Raising Entrepreneurial Capital
Chapter 5: Valuation
Asset based valuation
Capitalization of earnings
Excess earnings approach, and
Discounted cash flow (DCF) valuation
or present value of the firm's “free”
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.
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.
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.
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
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
Depth of management
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
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
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
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
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.