formula is as follows:

 

E(Ri) = Expected Return

Rf = Risk free rate

β = Beta

Rm = return on the market

The risk free rate is generally the U.S. treasury rate for the given period. The return on the market rate is the market rate for this type of equity on the open market. The difference between these two amounts is the premium associated with this equity above a risk-free investment. This amount is then multiplied by the Beta, which represents the historical rate of return attributable to this type of investment. Collectively, this formula provides the expected return of investors in the company.

You know have all of the elements necessary to value the whole company based on the capital structure and expected return from debt holders and equity holders. The whole process is depicted in the below formula:

 

 

The above formula demonstrates the process for valuing the debt and equity of the firm. To value just the equity of the firm (and not the debt), you must identify the free cash flow available to shareholders after all debt has been paid off. In the FCF calculation, the FCF is adjusted by adding any new debt taken on by the company and subtracting any debt repayment. The FCF is then discounted at the cost of equity (derived from CAPM), rather than at the WACC rate.

Discounted Future Cash Flow Model

The discounted cash flow suffers from the above-stated difficulties, as well as other specific cash-flow related challenges. The difficulty in this method is that the capital structure must be weighted based upon a “market risk premium” (beta). The beta can be difficult to identify in private companies and, as in the case of comparables, there may be few or no comparable private companies. Perhaps the most unreliable aspect of this method is that it relies upon the revenue projections for the company, which are often quite speculative and uncertain. The adjusted present value method is a variation of this method that values cash flows from assets and then calculates tax savings separately. This method is useful when the capital structure of the firm is changing or when the firm has significant net operating loss carry forward. However, the forward-looking nature of the financial projections is still speculative in nature. Further, the CAPM model for determining the expected return on equity has been shown to have a number of flaws.

Excess Earnings Method

Another earnings-based method is excess earnings. This method discounts company earnings based on two capitalization rates: a rate of return on tangible assets and a rate attributable to company goodwill. The method is often described as a hybrid method because it takes into account the company’s asset values as well as discounts expected cash flows. The following equation represents the valuation based upon the two rates of return:

V = Ea / R a + Eg / Cg

where

V = The value of the business

E a = The earnings attributable to a return on assets

R a = The appropriate rate of capitalization for earnings attributable to net tangible assets

E g = The earnings in excess of those attributable to a return on assets

C g = The appropriate rate of capitalization for earnings attributable to goodwill

In its most common form, the value is calculated as follows:

V = E – A*Ra / Cg + A

Where:

V = The value of the small business

E = The adjusted earnings of the firm

A = The net tangible assets of the firm

Ra = The appropriate rate of capitalization for earnings attributable to net tangible assets

Cg = The appropriate rate of capitalization of Goodwill

The process for valuing the firm based on the excess earnings method is as follows. Estimate the value of the company’s net tangible assets. Multiply that value by a fair rate of return to calculate earnings attributable to the company’s tangible assets. Estimate the company’s total normalized earnings. Subtract earnings on tangible assets from total earnings to arrive at excess earnings. This represents the company’s earnings above the return on the company’s net tangible asset velue. Divide the excess earnings by an appropriate capitalization rate to calculate the value of goodwill and other intangible assets. The capitalization rate may be subjective or obtained from a market indices. Once you have obtained both amounts, add them to arrive at the company’s valuation.

Issues with the Excess Earnings Method

The excess earnings method artificially divides a company’s earnings into two separate earnings streams: one for tangible assets and one for intangible assets. The problem is that these assets don’t generate earnings by themselves. Rather, a company’s earnings are derived from a combination of tangible and intangible assets working together. There is no market data to support an objective determination of a fair rate of return for tangible assets or a reasonable capitalization rate for intangible assets. So, application of the excess earnings method is highly subjective and easily manipulated. Also, the type of valuaiton method or discount rate for the subject earnings is not determined. This approach may only be appropriate for closely-held businesses or situations where the individual assets of a business must be distributed (such as the dissolution of a business). IRS Revenue Ruling 68-609 states that the method “should not be used if there is better evidence available from which the value of intangibles can be determined.”

Economic Value Added (EVA)

This methodology focuses on the return on investment expected from the company above the relative cost of capital. Take the amount of requested or required investment. Determine the cost of obtaining that capital. That is, what will investors require as a return (dividend or capital appreciation) for that amount of investment. Then determine the amount of return that the company will generate in excess of this required cost of capital. The metric will determine if the company will produce returns that exceed the expectation of lenders or investors. The present value of these expected excess values is then added to the capital invested.

