VALUATION Three Definitions of Value Fair Market Value Fair Value (Court determined weighted-average value) Negotiated Value o Investment Value o Strategic Value Reasons for Business Valuations Divorce Taxation (Estate/Inheritance/Gifts/Charitable Contributions) Buying, Selling, or Merging a business Selling Stock or Issuing stock options) Going Public or Going Private Buy/Sell Agreements Regulatory mandates (ERISA-ESOP’s) Shareholder/partnership Suits Fair Market Value The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts which would affect value. IRS Revenue Ruling 59-60 (Eight Factors to consider when valuing a closely held small businesses) History and nature of the business Economic outlook for the company and the specific industry Book value of the interest being valued and the financial condition of the firm Earning capacity Dividend capacity The value of intangibles such as goodwill Prior sales of the firm’s equity (must be arms length transactions, frequent trades, and published financial information) Market value of other firms which are traded actively in the free and open market (comparable market value or surrogates) Negotiated Value To negotiate, you must have a starting asking or offering price. Ad-Hoc Methods of Valuation MMM Theory – Make Me a Millionaire Industry multiples of sales, income or cash flow Ad-Hoc Formulas (Assets + 1 yr.’s profits) Business Broker’s SDI Seller’s Discretionary Income (SDI) Last Years Profits + Depreciation & Amortization (non-cash) + Owner’s Compensation & Benefits + Interest Expense + Extraordinary or non-recurring items = Seller’s Discretionary Income Ignores trends when using last year’s profits and is not valuing future earnings Adds back all owner compensation, not just excessive compensation (buyer has an opportunity cost or replacement cost) Business Brokers charge 10% commission and usually market the company at 2 to 3 times its SDI Purchase/Sale Issues Asset Sale vs. Stock Sale (legal/accounting) Price & Terms (Cash/Restricted Stock/Note) Goodwill vs. Covenant Not to Compete Employment Agreement Performance Based Price (Earnout) Operating Synergy Financial Synergy Asset Sale Usually preferred by Purchaser, by purchasing assets (including intangibles like the company’s name) and moving it to a new corporation, the asset’s values can be “stepped-up” to their appraised value thus increasing the depreciation tax shield. If the stock is purchases, the buyer assumes the seller’s basis in the assets. If the stock of the company is purchased and after the purchase a lawsuit is filed against the corporation, the purchaser is at risk (although there may be seller indemnification), whereas if assets were transferred to a new company, the lawsuit is against a shell corporation Stock Sale Preferred by Seller If stock is sold, Seller gets capital gains treatment at personal level (20% max. tax rate and no double tax) If the assets of a “C” corporation are sold, it could be ordinary income (34% tax) and to get the money out of the company, a liquidating dividend may have to be paid If stock is exchanged between buyer and seller (merger), then a like for like exchange may defer tax on the gain until the new securities are sold. Is the new stock exchanged marketable? Are there restrictions on selling the stock? (SEC Rule 144) Stock received may increase or decrease in value Price vs. Terms Most small businesses are not asset intensive (service/retail) and thus the cash flow produces a value higher than tangible asset value (blue sky value) Purchasers may not have sufficient capital resources to pay cash and banks don’t finance intangible assets. Banks also treat change of ownership like start-ups Thus, to get the best price, the Seller may have to carry a note o May be in a second lien position o May end up getting the business back in deteriorated position Cash flow of the company may not be sufficient to retire the debt quickly Goodwill vs. Non-Compete Usually the purchaser will require the Seller to execute a covenant not to compete (must be reasonable in duration and geographic area) Seller must report this as ordinary income Purchaser can write off the value over the life of the covenant (usually 3 years or less vs. goodwill of 15 years) Other Negotiation Issues Will the Seller stay to assist with transition? o How long and how will he/she be compensated? Employment agreements with key employees Performance Based Contract o Good way to bridge gap between expectations of future income and value o Should the seller pay more or the buyer take less for the performance of the purchaser? o Often used for personal service companies based on attrition rate of clients Operating Synergy By merging two firms, it is often assumed that some economies of scale will be generated o Decrease costs through elimination of duplicate functions (accounting, etc.) o Increase revenues by expanding the customer based, distribution channel or geographical area o Synergistic product lines Financial Synergy Make the sum of the parts greater than the whole (1+1=3) o Combining a high p/e stock with one of lower value can increase eps without increasing profit margins or return on equity by issuing fewer shares at the higher p/e multiple price Since most public companies trade at a higher multiple than private companies, acquisitions often create this synergy Financial Synergy Firm A Firm B Profit after tax $10,000,000.00 $1,000,000.00 # shares 10,000,000 1,000,000 Earnings per $1.00 $1.00 share Price per share $20.00 $10.00 Price/earnings 20/1 10/1 (p/e) Market $200 million $10 million Capitalization Offer price $15 million Shares of A 750,000 @ $20 required A + B Combined Profit after tax $11,000,000.00 # shares 10,750,000 Earnings per share $1.023 P/e ratio 20/1 Price per share $20.47 Market