Excess earnings

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					Raising Entrepreneurial Capital

   Chapter 5: Valuation
Valuation Methodologies
   Asset based valuation
   Market comparables
   Capitalization of earnings
   Excess earnings approach, and
   Discounted cash flow (DCF) valuation
    or present value of the firm's “free”
    cash flows.
Finance theory
 would argue that only the discounted
  cash flow method is theoretically
 the value of any asset is the present
  value of cash flows that the asset will
  generate over its useful life, adjusted by
  the risk of achieving those cash flows.
The problem for new ventures
is that the information that provides the
basis for the free cash flow estimates is
generally so speculative that the more
sophisticated DCF method may not be
perceived as worth the effort it takes to
generate a value.
Asset-based approaches
Assume that the value of a firm can be
  determined by examining the value of
  its underlying assets:
 Liquidation value of the assets
 Replacement value of the assets
 Modified book value of the assets.
Liquidation value
 Neglects that part of the firm’s value
  that would be contingent upon the
  business continuing in operation.
 This does provide a lower bound
  estimate for a valuation, however.
Replacement value
 Estimates the cost to replace each of the
  firm's assets. The value of the business
  is the sum of the replacement costs of
  the individual assets.
 Based not on what a willing buyer would
  pay for the assets, a market value test,
  but rather what it would cost to replicate
  the company by buying the assets in the
  open market.
Problems with replacement value
 There are likely to be large
  discrepancies between book value
  and replacement cost for assets like
  land, plant and equipment.
 Often ignores value adding assets
  such as human capital and intellectual
  property, potentially seriously
  understating the value of the
Modified book value approach
 Assets and liabilities are restated to
  their current fair market values.
 Items not found on the balance
  sheet, but that add to firm value, are
 On the liability side, the value of any
  pending lawsuits or tax disputes are
Market multiple approach
 Most common method of valuation;
  sometimes called guideline company
 Value of a firm is based on the
  observed market value of a
  comparable company relative to some
Comparison factors
   Capital Structure
   Credit status
   Depth of management
   Personnel experience
   Nature of the competition
   Maturity of the business
Valuing service businesses
 Multiples are usually applied to sales or
 Sales is better for a service business
  because sales drive profits and cash
  flows and expenses are more
  controllable than they are in an asset
  intensive business.
 The implicit assumption is that a certain
  level of revenue will result in a certain
  level of profit.
Discounted cash flow
Vt = CFt (1 + g)
 Vt = the value of the firm at time t
 CFt = the cash flow at time t
 g = the constant growth rate of cash
   flows in perpetuity
 r = the appropriate risk-adjusted
   discount rate.
Appropriateness of methods
 Value a firm from earnings? Some
  contend that markets value a firm based
  on future cash flows, and not reported
  earnings. Also, there are many ways to
  influence the firm's reported earnings.
 Proponents of the market multiple
  method argue that companies are more
  similar than they are different at various
  stages of fundraising and therefore
  standard multiples can be applied to
  companies at each stage of their
Capitalization rate
Inverse of market multiple.
 A multiple of 5 would correspond to a
  “cap” rate of 1/5 or 20%.
 Cap rates are typically applied to the
  next year’s earnings forecast, and
  chosen to reflect the risk of the
Excess earnings aproach
 An interest rate reflective of current
  returns on tangible assets (plant,
  equipment, land) is used to determine a
  fair return on the business' assets.
 This rate is relatively low, reflecting the
  low risk of investing in tangible assets.
 The dollar return on tangible assets is
  calculated by multiplying the fair market
  value of the assets by this risk-adjusted
Excess earnings - calculated
 An imputed return is subtracted from
  the forecasted normalized earnings for
  the next year to calculate excess
 Tangible assets are forecast to return
  the risk-adjusted rate for tangible
  assets. Excess return is then due to
  some intangible factor left off of the
  balance sheet.
Excess earnings - goodwill
 The excess earnings are capitalized at
  a higher rate than the rate on
  tangible assets to determine the
  present value of the company's
 The sum of the present value of
  goodwill and the firm's tangible
  assets equals the total firm value.
Problems in implementation
 Excess earnings, cap rate and DCF
  methods all require the use of a risk-
  adjusted discount rate.
 The excess earnings method requires
  the use of two risk adjusted rates
  which doubles the opportunity for
  error in the valuation.
Free cash flow valuation
 Defines the value of the firm as the
  present value of the expected future
  cash flows in excess of those needed to
  operate the company.
 A firm's economic or intrinsic value is
  then equal to the present value of its
  “free cash flows” discounted at the
  company’s cost of capital, plus the value
  of the firm’s non-operating assets.

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