Chapter 6: Business Valuation (Income Approach)

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1 Chaper 6: Business Valuaion (Income Approach) Cash flow deerminaion is one of he mos criical elemens o a business valuaion. Everyhing may be secondary. If cash flow is high, hen he value is high; if he cash flow is low, hen he value is low. However, many sellers have he illusion ha a buyer will pay more han wha he cash flows indicae in value. Inroducion The bes known mehodologies for he income approach o valuing he equiy of a firm are he dividend growh model and he free cash flow o equiy (FE) model. While many look a he dividend growh model for publicly raded companies, few look a he free cash flows o he company or o he equiy holders. Mos privaely held companies pay no dividends. This chaper focuses on he hree mos commonly used free cash flow models for valuing privaely held companies. Three of he mos used valuaion echniques are: (1) Valuing he cash flow o he invesed capial (deb + equiy), or free cash flow o he firm (FF); (2) Valuing he cash flow of he equiy holders, or free cash flows o equiy (FE); (3) Valuing EBITDA (Earnings before ineres, axes, depreciaion and amorizaion). Mos Typical Cash Flow Models A summary of he mos ypical cash flow models used for closely held businesses can be seen in Table 6-1 on page

2 Table 6-1: Summary of Typically Used Cash Flow Models Needed Cash Flow Used Discoun Rae When o Use Free Cash Flow of Equiy (FE) EBIT(1-) -Ineres Expense(1-) -Principal Repaid +New Deb issued -Preferred Dividends +Depreciaion & Amorizaion -Capial Expendiures -Change in Working Capial Discoun Rae is R e (reurn on equiy). Good for companies growing a or below ha of he economy. Free Cash Flow of Firm (FF) or cash flow o invesed capial EBIT(1-) +Depreciaion & Amorizaion -Capial Expendiures -Change in Working Capial Discoun rae r w (weighed average cos of capial: ax affeced). Good for highly leveraged or cyclical firms. EBITDA EBITDA Discoun rae is preax cos of capial Good for highly leveraged or cyclical firms where capial expendiures and working capial canno be calculaed. Free Cash Flow o Equiy Model (valuing he equiy) Direc Capializaion Free Cash Flow o Equiy (FE) can be inflaed/deflaed by reducing or increasing capial expendiures as compared o depreciaion. This model is sensiive o growh rae assumpions. The growh rae of earnings, revenue, depreciaion and capial expendiures need o be similar o he growh of he economy. Overall, he model is good for companies growing a or below ha of he economy. Discouned Cash Flow FE in a discouned cash flow can also be inflaed/deflaed by reducing or increasing capial expendiures as compared o depreciaion. The model is also sensiive o growh rae assumpions. Growh raes need o be similar o he growh of he economy (usually Gross Domesic Produc growh), as well as depreciaion and capial expendiures. Overall, his model is good for companies growing a or below ha of he economy. This calculaion beer racks he solvency of a firm by coninually adjusing for leverage. In addiion, capial expendiures will differ from depreciaion depending upon where a firm is in he growh cycle. High growh should have higher capial expendiures, relaive o depreciaion, and sable companies 100

3 should have similar depreciaion and capial expendiures. Maure companies will have smaller capial expendiures relaive o depreciaion. Assumpions abou he fuure selling value (erminal value) are needed. Direc Capializaion Free Cash Flow o he Firm (FF) can also be inflaed/deflaed by reducing or increasing capial expendiures as compared o depreciaion. The model is sensiive o growh rae assumpions and he growh raes need o be similar o he growh of economy. Depreciaion and capial expendiure growh raes need o also be similar o ha of he growh in he economy. In summary, o arrive a he equiy of he firm, subrac he oal mark o marke value of deb (shor erm porion plus long erm deb-see Table 6-13 on page 126 for an example) from he business enerprise value (oal invesed capial). Noice in his example ha $517,000 is subraced from he value of he firm o arrive a he value of equiy. Free Cash Flow o he Firm Model (valuing he company) Discouned Cash Flow FF for a discouned cash flow is similar o ha of a direc capializaion calculaion. This model is good for highly leveraged or cyclical firms. The capial expendiures will differ from depreciaion depending upon where a firm is in he growh cycle. The high growh firm will have higher capial expendiures, relaive o depreciaion. Sable companies should have similar depreciaion and capial expendiures, and maure companies will have smaller capial expendiures relaive o depreciaion. Finally, he assumpions abou he fuure selling value needs o be idenified as well as changes in working capial. For a direc capializaion, his model assumes no capial expendiures and no working capial. The growh rae needs o be similar o he growh of he economy. To arrive a he equiy of he firm, subrac he oal mark o marke value of deb from he oal enerprise value. For a discouned cash flow, addiional assumpions abou he fuure selling value need o be idenified. This model is useful for highly leveraged or cyclical companies where capial expendiures and working capial canno be quanified. EBITDA Model One of he problems wih hese hree models, and for discouned cash flow models in general, is ha hey are all sensiive o he assumpions made abou growh raes and capial expendiures. Problems wih Models Relaionship beween Discoun and Capializaion Raes Having looked a he models described in Table 6-1 on page 100, i is imporan o undersand how capializing income leads o a value conclusion. Capializaion is a echnique used o conver an esimae of a single year s income expeced ino a value, in one sep. Generally, he value of he business can be calculaed by one of wo ways: (1) a discouned cash flow (Equaion

