Valuing Businesses

I. Introduction Anyone involved in business must value businesses for a variety of reasons. Bankers must assess collateral value in setting the terms of a loan. Investors will value the business based on their independent forecasts and then compare their valuation with the market price. If the market price is below their value, they will buy. If it is above their price, they either won=t buy or they will sell the security if it is already in their portfolio. Underwriters, or those assisting with the underwriting process, must offer the security at a fair price. Finance professionals advising clients on acquisitions, mergers, or divestitures must determine value to recommend whether the client should complete the transaction at the proposed price. Financial advisors may be required to offer fairness opinions for employee stock ownership plans, tax purposes, or private estate planning purposes. Bankers who try to adjust the required rate on non-investment grade debt instruments must often evaluate the underlying value of the businesses to fairly adjust for embedded options in the debt contracts. Virtually any decision in business is driven by the desire to add value. Businesses can be valued using a variety of approaches. This study will address three fundamental approaches, all of which have variants for particular assets or industries: Cost, Discounted Cash Flow (Income Approach), and Price/Characteristic ratios (Market or Sales Comparison Approach). II. Cost Approach In the Cost Approach to valuation, the appraiser attempts to estimate the cost to replicate or reproduce the assets or company and then adjust for various types of depreciation or intangibles. The simplest version of the Cost Approach is to estimate the value of the company as equal to the book value. For a company that has been recently purchased or has few intangible assets, the simple Book Value version may be reasonable. However, for the vast majority of companies, this approach will grossly mis-estimate the value of the company. Most companies have intangible values which stem from brand-name recognition, relationships with clients and customers, reputation, software, experience and knowledge, along with a variety of other values which are not captured in accounting numbers. In addition, the tangible assets may have been purchased long ago and the land, real property, or other asset may have changed substantially in value since the purchase. Inflation may have increased the market value of the old assets whereas the accounting depreciation would have reduced the book value from original purchase price. Alternatively, the tangible assets may reflect old technology and seriously overstate the market value; a number of computer, semiconductor, telecommunication, cable and other companies have written down assets which have been rendered obsolete by technological advancement. Adjusted Asset Valuation A more sophisticated version of the Cost Approach is commonly referred to as the Adjusted Asset Valuation. In the Adjusted Asset Valuation version of the Cost Approach, appraisers will look at each asset on the books and estimate the market value. For example, if the company owns 50 acres of land in Silicon Valley purchased 30 years ago for $1500/acre, the appraiser might write those assets up to over a million dollars per acre to reflect current values. If the books reflect obsolete 4-inch silicon wafer fabrication equipment, the appraiser might write the value of those assets to zero. The Adjusted Asset Valuation version can be very time-consuming and for many used assets, it is difficult to estimate the current market value. This approach may be particularly helpful, though, to get a thorough understanding of the individual assets, manufacturing technology employed, and a variety of other information which may be used to structure asset-based loans or leases and/or determine tax consequences of a transaction. The major drawback of this approach is that intangible assets which usually don=t appear on the books may be ignored completely. Of course, an appraiser could attempt to estimate the value of an intangible; for example, the value of brand identity may be approached by estimating the cost of advertising over time that would be required to build the same brand identity and discount those costs to present value. However, using a Cost Approach for intangibles is very subjective. Liquidation Value Another variant of the Cost Approach is the Liquidation version. The Liquidation version is similar to the Adjusted Asset Value version except that it is generally used to estimate Acontingent@ value rather than book value. Usually bankers do not care what the value of the collateral assets are. Only in the event of bankruptcy or inability to meet loan covenants do these asset values matter. However, if the company is bankrupt, the industry is obviously not doing well and the values of the assets may be much lower than they would be under normal circumstances. Hence, often in the Liquidation version, the appraiser will ask, AWhat is the value of this asset if (contingent on) the company is bankrupt?