Economic Value Added

The EVA method is sound in nature in that it values the firm based on the value of returns from invested capital above the firms average cost of capital. The difficulty with this approach is attributable to the early stage of the startup in the business lifecycle and the growth-based nature of the venture. The early stage of the business makes the estimation of revenue (or profits) difficult to project. The growth-based nature of the venture means that the firm will likely not return any profits to investors until a given date in the future. As such, the EVA approach is better suited to established firm that makes constant returns (such as dividends) to investors.

Value of Dividends Method

This method relies on the idea that a stock is only worth what it will provide to investors in future dividends. If a business does not currently distribute dividends, the value of the stock will appreciate under apprehension of future dividend distributions. As such, the firm can be valued by discounting future cash flows (dividends) to shareholders. The appropriate discount rate may be determined by any method. Here is a formula for this valuation method:

 

Where:

P= the price at time 0

r= discount rate

This formula is the basic equivalent of the formula for bringing a perpetual cash flow back to present value.

 

This method is often modified to project the present value of the dividends given a constant, perpetual growth rate for the dividends. This is known as the constant growth DDM or the Gordon model for discounting future cash flows. The formula is as follows:

 

 

Issues with Value of Dividends

Like the EVA approach, the dividend discount model requires the individual valuing the business to speculate as to the future dividends of the business. Some DDM models assume that a business’ dividends grow at a constant rate. Other models attempt to identify variable dividends based upon the growth stages of the business. These forms of valuations involve complex models that must also rely on assumptions about uncertain cash flows. Lastly, the required rate of return to use to discount future dividends is speculative. If a company is high-growth, a valuation based upon the company meeting an expected rate of return will undervalue the company. Further, if the company fails to pay a dividend at a given point, it affects the valuation from that point forward.

Overview of Pre-Money and Post-Money Calculations

The value of a business in a funding transaction begins with determining the pre-money and post money valuation. This valuation will be used to determine how many shares are issued to the investor and what percentage of ownership all owners will have following the funding transaction.

Pre-Money and Post-Money Valuation

Pre-money valuation is the value attributed to the company before any new equity is brought into the company via the equity funding transaction. In turn, post-money valuation is the value of the business following the infusion of capital. Therefore, the post-money valuation of the company will equal the pre-money valuation plus the funds injected into the business from the investor.

Calculations Based Upon Pre and Post-Money Valuation

The following equations are important for determining the projected capitalization of a business in a funding transaction.

  • Post-money valuation = Pre-money valuation + Investment amount
  • Purchase price per share = Pre-money valuation / Number of fully-diluted shares before investment
    • Fully-diluted shares means the total number of outstanding shares (any class of shares) or share equivalents. Share equivalents may be any instrument that converts into shares, such as warrants, options, convertible notes, etc.
    • Example: Pre-Money valuation is $500 and there are 25 outstanding shares or share equivalents, then the purchase price per share would be $20.
  • Number of new shares issued to investor = Investment amount / Purchase price per share
    • There is an assumption that the shareholder is investing in the company at the present valuation. As such, if the company is valued at $20 per share and the investor injects $100, she gets 5 shares.
  • Number of fully-diluted shares after investment = Number of fully-diluted shares before investment + Number of new shares issued to investor
    • In a funding transaction, the investor will generally acquire a new class of shares for her investment. This is generally a form of preferred share.
    • Example: If there were 25 outstanding shares or share equivalents and the investor received 5 newly authorized shares, then the total number of fully diluted shares is now 30.

Introducing ESOPS

ESOPs are employee stock option plans or pools. Investors know that a startup company will need to issue shares of equity to hire and retain certain employees. The investor does not want these shares to be authorized later and dilute her ownership interest (i.e., reduce the value of her shares). As such, before the investment, the startup will need to authorize shares as part of the equity pool to be retained for compensating employees.

  • Example: There are 25 outstanding shares or share equivalents. The investor wants an equity pool of 5 shares. Before the transaction gets off the ground, the current owner’s ownership is diluted.
    • 25 shares = 100% ownership before the ESOP
    • 30 shares = 100% post ESOP
    • Owner’s interest post ESOP = 25/30 or 83.34%

Post-Money Valuation including ESOP

The price per share of the company is the valuation / fully diluted shares. Now that there are more shares, the price per share to the investor is lower.

