Business valuation concepts:

Traditional methods

Raul Nicolas S. Tomas

Director, Advisory Services

10 April 2019
What is valuable to you?
Why?
 “Everything that can be counted does not
necessarily count; everything that counts cannot
necessarily be counted.”
-Albert Einstein

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Important things to remember about valuation

 Valuations can be very subjective

 What something is worth can be different from one person to the
next
 Influences: stage in life, experience, aspirations and plans
 Value would not necessarily be constant (actually, most of time, it is
not)
 Knowing this, objective is to understand the bases of the value
claims and know how to react to other value claims accordingly
 While there are various ways of valuing a business, they are all
rooted on the concepts underlying the traditional methods
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The traditional valuation methods

VALUE

Cost- /
Market-based Earnings-based
Asset-based
 Net asset value  Relative methods  Discounted cash
(NAV) o Enterprise value/ flow (DCF)
 Liquidation value EBITDA
o Price/Earnings
o Price/Book value
 Comparable
transactions

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Cost- / Asset-based method
Cost- / Asset-based: Net Asset Value

 Main idea: A business is worth what it currently has net of its

obligations (i.e. assets less liabilities)
 Basis of valuation: Statement of Financial Standing (balance sheet)

Assets are adjusted at fair value

Liabilities are stated at amortized cost

Equity is adjusted for Preference Shares

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Accounts typically reviewed

Assets:
 Cash Cash is cash; confirm balances

 Accounts receivable Check aging. Are there receivables that may

no longer be collected (e.g., age, already paid,
etc.)?
Marked-to-market; check current prices
 Marketable securities quoted at active market
 Inventory Check current prices and obsolescence

 Fixed assets Appraisal

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Accounts typically reviewed

Liabilities
Can do confirmation with suppliers (not
 Accounts payable usually done); conduct analytical procedures
 Loans Ensure presented at amortized cost (i.e., cost
of acquiring the loan are amortized and is
included in interest payable/expense)
Equity
Confirm presence of preference shares and
 Preference shares its terms (e.g., cumulative dividend
liabilities/obligations)

Contingent liabilities Confirm with company, usually with legal

counsel. This includes existing lawsuits.
Ascertain probability of losses and liabilities

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NAV strengths and weaknesses

 Strengths
 Data required to perform the valuation are usually easily available
 Suitable for firms whose value drivers are its tangible assets (e.g. real
estate, asset management, mutual funds, banks, etc.)
 Helpful when the company’s future is in question or when it has a
brief or volatile earnings record
 Weaknesses
 Can understate the value of intangible assets such as copyrights or
goodwill
 Does not take into account future changes (up or down) in sales or
income
 Balance sheet may not accurately reflect all assets

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Market-based method
Market-based method

 Main idea: If there are assets where prices are known, then it can be
the basis to price similar assets
 Best attribute: easy to understand intuitively; commonly used
 Most critical element: existence of reasonably comparable publicly-
listed companies or transactions
 Most difficult aspect: Justifying choice of “reasonably comparable”
companies and transactions

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Comparability “defined”

 No agreed criteria
 Common comparability parameters used for candidate company or
transaction:
o Industry Classification – if you can find almost similar business; even better
o Size – can be based on revenue, assets, number of employees, etc.
o Geography – same jurisdiction, similar general market condition, regulations
o Growth Rate – you can’t compare a new high-growth company to a mature one
o Profitability – level of profitability affects expectations of value
o Capital Structure – the more debt a company has, the greater the risk
shareholders/potential investors adopt with regard to potential bankruptcy

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Market approach concept

What is being valued Market multiplier to use Performance basis

 EV / EBIT  EBIT
Enterprise / Business  EV / EBITDA  EBITDA
 EV / Sales  Revenues

 Price / Earnings  Net Income

Equity
 Price / Book Value  Net Book Value

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Multiples strengths and weaknesses
Multiple Strength Weakness
EV / EBIT Distorted by depreciation
 Not affected by tax effects
 Does not use non-operating
Implicitly assumes same
results
EV / EBITDA capital intensity as
 Capital structure has no effect
comparable

 Can be applied for companies

Ignores the profit situation of
EV / Sales with no profits
company
 Information easy to obtain
Implicitly assumes same
 Information easy to obtain
P/E capital and cost structure as
 Most popular among all ratios
comparable
 Can be applied for companies
Comparable ratio distorted by
P/B with no profits
capital structure
 Information easy to obtain

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Reminders about market approach

 Must know if the multiple uses historic or future information (i.e.,

historical vs. trailing vs. forward); should apply to consistent
information about the company being valued
 Business/Equity values derived using listed company multiples are
discounted for being less liquid; no rule but usual practice is 25%

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Earnings-based method
Earnings-based method

 Main idea: Value of a business based on its anticipated future

earnings
 Basis of valuation: Projected earnings, cash flow
 Best attribute: Good estimate of the intrinsic value of the company

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Main components of the DCF method