@ As a result, the Liquidation version values will be well below most adjusted asset values. Replacement Cost Another variant to the Cost Approach is the Replacement Cost version. In the Replacement Cost version, the appraiser will estimate what it would cost to build the productive capacity of the assets using current technology. For example, a semiconductor plant may have a book value of $1.5 billion, but due to technological advancement, the same capacity could be built today for newer, more advanced chips with the same capability for $.7 billion. The reproduction cost of $.7 billion would be used to estimate the value of the old plant even though the old plant cost much more to make originally. III. Discounted Cash Flow Approach Perhaps the most basic approach to valuing a business is the Discounted Cash Flow or Income Approach. This approach requires the appraiser to estimate the cash flows after all operating expenses, taxes, and necessary investments in working capital and property, plant and equipment. What is left is the cash that is available to pay off the various sources of financing, whether the sources are banks, bond-holders, equity investors, or others. This cash flow is referred to as free cash flow (FCF). This cash flow is then discounted at a cost of capital, which reflects the investors= required return for an investment of the risk of the particular business. The reason the Discounted Cash Flow approach, or Income Approach, is so critical to most appraisals stems from the definition of value: value is the transaction price between a willing buyer and willing seller. The buyer must usually obtain financing and the suppliers of capital will require a return on their investment from the cash flows of the firm. The Discounted Cash Flow approach estimates value as the highest price a willing buyer could pay and still be able to compensate the investors for their required return on capital. In the Discounted Cash Flow approach, the appraiser first estimates after-tax cash flow available to pay off all investors (equity investors and debt-holders): Revenues - Costs = Earnings before interest and taxes (EBIT) - Taxes payable on EBIT = Net operating profit after tax (NOPAT) + Any noncash costs subtracted in "Costs" (e.g., depreci­ation) + Any capital expenditures needed to achieve revenue forecast (e.g., new equipment) + Investment in net working capital (e.g, additions to inventories, accounts receivable, etc. less accounts payables and other current liabilities) = Free Cash Flow Note that the estimated taxes in this approach are more than the actual taxes that will likely be paid since interest payments are not subtracted before calculating taxes. This approach values the assets and ignores financing at this point. The tax benefit of tax-deductible interest payments will be adjusted for later in the calculation of the weighted average cost of capital (WACC). The appraiser then discounts these free cash flows at the after-tax cost of raising the money. If money is raised with both debt and equity investors, then this cost is given by: Interest on debt x (1 - Tax rate) x (% Funded with Debt) + Required return on equity x (% Funded with Equity) For example, as a client is acquiring a business, financing sources are contacted to determine required rates of return on the business. Suppose that with a capital structure of 40% debt, an insurance company would be willing to accept 8% interest on long term debt for the type of business involved. Private equity investors would require 16% return to attract them into the venture. The business will be incorporated and be in the 40% tax bracket. The average cost of funds for this business is: 8% x (1 - 40%) x 40% + 16% x 60% =11.52 % This 11.52% is also referred to as the "cost of capital" or the "weighted average cost of capital@ (WACC) since it reflects the return the overall business must earn to compensate investors. Example of Limited-Life