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CHAPTER 2 Valuation Approaches: How We Value a Business
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1 Forecast cash flows 2 Discount cash flows to present value This is the essential valuation arithmetic 3 Adjust for the level of control, ie, a control interest or a minority interest 4 Adjust for the level of marketability The first two steps forecasting cash flows and discounting them to present value are fundamental and primary in valuing your business In fact, the size of cash flows is the primary determinant of value 3 focuses on forecasting net income, and in 4 we will define and analyze cash flow and explain why it is so fundamental to valuation In 5, we will discuss discounting cash flows to present value The valuation adjustments in the final two steps, above, are part of the fine-tuning of the valuation and will be discussed in 8 For those readers who like to ponder the unity of the universe, notice that the Liquidating Balance Sheet is also in its essence a Discounted Cash Flow Method The difference is the underlying assumption of whether the business is more valuable dead or alive With the Liquidating Balance Sheet, we are valuing the business dead by assuming we liquidate it and turn it into cash The cash flow happens nearly immediately usually over a three- to six-month period Indeed, we may even discount the liquidating cash flows to present value and use that valuation for different assets and liabilities on the Liquidating Balance Sheet, depending on how long it takes to liquidate For example, suppose we estimate that it will take one month to liquidate inventory and three months to liquidate machinery and equipment, and that each one has the same net realizable value of \$300,000 While it is too early in this book to have developed the financial theory to explain the present value calculations, please take it on faith at the moment that the present value of the inventory is \$295,476, while the present value of the machinery and equipment is \$286,63315 Intuitively, it
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That is assuming a 20 percent discount rate In 4 we cover how to calculate present value
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makes sense that even though we expect to receive the same nominal amount of cash for both assets, it s the inventory that s more valuable This is because we expect to receive the cash for inventory two months earlier than the cash we expect to receive for the equipment, and we can invest the \$300,000 cash from the inventory for two months which we will not be able to do for the equipment Thus, at the end of three months, we should have \$300,000 for the equipment, but more than that for the inventory In other words, the curtain that separates the Liquidating Balance Sheet and the Discounted Cash Flow is much thinner and more transparent than one would have first thought
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Hybrid Method: Excess Earnings
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The Excess Earnings Method is a hybrid valuation method using the income statement and the balance sheet It is an inferior method and generally should not be used16 However, because it is somewhat mechanical and relatively simple, it frequently is used, and it s even unofficially required in valuation for property settlement in divorce proceedings in some jurisdictions We will only briefly go into this method, but it s important to know that it suffers from theoretical and empirical problems that can produce serious distortions of value if handled improperly, and even if handled properly for high-growth firms! For small, low-growth firms, its weaknesses matter much less It is not a tool for a business owner; but be forewarned: If you are involved in a divorce proceeding and the company being valued is a high-growth firm, it s extremely important to have a top-notch business valuator Too many small practitioners do not fully understand the limitations and the distortions in valuation that this method can produce The Excess Earnings Method involves calculating a normal return on tangible assets, then calculating excess returns by subtracting the required return on tangible assets from net
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16 It requires two discount rates instead of one, and generally neither of them are empirically observable
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