Conducting a Sound Valuation Analysis

Perhaps you want to sell your company or a portion of your company. You’re retiring without a successor. You need to raise cash to expand. Or you just want to know what you’ve built – what is the worth of my company?

Conducting a sound valuation analysis is always more of an art than a science. This means the valuation of a company is always an estimate. A company’s worth at any given point in time depends on its cash flow, the current valuations for similar companies and prevailing market conditions. The number of potential buyers alone can drive a company’s price up or down.

It’s like this: on the one hand, a company is worth whatever the market, or buyer, will bear. That’s reality. On the other hand, one cannot begin negotiations without a pretty clear idea of what one will and will not give up for a certain amount of cash.

So how does a valuation analyst start to get a handle on reality?

A good analyst will always provide a range of values for a company, with considerable back-up data, from which the negotiations may begin. There are several alternative approaches to valuing a company such an analyst will take. They include discounted cash flow analysis, ratio-based approaches, formulaic models for discounted cash flow analysis and options pricing.

This article describes the nuts and bolts of the various alternatives, as follows:

ALTERNATIVE #1. Discounted cash flow analysis [DCF].

To value a company using the DCF model, the analyst must:

A. Forecast a free cash flow
B. Estimate a discount rate
C. Estimate a terminal value
D. Calculate and interpret results

A. Forecasting free cash flow [FCF]

Free cash flow is a series of annual cash flows a business throws off for shareholders and creditors. FCF is essentially net operating profit plus non-cash charges (e.g. depreciation), less investments and increases in working capital, plus financial flows (e.g. increases and decreases in stock and bond issues and interest income/expense). In forecasting free cash flows, the analyst takes into account inflation, historical financial analyses, industry forecasts, the company’s internal plans, and strategy analysis.

B. Estimating a discount rate

The discount rate or cost of capital is the rate at which annual free cash flows in future years are discounted back to today’s value, i.e. the present value of $10 , 2 years out at a discount rate of 10% is $10/((1.1)squared) or $8.26. The appropriate discount rate comprises a weighted average of the costs of all sources of capital, is computed after-tax, uses nominal rates of return, adjusts for the investor’s systematic risk, employs market value weights. All of this means that the WACC or weighted average cost of capital for the company (its discount rate) is the weighted average cost of debt and equity capital for the company at its current debt and equity structure, taking to account the risk premiums debt and equity holders would require for investing in the particular sort of business. So, if a company has a tax rate of 30%, 60% debt at 10% and 40% equity costing 25% (investors’ expected returns) the WACC is 14.2% (((1-.3)x.6x.1)+(.4x.25)). You should note that debt and equity weightings are calculated at market, not book, value.

C. Estimating terminal value

Terminal value is the present value of cash flows after the explicit forecast period (the date for which the most up-to-date pro-formas are available, usually five to ten years). To find the value of a company, the present value of cash flows after the forecast period is added to the present value of cash flows during the forecast period. Terminal value equals the company’s last year cash flow times a growth rate, taking into account the requirement for investor returns, divided by the cost of capital less a growth rate.

In the case where the last year’s cash flow (in year 10) is $10 million, growth is flat and the cost of capital is 10%, the terminal value of the company is $100 million. The analyst would then discount that number back to year 0.

D. Calculating and interpreting results

Calculation involves discounting the free cash flows and terminal value back to the present day at the appropriate discount rate, given the company’s capital structure and WACC. The analyst then adds the value of non-operating assets whose cash flows were excluded from free cash flow and subtracts the market value of all debt to determine the value of the firm.

Interpreting results generally involves running sensitivities on the valuation model. Suppose, for example, company sales are 20% higher or lower than predicted? Variable costs are higher or lower? More debt or equity is required? A good analyst will run several scenarios, review the results and provide a range of possible valuations, all based on discounted cash flows. The analyst will then consider alternative valuation approaches.

Alternative valuation strategies are particularly crucial in cases where a company has little or no cash flow. Suppose the company is like AOL or Amazon.com, for example — no profits, no clear time frame for profitability and little or no cash flow. The analyst must turn to alternative valuation strategies to help interpret results.

ALTERNATIVE #2. Ratio-based approaches.

These include price-earnings ratios, market-to-book valuations, revenue-to-price ratios. Ratio-based approaches are, in general, price and not value oriented — the two are different. In buying or selling a company we are concerned with price, as well as value. Ratio-based approaches compare a company and its performance with the performance of like companies – a viable alternative for valuation.

ALTERNATIVE #3. Formula-based DCF approaches

These are variations on the discounted cash flow analysis, such as the Miller Modigliani DCF Formula and the Fruhan Model. (Please contact me if you’d like the exact mathematical models.) Formula-based DCF models make simplified assumptions about a business so that its value may be estimated using formulae rather than forecasting cash flows for each period.

ALTERNATIVE #4. Option pricing

This approach values the strategic and operating flexibility inherent in many situations, e.g. where opening and closings of various plants may produce varying results. Or where there are contingent assets and liabilities. In today’s shifting markets where technological and regulatory change are very rapid, a good analyst will always consider where and how he may apply option pricing.

These are the four key approaches to company valuation. They provide the ammunition you may need to enter into negotiations on price. They will also enable you to define the worth of your company, independent of the vicissitudes of the marketplace. And to determine whether today is the best time to buy or sell.