Business Asset Valuation An example will be helpful at this point. In this first example, a company or project will start at $22 million in revenues and will decline over time. This example is based on an older oil well; revenues decline as the resource is depleted. This will provide an interesting contrast to the example of a company that is expected to grow over time which will be presented later. The com­pany will be financed with 40% debt costing 8% per year and 60% equity on which investors demand a 16% return; thus we will have an 11.52% cost of capital. The first step is to forecast the company's income statement­: Forecasted Company Partial Income Statement Year 1 Year 2 Year 3 Year 4 Year 5 Revenues $22,000 $20,680 $19,439 $18,273 $17,176 - Operating Exp 13,342 12,598 11,933 11,343 10,822 - Depreciation 4,050 4,050 4,050 4,050 4,050 EBIT $4,608 $4,032 $3,456 $2,880 $2,304 EBIT is sometimes referred to as operating profits. This partial income statement is used together with capital expenditure information to generate the free cash flow from operations: Free Cash Flow from Operations Year 1 Year 2 Year 3 Year 4 Year 5 EBIT $4,608 $4,032 $3,456 $2,880 $2,304 - Taxes @ 40% 1,843 1,613 1,382 1,152 922 NOPAT 2,765 2,419 2,074 1,728 1,382 + Dep'n 4,050 4,050 4,050 4,050 4,050 - Cap Exp 1,300 1,300 1,300 1,300 1,300 + ΔNWC 250 250 250 250 250 Operating Cash Flow $5,765 $5,419 $5,074 $4,728 $4,382 Note that since revenues are declining, net working capital require­ments decline over time and provide positive cash inflow. Positive cash inflow from net working capital is unusual since most businesses grow and growing businesses must typically add to inventories and accounts receivable. An estimate of the terminal value of the company needs to be added in year 5 to the operating cash flow. Since revenues are declining, an estimate of the salvage value of the assets (including net working capital) in year 5 is needed. To find the operating cash flow, look at the used asset market for 5 year-old drilling equipment. Assume that the salvage value of the assets net of taxes is $9,000 in year 5. Hence the total free cash flows are: Year 1 Year 2 Year 3 Year 4 Year 5 Operating Cash Flow $5,765 $5,419 $5,074 $4,728 $4,382 Terminal Value $9,000 Free Cash Flow 5,765 5,419 5,074 4,728 13,382 PV Factor @(11.52) .8967 .8041 .7210 .6465 .5797 Present Value $5,169 $4,357 $3,658 $3,057 $7,758 Summing these present values will yield a net present value of $24,000. Hence the value of the assets of the company is estimated to be $24,000 at the11.52% cost of capital. If the value of the equity is desired it can be determined by noting that the cost of capital calculation assumed that equity was 60% of financing. Thus the estimated value of equity is: 60% x $24,000 = $14,400. To get the price per share would require dividing $14,400 by the number of shares outstanding. Example of Limited-Life Business Equity Valuation Often the value of the stock or equity position in a company is desired rather than the value of the assets. Valuing a business using the Free Cash Flow to Equity-Holder version is very similar to using the Asset valuation discussed above. However, there is one critical difference; whereas Asset valuation requires estimating the cash flow available to both the debt and equity-holders, Equity valuation requires estimating only­ free cash flow to equity-holders after debt-holders have been paid off: Revenues - Costs = Earnings before interest and taxes (EBIT) - Interest = Profit before tax - Taxes payable = Net profit after tax + Any noncash costs subtracted in "costs" (depreciation) + Any investments in plant and equipment nee­ded to achieve revenue forecast + Changes in net working capital + Any principal payments to or from debt-holders (repayments of a loan are negative and new loans are positive) = Free Cash Flow to Equity-holders In this approach an appraiser must look at the company solely from the standpoint of the equity investor. It is necessary to explicitly forecast how much debt the company will have over time and what that debt will cost. Forecasting future interest rates is difficult and hence most appraisers prefer to use the first or Asset approach. However, for finance companies an appraiser may simply assume that assets will earn a fixed spread over the cost of debt. In this special case, it is not necessary to forecast interest rates explicitly; an appraiser can simply estimate the amount of net operating profits as this spread times the amount of loans outstanding. It will be