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CHAPTER 9 Increasing the Value of Your Business
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is the forecast (Year One) economic net income and Payout Ratio that we use in the formula Now let s modify the formula to produce the FMV of the firm n years from now In other words, with now being Year Zero, imagine yourself standing at the end of year n You will forecast economic net income and the Payout Ratio for Year n 1, as well as the discount rate (r) and the constant growth rate (g) that will apply at that time, ie, the end of Year n The valuation formula for the FMV of the firm as of the end of Year n is Equation 92 FMVn 110 Incn
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Payout Ration
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(92)
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This equation says that the Fair Market Value of the firm as of the end of Year n is approximately equal to 110 times economic net income forecast for Year n 1 times the Payout Ratio for Year n 1 times the end-of-year Gordon Model multiple, using the discount rate that we expect to prevail at the end of Year n and the average growth rates that we expect to prevail from the end of Year n to infinity So, if you want to know the valuation of the company 10 years from now, then n 10, and it is the forecast of economic net income and Payout Ratio for Year 11 that we use in the formula, and the discount and growth rates for the end of Year 10 However, Equation 92 is not a final equation for our analysis, as it has some hidden variables that we need to bring to light and explicitly incorporate into the future value equation So let s look at each variable to see what lies underneath it The factor 110 is not a variable, so we do not have to worry about it Let s look at the second term on the right-hand side, forecast economic net income in Year n 1 That equals actual economic net income last year times one plus the compound average growth rate for the n years to the nth power, which we show in Equation 93: Incn
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(93)
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The next term in Equation 92 is the Payout Ratio, the formula for which comes from 4 and is expressed in Equation 94:
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PART ONE Business Valuation
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1 Depreciation) Net Income Increase in NWC (94)
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(Capital Expenditures
Note that the net income in the denominator is for Year n 1, the first forecast year, which is defined by Equation 93 The final terms in Equation 92 are the discount rate and the growth rate that we expect to prevail at the end of Year n, which we will leave as is for now Substituting Equations 93 and 94 into Equation 92, our future valuation date equation becomes Equation 95: FMVn 1 110 Inc0(1 g)n 1 rn gn (95) (Cap Expend Depr) Incr NWC Inc0(1 g)n
Analysis of the Equation
Let s work to understand the meaning of Equation 95 The 110 is not a variable and certainly is not under your control Inc0 last year s economic net income is an historical number over which you have no control Nor will you have any significant control over depreciation expense in Year n, since that is a relatively mechanical calculation that results from your capital expenditures4 Thus, the only variables over which you have any control that determine the value of your business whether now or at a future date are the following: Growth rate for the first n years (g) Management of fixed assets (Capital Expenditures Depreciation) Management of net working capital (NWC) Discount rate (r), which measures the risk of your business
It is true that your depreciation policy, such as your choices of using accelerated depreciation and depreciable lives, may have some impact However, that should be immaterial
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