  • Example: Pre-money valuation is $1,200. The total number of shares including the ESOP is 30. The price per share is $40. If the investor injects $1000 of capital into the business, she will receive 25 shares. The post-money valuation is $2,200 and there are 55 outstanding shares and the price per share is still $40.

How Investors Use Pre and Post-Money Valuation in Negotiations

Investors put money into the company based upon post-money valuation. If an investor says, “I’ll invest $100 for 20% of the business.” The investor is saying that, after the transaction, he wishes to own 20% of a company. He assumes that 20% is immediately worth $100 (and will hopefully grow). This means that 100% of the company must be worth $500 ($100 x 5). As such, the pre-money valuation of the business is Post-Money valuation ($500) minutes the amount invested ($100). In this example the pre-money valuation is $400.

You can now use the above calculations to determine the purchase price per share issued to the investor.

Angel Investor Methods

Investors have developed multiple valuation strategies to account for the difficulty in assessing the value of early-stage, growth-based startups in the technology space. Two well-known methods are the “Berkus Method” and the “Scorecard Method”.

Berkus Method

The Berkus method was developed by a well-known angel investor named Dave Berkus. The Berkus method values a business venture based upon value drivers. The value drivers are soundness of the business idea, quality or existence of a product prototype, quality of the business management team, strategic relationships in the market, and existing product sales. The extent or development of each of these value drivers adds to the pre-money valuation of a venture. Generally, each driver will account for between zero ($0) and five hundred thousand ($500,000) of value to the business. The idea is that each value driver increased the likelihood that the firm will meet intended goals and reduces the risk of failure.

For a full explanation of the Berkus Method, visit: http://berkonomics.com/?p=131

Scorecard Method

The Scorecard Method, also known as the Benchmark Method, was created by a well-known angel investor name Bill Payne. This method derives a valuation by comparing a pre-revenue business venture to other ventures in the same business sector or region. It relies on the ability to determine the valuation of other entities and average those valuations to arrive at a benchmark. One then compares the business venture to those average ventures based upon: the strength of the management team; the size of the business opportunity; the product or technology at the center of the business; the competitive environment of the business; the existing marketing or sales channels; the need for capital, and other investment specific information. Each of these factors is attributed a percentage, with 100% being average. If the business is strong in a given area, then it would be rated as higher than 100%. If it is less than average, it would be below 100%. Each of these factors is then ascribed a weight that totals 100 or 100%. Multiplying the assessed percentage by the ascribed weigh provides a value factor. Multiplying the resulting value factor by an average pre-money valuation from similar businesses provides a valuation for the target business. The salient issue with this method is that it relies heavily on identifying comparable firms.

For a full explanation of the Scorecard Method, visit: http://billpayne.com/wp-content/uploads/2011/01/Scorecard-Valuation-Methodology-Jan111.pdf

Venture Capital Method

The venture capital method (VC Method), as the name implies, is most commonly used in the venture capital industry and for valuing startup ventures. As discussed in separate lectures, investors seek to capitalize on their investment via an exit at some future date in the startup’s lifecycle. Investors will seek a return equal to some multiple of their initial investment or will seek to achieve a specific internal rate of return based upon the level of risk they perceive in the venture. The VC method incorporates this understanding and uses the relevant time frame in discounting a future value attributable to the firm.

The future value of the firm can be determined by any of the previously described methods, including the discounted cash flow or using market multiples. Using market multiples is the most common method of arriving at a terminal value, because a projection of future cash flow at that point would be excessively speculative. The parties will generally use a price to earnings ratio to calculate the terminal value. Once a terminal value is calculated, the post-money value is calculated by discounting (dividing by a discount factor) that represents an investor’s expected or required rate of return. The investor seeks a return based on some multiple of their initial investment. For example, the investor may seek a return of 10x, 20x, 30x, etc., their original investment at the time of exit. The required multiple is based upon the risk perceived by the investor. The higher the risk, the higher the return required. Also, angel investors generally have a portfolio of approximately 10 companies. If statistically 6 will lose money and 3 will break even, the angel investor needs the successful venture to carry the entire portfolio. As such, the investor will seek a minimum of 10x return in most (if not all) of its invest. On average, the entire VC portfolio returns about 27% on average.

Below is an illustration of the calculations.

  • Return on Investment (ROI) = Terminal Value ÷ Post-money Valuation

So, inversely:

  • Post-money Valuation = Terminal Value ÷ Anticipated ROI

If the investor expects 10x as her return on investment and her terminal value is $10,000, then the post-money valuation will be the terminal value divided by 10 or $1,000.