useful to demonstrate this approach using the prior example in which the assets were valued. To be consistent with the earlier example assume there is $9,600 in debt costing 8%. Perhaps this is the debt still outstanding and the buyer can assume the existing debt. Also assume that $1,200 in principal must be paid at the end of each year. Again, the first step is to forecast the company's income statement: Forecasted Company Income Statement Year 1 Year 2 Year 3 Year 4 Year 5 Revenues $22,000 $20,680 $19,439 $18,273 $17,176 Operating Exp 13,342 12,598 11,933 1,134 10,822 Depreciation 4,050 4,050 4,050 4,050 4,050 EBIT 4,608 4,032 3,456 2,880 2,304 Interest 768 672 576 480 384 Profit 3,840 3,360 2,880 2,400 1,920 Taxes 1536 1344 1152 960 768 Net Profit $2,304 $2,016 $1,728 $1,440 $1,152 Note that the interest decreases as the debt is paid down. Just as before, forecast cash flow from operations, but this time adjust for payments to debt-holders by using profit after tax (which reflects interest payments on the debt) and also adjust for principal payments: Free Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Profit After Tax $2,304 $2,016 $1,728 $1,440 $1,152 + Depn 4,050 4,050 4,050 4,050 4,050 - Cap Exp 1,300 1,300 1,300 1,300 1,300 + ΔNWC 250 250 250 250 250 - Debt Payment 1,200 1,200 1,200 1,200 1,200 Operating Cash Flow $4,104 $3,816 $3,528 $3,240 $2,952 To these operating cash flows, an estimate of the terminal value of the equity must be added to get the total free cash flow. The salvage value of the assets is $9,000 from the previous analysis. However, to get the value to the equity-holders, the appraiser must subtract the remaining debt. The company started with $9,600 and has repaid $1,200 per year for five years. Therefore, $3,600 in debt is still outstanding after five years. The value of the terminal equity is: $9,000 - $3,600 = $5,400. Hence the total free cash flows are: Year 1 Year 2 Year 3 Year 4 Year 5 Operating Cash Flow $4,104 $3,816 $3,528 $3,240 $2,952 Terminal Value $5,400 Free Cash Flow 4,104 3,816 3,528 3,240 8,352 PV Factor @16% 0.8621 0.7432 0.6407 0.5523 0.4761 Present Value $3,538 $2,836 $2,260 $1,789 $3,976 Note that the cash flows were discounted not at the weighted average cost of capital, but rather at the cost of equity since these are cash flows solely to equity investors. The sum of these present values is $14,400. Thus an equity investor would be willing to pay $14,400 for the equity of this company today. If the total value of the company (the value of the assets) is desired, one would add the $9,600 in debt (which we assumed at the beginning) for a total value of $24,000. This Equity value version should produce the same results as the Asset valuation version if the assumptions are identical. However, keeping assumptions constant across both free cash flow versions is difficult. For example, since in this approach the explicit amount of debt is forecasted, it could be that the value of the debt to the value of the equity is changing over time and therefore the assumption of 60% equity and 40% debt was changed without the appraiser actually knowing it since the value of the company was not explicitly calculated each period. Example of Growing Company Asset Valuation The prior two examples were based on a company that is expected to be liquidated after five years. A more common situation is a company that will grow indefinitely into the future. Although the basic valuation approach is the same as before, the assumption of a perpetually growing company produces some additional complications. Suppose a company is expected to grow at 9% for five years and at 6% thereafter. As before, the company will be financed with 40% debt costing 8% per year and 60% equity on which investors demand a 16% return. Therefore, the weighted cost of capital is 11.52%: 8% x (1 - 40%) x 40% + 16% x 60% =11.52 % First forecast the company's partial income statement just as before: Forecasted Company Partial Income Statement Year 1 Year 2 Year 3 Year 4 Year 5 Revenues $22,000 $23,980 $26,138 $28,491 $31,055 Operating Exp 15,472 16,864 18,382 20,037 21,840 Depreciation 1,920 2,093 2,281 2,486 2,710 EBIT $4,608 $5,023 $5,475 $5,967 $6,505 Note that the appraiser must decide how many years to forecast. The company will continue indefinitely, but the appraiser must decide to cut off the forecast at some point. The general principle in this decision is to forecast at least through any unusual period. In this case, the company grows rapidly for five years and then drops to a long run