Capitalization $220,052,500.00 Increase in value $10,052,500.00 Firm A could give Firm B up to 1,000,000 shares ($20 million at $20 per share) and EPS would have stayed the same after the merger as before the merger. The p/e ratio could change if the market felt the risk was greater or the returns diminished as a result of the merger, but Firm A is 10 times larger than Firm B and should have little effect on Firm A’s p/e multiple Valuation Models Book Value o Appraised Book Value Market Value o Prior Sales of Stock/Transaction Analysis o Comparable Market Value Capitalization Models o Constant Growth Model o Discounted Cash Flow Model o Excess earnings Model Book Value Accounting Book Value Total Assets Less: Total Liabilities (Claims on Assets) Book Value of Owner’s Equity Are intangible assets recorded should they be included? Are the assets properly recorded (bad debts and obsolete inventory written off)? Have the fixed assets appreciated or depreciated less than shown on the books for GAAP or tax purposes? Service companies rarely have many assets Present Book Value Appraised Book Value Appraised Value of Fixed Assets + Adjusted Value of Current Assets + Income producing intangible assets Total Present Book Value Assets Less: Total Liabilities Present Book Value of Owners’ Equity Use of Book Value Technique Liquidation Purposes Financial Institutions Extractive Industries o Oil, Coal, Gravel, etc. o May trade at a discount or premium to book (bases on the quality and income producing capacity of the assets). Banks are currently trading at 1.5 to 3.0 times book. Market Value Previous Sales of Stock Arms Length Transaction Frequent Trades Financial information on company is regularly published in accessible financial media. Transaction Analysis o The best value might be a similar transaction of a similar company in the same industry. Merger and Acquisition Data Private transactions often prove difficult to obtain information about the transaction. Access to private data bases is often very expensive. Use of a financial intermediary may increase transaction costs. Comparable Market Value Surrogate Market Value based on valuation benchmarks of similar publicity traded companies. Price/Book Value Price/Earnings Price/Cash Flow Price/Revenues Price/EBITDA Comparable Firms should be similar in: Industry and Products Management Size and geographic area Accounting Methods Risk and Return Usually only publicly traded firm’s information can be found and do not meet the requirements above. Capitalization of Earnings Constant Earnings Model Average Earnings into Perpetuity Year 1 2 3 4 5 EAT $100 $200 $300 $400 $500 Average EAT= $1,500/5 = $300 If you expected to earn an average of $300 every year into perpetuity, what would be the value if you expected to earn 20% on your investment? The Present Value of $300 into Perpetuity at a 20% required rate of return is equal to: $300 PV = .20 = $1,500 Average EAT $300 Equity Cap Rate 20% PV $1,500 A cap rate of 20% is the equivalent to an earnings multiple of 5 times. Earning’s Adjustments Excessive compensation Tax Strategies o Excessive lease expense paid to owners o Personal expenses paid by the business Non-Recurring Income or Expenses Capitalization Models Constant Growth Model Projected Earnings Year 1 Equity Cap. Rate – Growth Rate All valuation models would add back surplus cash or undeveloped assets to the value of the cash flows. What is the value of an equity stream projected to be $100 in year 1 and expected to grow at 10% per year assuming the investor’s required rate of return is 20%? $100 PV $1,000 .20 .10 By paying $1,000 to receive $100 in year 1 with a 10% expected growth in the payment would give a perpetual 20% rate of return. Problem with this model is that few firms grow in a linear, constant growth fashion. Many firm’s growth rate would produce a negative denominator by growing faster than the required return. Discounted Cash Flows In a going concern, the value of the assets is the future income or cash flow the assets can produce, discounted the present value at a required rate of return commensurate with the risk in achieving the projected earnings or cash flow. Assumes the assets are used and reused (turned- over) to produce future income and cash flow. Equity Capitalization Rate Required R ate of Return (Opportunity Cost) Risk Free Rate o Treasury Bill or Treasury Bond + Risk Premium o Unique Risk of the Company Variability of Sales and Income, Small Firm Size Key Man, Lack of Succession, Concentration of Sales Market and Financial Risk CAPM Model In the Capital Asset pricing Model (CAPM), beta (covariance with a market index) is used to measure the unique risk or estimate the risk premium. Small businesses do not have betas and thus can not use the CAPM model. If venture capitalists required returns of 35% - 50% are an indication, betas would be 4 to 6. Equity Capitalization Rate Risk Premium is based upon the analysis and experience of the appraiser. Assuming a risk free rate of 6%, then the equity cap rate with the risk premium would range: o Low Risk 15% - 20% o Medium Risk 20% - 30% o High Risk 30% - 50% Discounted Cash Flow (DCF) FCF1 FCF 2 FCF 3 FCF n Firm Value (1 r) 1 (1 r) 2 (1 r) 3 (1 r) n Where FCF is “free cash flow and “r” is the required rate of return (weighted average cost of capital) Market value of the debt is then subtracted from this firm value to arrive at the value of the equity of the company. Free Cash Flow t NOPAT + Depreciation and Amortization - Δ in Net Working Capital* - Capital Expenditures (Δ in Gross F.A.) Free Cash Flow t * Δ W/C is the spontaneous assets and liabilities only (A/R, Inv, A/P and Acc. Exp) not CA-CL. Firm Value NOPAT is net operating profit after tax. NOPAT is EBIT (1-t) which equates to EAT + Interest (1-t). Since interest is included in the cash flows and no principal reduction to these FCFt these cash flows represent the cash flows to both creditors and owners. As a result, the cost of both debt and equity should be calculated to determine the WACC. When the FCFt are discounted at the WACC, the resulting value is Firm or Enterprise Value (Value of the Debt plus equity or Total Assets). Free Cash Flow to Shareholders FCFs = Net Income After Tax + Deprec. & Amort. - Δ Working Capital - CAPEX (Δ Gross F.A.) - Principal Repayment + Proceeds from new debt Equity Value The FCFs do not include interest and principal repayment and new borrowings are considered in the cash flows. Since the financing cash flows from debt are deducted, the remaining cash flows are for the shareholders. Equity Value The appropriate discount rate for the FCFs is the required rate of return for equity which can be determined using CAPM. The resulting value is the value of the equity of the firm. To get back to firm or enterprise value, the value of the debt (interest bearing debt, not working capital spontaneous liabilities) should be added to the value of the equity. APV – Adjusted Present Value Read the articles on reserve in the PCL Library under Nolen, Fin 393.4 – Valuation 1) Luehrman, HBR – Using APV: A Better Tool for Valuing Operations 2) Luehrman, HBR – What’s it Worth? A General manager’s Guide to Valuation APV Model Take the FCFs, including terminal value, but instead of using WACC, make the assumption that the firm is unlevered and use the Cost of Equity determined by CAPM (find comparable firms and unlever their beta to an asset beta). This will yield the value of the cash flows from an unlevered financing structure and would represent the equity value of the firm. Take the present value of the interest tax shields to determine the value from the financing decision. Use the firm’s average cost of debt to discount the tax shields. Add the present value of these tax shields to the value of the equity cash flows to get the value of APV. This is the M&M argument that the value of a levered firm is the value of an unlevered firm plus the present value of the tax shield. Option Model The various models presented previously are good for valuing “assets in place” where the value is not dependent on further discretionary investment and where most of the investment is up-front with few incremental operating expenses (i.e. the value of the proven reserves in an oil well). How do you value the probable and possible reserves? Additional exploration might yield additional cash flows i.e.”a call option”. The “growth option” can be regarded as call options since their ultimate value depends in part on further discretionary investment (R & D, etc.). Using the capital expenditures as the exercise price then determining the value of the future cash flows and standard deviation of those flows, the European Call (see page 345) can be used to determine the value of the option. Risk Factors Key Man Concentration of Customers Concentration of Suppliers Variability of Sales and Profits Regulatory Degree of Competition Discounted Cash Flow Projected earnings or cash flow o Usually forecast 5 years into the future. o Assume a residual value at the end of year 5 Can use the constant growth model or comparable value YEAR 1 2 3 4 5 Residual FCF $100 $200 $300 $400 $500 $5,000 PVF@20% .833 .694 .579 .482 .402 .402 PV = $83 $139 $174 $193 $201 $2,010 DCF Firm Value = $2,800 Residual Value Model Residual Values can be assumed to be the book value, market (IPO) value or capitalization of the last years cash flow into perpetuity. In our example, the $500 earnings in year 5 were capitalized into perpetuity using a 20% weighted average cost of capital and a 10% growth rate. The residual value was then discounted back to the present at the 20% WACC required return. Residual Value was calculated as follows: Year5FCF $500 WACC g .20 .10 Discounted Cash Flow Venture Capitalists usually place all the value on the exit point. They assume the company will “go public” with an IPO, be merged or sold, or will execute put agreements. Five to seven year holding period 35% to 50% required returns (5 to 7 times their initial investment back). Excess Earnings Model Total Tangible Assets of Company = $1 million Industry Average ROA 12% Projected cash Flow of Firm $150,000/yr. Cash Flow on Tangible Assets = $120,000 which might be discounted at a 20% discount rate. Excess Cash Flow = $30,000 which might be discounted at 25% or 30% due to the higher risk. Lack of Marketability Discounts range from 10% to over 50%, but studies of court cases found the average discount for lack of marketability is 35%. Thus if the surrogate market value or capitalized value of the company were $1 million, the value after this discount would be $650,000 at 35% discount. Do not use for book value technique. Minority Interest Discount A minority block of stock is worth less than controlling interest since the minority stockholder cannot influence the decisions of the company. Conversely, a majority interest has more value than a minority interest. An additional discount (on top of the marketability discount) for minority shares should be applied. The discount for minority interest can range from 10% to 25%. The combined discount for lack of marketability and a minority block of stock often total 50% to 60%. This explains why publicly traded companies trade at higher multiples than small firms as they exhibit liquidity Minority Interest Discount When using comparable market value, the valuation benchmarks of public companies already assume a minority block of stock is trading so no discount is applied to comparable market value technique, but is applied to the capitalization of income technique.