  • Pre-money Valuation = Post-money Valuation - Investment amount.

If the investor invests $250 for 25% of the ownership interest, the pre-money valuation is $750.

Taking Dilution into Consideration

The above formula demonstrates the venture capital method in its purest form. If, however, the startup is likely to need additional capital prior to an exit event where the investor can liquidate her investment, she will be diluted by the follow-on issuance if she does not participate. The investor will account for and attempt to mitigate this risk in a number of ways. The investor may seek anti-dilution protection, but exceptions to these provisions are often crammed down by the follow-on investors. There are also complicated formulas used to calculate probability of future funding rounds. A simple manner to address the threat of future dilution is to make a strategic guess as to the future capital needs of the firm and calculate what level of dilution that would be. You will calculate dilution for a scenario where the firm meets its optimistic projections, grows but misses it projections, and a scenario where it stays flat in its growth. Average the expected dilution between these scenarios and reduce the post-money valuation by this percentage.

Issues with the Venture Capital Method

The VC Method (discussed in a separate lecture), while the dominant method used in early stage investment, has numerous shortfalls. First the VC method requires reliance on projected growth and future revenues. As discussed below with regard to income-based valuation methods, projecting company revenue at a future date is extremely difficult and speculative. Further, the VC method relies upon valuation multiples in deriving a terminal valuation. All of the issues identified in market-based valuations make this method less certain. Lastly, the discount rate of return or multiples required by investors is a subjective determination based upon the perceived risk of a given investor. There is no fixed method for assessing risk associated with the subject business. Therefore, the VC method can produce wildly varying results between investors.

The First Chicago Method of Business Valuation

The First Chicago Method is a hybrid approach that employs multiples to derive a terminal value and discounts future cash flows to arrive at a present valuation. Notable about this method is that it requires three projections based upon company performance. A “best case scenario” is based upon company performance that exceeds most expectations. A “base scenario” is what the majority believes to be the future performance of the firm. Finally, a “downside” or “worst case scenario” projects company performance if many contingencies go wrong.

The method begins by projecting future cash flows of the firm in the above three scenarios. As with any future projection, future cash flows are very speculative. Allowing for the three scenarios allows for the risk associated with each scenario. The cash flows continue until an anticipated exit event for the firm. This is generally between three and seven years for most firms. Then the firm uses the final year’s cash flows comparable multiple to project a terminal valuation for each scenario. The comparable multiple is derived from the methods previously discussed. The prospective investor will then discount each year’s cash flows and the terminal value based upon the investor’s required rate of return. For the terminal value, this will involve identifying a required multiple that produces an acceptable annual rate of return. For the cash flows, the required rate of return will be used to discount the value of each year’s cash flow.

At this point, the investor has six present value calculations (i.e., a multiples and discounted cash flow calculation for each performance scenario). The investor will now multiple each of these valuations by an anticipated probability of occurrence. All the probabilities together should add up to one or one-hundred percent. The resulting amounts are then tallied to arrive at a single present valuation for the firm. This weighted-average valuation takes into account the risks inherent in company operations and reduces the effect of inadequacies in any single valuation method.

The First Chicago method has emerged as an industry leader among venture capital and private equity firms. Early stage investors, however, have not fully adopted this approach. As with all income-based approaches, the projection of revenues for an early-stage venture is too speculative to be of value to these investors. As such, the early-stage investor generally employs the venture capital method, along with any secondary asset-based approaches.

Strategic Considerations in Valuation

Subjective factors are routinely used to either discount or justify a premium valuation. For example, a specific company may derive a valuation for a firm based upon strategic considerations that are unique to that entity. Strategic considerations when valuing a business include the synergies that will result as a result of a prospective combination or the competitive advantages created by a transaction. The combination of innovative firms makes the determination of synergies largely speculative. For example, Facebook, Inc., recently purchased WhatsApp, Inc., for approximately $19 Billion in cash and stock. The valuation of this purchase was largely based upon the synergies available from combining the two companies and the competitive advantage that WhatsApp possessed in the current market. This merger represents a valuation based upon market or industry trends. Facebook’s valuation of WhatsApp reflected a belief that the market for this type of free-communication technology will continue into the future.

Other factors to consider in the valuation of a firm include: the bargaining power of a prospective purchaser; the competitive landscape for a company, the cost of entry for new competitors, the legal or regulatory risk associated with a business activity. While all of these considerations are common in valuing a firm, the innovative nature of startup ventures often makes the impact of these factors on business productivity difficult to value.

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