 |
||||
methodology The following information is for the person who wants to more fully understand the principles of this model. You do not need to understand it to use the model. ValueThisCompany.com uses the Discounted Cash Flow (DCF) method, by far the most used method in business. There are a variety of other methods used to value businesses including LBO, EVA, Liquidation Value and various market multiples models. While these models are often used to help a buyer triangulate to the fair market value of a company, they almost always complement the DCF model. They are seldom used as a substitute and there are some special cases where any one of those models might be weighted more heavily. But, again, a DCF valuation is virtually always used as a baseline. There are even models out there that will average results of ten different models. That puts equal weighting to all the different models, or at best, some subjective weighting of each method and will only serve to dilute the most widely accepted method, which is the DCF method.
In the final analysis, you can do all the analysis you want. But the true value of any company is what a buyer is willing to pay at a particular point in time. This model can help you make sure that you are either paying or selling at a price that is reasonable. More About the Discounted Cash Flow Method (for those who want the gory details!) The section explains some of the principles behind the DCF method. You do not need to understand this to use the model. This information is simply provided for background. The primary premise of this method is that all activities of a company can be translated into cash flows, either now or later. So, whether you are talking about sales, expenses, patents, competition or talent within the company, that all translates into cash flows somehow. The challenge for the appraiser or manager is to make reasonable assumptions around these parameters. One person’s evaluation of talent, for instance, might be very different than someone else’s. But DCF allows for questioning all of the assumptions and for performing sensitivity analysis. The primary steps involved are as follows:
The Terminal Value of a business is the present value at a future point in time of all future cash flows when we expect a stable growth rate forever. Forecasting results beyond such a period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years. Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. In this model it is a multiple of the final year’s income discounted back to present day using the discount rate. Note that because the Terminal Value represents all future years’ performance of the company, changing any values in the final year can have a dramatic effect on the overall value of the company. If the performance of the company seems to get dramatically better in the final year, the buyer may further discount that amount because the company has not shown that it can do that every year. In this case, you may want to select a lower terminal value or a higher discount factor. Calculate the appropriate discount rate. What does the term “Discounted” mean in the Discounted Cash Flow method? Quite simply, it is a factor that is used to discount future expected cash flows of a company into today’s dollars. Calculation of what is called the Weighted Average Cost of Capital (WACC) for a company can be very involved, involving lots of financial theory, and can make a big difference in determining company value. This model uses an industry-accepted approach to calculating this rate using principles taught in the leading business schools and financial communities. The formula for calculating the WACC is as follows: Debt / TF(cost of debt)(1-Tax) In this formula, *TF means Total Financing. Total Financing consists of the sum of the
Market values of debt and equity finance. As an example, assume the following for a given company: The Market value of debt = $300
million The WACC of this company is: 300/700*8%*(1-.35%) How is the cost of equity calculated, especially for a private firm? Essentially, this is the sum of the Risk-free Rate of Return (normally considered the yield on long-term Treasury bonds) and the Market Risk premium (the historical average excess return of S&P 500 funds over Treasury bonds) multiplied by the company equity beta. You will be asked in this model to identify the industry most closely related to the company you are valuing. Your answer correlates to an historical beta for that industry. Beta refers to the tendency of companies within that industry to correlate to swings in the broader market. It is really a measure of risk. Below is an example of the calculation of Cost of Equity for a company in the diversified chemical industry:
Since the cost of equity goes up for a risky firm, the person valuing the firm may want to add other premiums to the equity risk premium. Other considerations that might add to the risk of the firm could be in the area of:
Discount the annual cash flows and the terminal value to present. This model does this for you depending on your inputs. Interpret the results and perform sensitivity analysis. When you are finished entering the required information, you may want to test your assumptions. For instance, what if the company doesn’t get that contract? What if store traffic is much greater than what was expected? What if the market goes wild about the new product? What does that do to cash flows? All those parameters can be gamed to give you a feel for how the value of the business will be impacted. Below is a list of other factors that a buyer will take into account when valuing a business. Note that some of these questions are relevant only for a strategic buyer (another company, rather than an investor):
Note: If the model returns a negative number for the value of the company, it may not be in error. Remember, the DCF method simply assesses the value of the company based on the present value of all future cash flows. If it turns out that those cash flows end up being negative, that’s useful information. However, that doesn’t necessarily mean that the company is worthless. Look again at the list above. While the company may not be valuable to a strictly financial buyer (such as a silent investor) who cannot or will not add value to the company, a strategic buyer (such as another company in the same industry) may place a very different value on the company for any of the reasons noted above. In those cases, the seller needs to make an assessment as to how valuable the company would be in the hands of the right buyer. A buyer will likely not pay for all that synergy but will pay for some. There is much more that can be said about the DCF method. For additional resources, do a search on “Discounted Cash Flow Method” on the internet. By doing this, you will also learn about some of the pitfalls of this method. Every method has its shortcomings. But there’s no doubt that it is the most widely used method for valuing companies. |
Beware of simple valuation models
available on the web that claim to ascribe a value to your company of interest
by comparing to market multiples of a large database of similar companies. This shortcut method frequently has no
correlation with the specifics of your company of interest and usually the
multiples used are collected over several years and may not even include the
most recent year. Just think how
different the economic climate was in 2008 vs. 2007. Does it make sense to just average multiples
over the last 10 years? Does it make
sense to compare the multiples of your gourmet, high-end restaurant to all the
restaurants in the country, including all the franchise burger businesses? Of course not. Again, these alternative valuation models can
be helpful by providing additional points of reference. But don’t rely on them exclusively. A thorough DCF analysis is the one method
used by virtually all professionals, at least as a baseline valuation
method. And that’s true for small
businesses, medium-sized businesses and Fortune 500 companies. 
Projecting
operating results and free cash flows is determined by your entry of historical income statement and balance sheet
information and making assumptions about the future performance of the
company. Of course, the more thought
that goes into the future plans of a company, the more valuable are the projections. In most cases, business owners tend
to be very optimistic about the future of their company while buyers will tend
to significantly discount those projections. One thing is for sure, a potential buyer places way more credence to the
most recent performance of the company than they do to any future projections,
even if backed by a detailed business plan. 
This
model calculates WACC for you using the information you provide from the income
statement and balance sheet. You will
also have the option of entering your own WACC (discount rate).  |
|
|