4 on page 103); or, (2) a direc capializaion of he firm s cash flow, or weighed average cash flow of he previous 3-5 years (Equaion 6-10 on page 103). As will be shown, he capializaion is a derivaion of he discoun rae. Capializaion Capializaion is defined as he conversion of income ino value. This mehod is mos appropriae for smaller businesses and can be seen in Equaion i (EQ 6-1) where nex year s cash flow i capializaion rae ime Example of Capializaion: Assuming FF of $500,000, and he long erm capializaion rae for he firm is 23%, he business enerprise or invesed capial value (deb + equiy) is $2,173,913 ($500,000/0.23). Assuming ha he oal long and shor erm deb is $1,000,000, hen he value of he equiy componen is $1,173,913. Theoreically, he capializaion rae plus he growh rae equals he discoun rae (see Growh Raes on page 114). When providing a valuaion, he choice needs o be made as o wheher o use one year s normalized cash flow 1 o esablish a value, or o use a number of successive (nex year s) cash flows. If cash flow has sabilized, hen only one year s normalized cash flow is used and a direc capializaion mehod is execued. Equaion 6-2 hrough Equaion 6-4 show he basic formula for capializing a cash flow (e.g., EBITDA) o a value indicaor for a business. If you have wo of he variables seen in he following hree equaions, hen you can calculae he hird variable. This calculaion is imporan o undersand when you wan o know wha he reurn on equiy would be for a given cash flow or sale price Cash flow Capializaion rae (EQ 6-2) Capializaion rae Cash flow (EQ 6-3) Capializaion rae Cash flow (EQ 6-4) 1. Normalized means afer you have made adjusmens for nonrecurring iems, and so on (See Adjusmens for Exraordinary and Nonrecurring Iems on page 48). 102

5 A discouned cash flow is a muli-year, or period, calculaion of value. Is basic formula can be seen in Equaion 6-5. Discouned Cash Flow ( 1 + k) 1 ( 1 + k) 2 ( 1 + k) ( 1 + k) (EQ 6-5) n n ( 1 + k) n (EQ 6-6) or n TV ( 1 + k) n ( 1 + k) n 1 (EQ 6-7) where cash flow k discoun rae n ime periods, ime 1 o ime TV erminal value Basically, he cash flows of he business, designaed as for each ime period (n) is added ogeher and discouned. The erminal value (TV) is he value which he business is assumed o be sold a in he fuure, discouned a he discoun rae (k), for (n) years or ime periods. Equiy discoun raes usually incorporae eiher he growh rae (g) of a company s earnings or he long erm rae of inflaion, depending upon he ype of discoun rae (k) which is calculaed. In he long erm few companies or equiy reurns grow faser han he rae of inflaion. The discoun rae (k) many imes equals he capializaion rae plus he growh rae. This can be seen in Equaion 6-8 and Equaion 6-9. Capializaion rae k g (growh rae) Discoun rae (k) capializaion rae + g 0 ( 1 + g) Nex years cash flow ( k g) Capializaion rae (EQ 6-8) (EQ 6-9) (EQ 6-10) Example: If he growh rae is 5% and he discoun rae is 25%, hen he capializaion rae would be 20%. If he growh rae is negaive 10% (obsolee indusry, which is conracing) and he discoun rae is 25%, hen he capializaion rae is 35%. Finally, if he growh rae is 0%, and he discoun rae is 25%, hen he 103

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