Discount
Rate

Projected
Assumptions
Cash Flow VALUE

Terminal
Value

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Assumptions

 Can be based on the company’s business plan or management

expectations
 Depending on the circumstances, could incorporate expansion plans
 Investors may want to limit valuation on organic growth of
business
 Assumptions must be based on historical and projected information
on the company and the market, aside from management plans

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Projected cash flow
 In DCF valuation, we typically use either the free cash flows to the
firm (FCFF) or the free cash flows to equity (FCFE)
FCFF
 Used to value the whole company
 = cash flow from operations – capital
expenditures
 Represents the cash produced by
operations that is available to both
shareholders and creditors, after
investing in future operations
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FCFE
 Used to value the equity of a company
 = cash flow from operations + proceeds
of debt incurred for the period – debt
payment (principal and interest) – capital
expenditures
(or = FCFF – net repayment of debt)
 Represents the cash produced by
operations that is available to
shareholders, after investing in future
operations and paying creditors
Additional notes on the use of FCFF or FCFE

 Use FCFF:
o When the potential transaction involves buying/acquiring or
selling the business (not just investing/buying shares)
o When the leverage level (historically and projected) is volatile
o When there is not much information on projected leverage
 Choose FCFE:
o When the potential transaction involves investing into the
business
o When leverage levels are quite stable

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Terminal value

 Terminal value captures the estimated cash flows beyond the

projected period
 Ways to estimate:
o Perpetuity of earnings / Stable growth approach
o Multiples approach
o Liquidation value approach

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Terminal value – perpetuity of earnings approach

 Assumes that beyond the projection period, the cash flows would be
at the same level based on some previous years’ level
o final projection year
o average of the previous projected years
o highest cash flow achieved
 Whatever cash flow value is used as basis for perpetual cash flow,
KNOW what is included (or not) in such cash flow

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Be careful of where you base your TV….

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Terminal value – perpetuity of earnings approach

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 (𝑇𝑉) =
𝑟−𝑔
where,
Cash Flow - cash flow amount you decided to use
r - discount rate
g - growth rate

 Growth rate limitation: cannot be higher than projected long term

growth of economy

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Discount rate

 The rate at which the present value of projected cash flows are
determined
 Accounts for the time value of money and the risk or uncertainty of
the anticipated future cash flows
 Common discount rates used:
o Weighted average cost of capital (WACC)
o Cost of equity
o Target rate
o Required return

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Discount rate - WACC

Cost of Debt x (Debt / Total Assets)

WACC = +
Cost of Equity x (Equity / Total Assets)

 Cost of debt = typically the weighted interest rate of existing loans

of the company (net of tax)
 Cost of equity = typically estimated using the Capital Asset Pricing
Model (CAPM)
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Cost of equity: Capital Asset Pricing Model

Risk-Free Beta x Cost of

Rate Market Risk Equity (ke)
Premium

Rf + b(Rm-Rf) = ke
 Risk-free rate = yield rate of government bond
 Beta = measure of the volatility, or systematic risk, of a listed
security or a portfolio in comparison to the market as a whole
 Market risk premium = extra earnings expected in investing in
riskier investments
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Putting it all together – DCF

S
Cash Flow t Terminal Value t +1
DCF value = +
(1+r) t
(1+r) t + 1

 Strengths:
o Good estimate of intrinsic value
o Can easily incorporate sensitivity analyses
o Incorporates potential upsides for investors
 Weaknesses:
o More intricate than other methods
o A number of subjective decisions
o Value susceptible to differing perceptions and assumptions
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Traditional valuation methods and
Startups
Which method should be used?

Appropriateness and choice depends on:

 Nature of business
 Current condition of the company
 Availability of financial information
 Existence of comparable companies/transactions (and availability
of data on them)
 Presence of business plan
 Stage of deal transaction
 Business life cycle stage

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Valuation method and deal transaction stage

Deal Stage Information Available Methods Used

Target searching  Industry studies, prospects  Comparable transactions
 Industry players
 Sales, market share

Identification of target  Basic financial statements  Comparable companies

or information  Net asset value
 Annual reports
 News and other public
information about company

Negotiations & closing  Management plans;  Discounted cash flow

business plan
 Full financial information

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Valuation method and the business life cycle

Image from Corporate Finance Institute

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Valuation method and the business life cycle
Life-cycle Stage Characteristic
Startup or launch  Minimal or no sales,
earnings and cash flow
 Company may have
management plans
Growth  Faster-than-industry growth  Earnings-based
in sales and earnings
Maturity  Sales and earnings stable
 Business plan for more
stable growth
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Methods Used
 Cost- / Asset-based
 Earnings-based (but
reasonableness of plans
could be questioned)
 Multiples based on sales
 Earnings-based
 Multiples based on earnings
 Cost- / Asset-based
(particularly for those
expected to eventually
liquidate)
Thank you
Thank you.

This presentation is not a comprehensive analysis of the subject matters covered and may include proposed
guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including
the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters
addressed in this presentation. The views and interpretations expressed in the presentation are those of the
presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to
the matters covered.

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