growth rate thereafter. Hence five years would be a natural forecast period. If the company has a major restructuring period in which new businesses will be entered and other businesses divested, the appraiser should forecast for at least the restructuring period until the company reaches a stable growth. Next, the partial income statement is used together with capital expenditure information to generate the free cash flow from operations: Free Cash Flow from Operations Year 1 Year 2 Year 3 Year 4 Year 5 EBIT $4,608 $5,023 $5,475 $5,967 $6,505 - Taxes 1,843 2,009 2,190 2,387 2,602 NOPAT 2,765 3,014 3,285 3,580 3,903 + Dep'n 1,920 2,093 2,281 2,486 2,710 - Cap Exp 3,864 4,212 4,591 5,004 4,540 - ΔNWC 216 235 257 280 203 Operating Cash Flow $605 $659 $719 $783 $1,870 Note that there is a large increase in cash flow in the last year. This reflects the decreased capital expenditure needs due to the lower 6% forecasted growth from year 6 on as compared with the 9% previous growth. An estimate of the terminal value of the company needs to be added to the operating cash flow in year 5. If the company will grow at 6% per year, then presumably the cash flows will also grow at 6% per year. Hence the cash flow for year 6 should be: $1,870 x 1.06 = $1,982 If this cash flow grows continually at 6% after year 6, then the value of the company in year 5 will be (using the Gordon Growth model for a perpetually growing cash flow): $1,982/(11.52% - 6%) = $35,911 Hence the total free cash flows are: Year 1 Year 2 Year 3 Year 4 Year 5 Operating Cash Flow $605 $659 $719 $783 $1,870 Terminal Value $35,911 Free Cash Flow 605 659 719 783 37781 PV Factor @11.52 % .8967 .8041 .7210 .6465 .5797 Present Value $542 $530 $518 $506 $21,903 Summing these present values will yield a net present value of $24,000. Hence the value of the assets of the company is estimated to be $24,000 at the 11.52% cost of capital. Contrasting this with the declining company of the first example will illustrate a very important point. The two examples are two companies with the same starting revenues, debt/equity, and risk. The first shrinks and dies and is worth $24 million; the second grows rapidly at first and then grows forever thereafter, but is still worth the same $24 million. How can this be? The answer stems from the fundamental notion of creating shareholder value: value is only created if the company can earn more than the cost of capital. In these examples, both companies only earned their cost of capital in the future. Hence all of the growth of the second company added no value. That is, the incremental profits in later years just compensated investors for the incremental capital expenditures in prior years. All of these investments had zero net present values and hence did not affect today=s share value. A company can be expected grow extremely rapidly, but if it does not earn more than its cost of capital, today=s share price will remain unaffected. Example of Growing Business Equity Valuation For completeness, valuing the company solely from the standpoint of the equity investor using free cash flows to equity-holders is illustrated next. Assume the same growing company but now there is $14,400 million in debt costing 8%. Also, assume that as revenues and assets grow, additional debt at the same 8% rate is attainable since the same debt/equity ratio will be maintained. The first step is to forecast the company's complete income statement: Forecasted Company Income Statement Year 1 Year 2 Year 3 Year 4 Year 5 Revenues $22,000 $23,980 $26,138 $28,491 $31,055 Operating Exp 15,472 16,864 18,382 20,037 21,840 Depreciation 1,920 2,093 2,281 2,486 2,710 EBIT 4,608 5,023 5,475 5,967 6,505 Interest 768 837 912 995 1,084 Pretax Profit 3,840 4,168 4,562 4,973 5,420 Taxes (40%) 1,536 1,674 1,825 1,989 2,168 Profit $2,304 $2,511 $2,737 $2,984 $3,252 Note that the amount of interest in each period must be explicitly forecasted; this requires explicitly forecasting the amount of debt necessary to maintain the constant debt/equity ratio. Just as before, subtract cash flow needed for working capital and capital expenditures, but this time also adjust for payments to debt-holders by using profit after tax (which reflects interest payments on the debt) and also adjust for principal repayments of new debt: Free Cash Flow Year 1 Year 2 Year 3 Year 4 Year 5 Profit After Tax $2,304 $2,511 $2,737 $2,984 $3,252 + Dep'n 1,920 2,093 2,281 2,486 2,710 - Cap Exp 3,864 4,212 4,591 5,004 4,540 - ΔNWC 216 235 257 280 203 + New Debt 864 942 1,027 1,119 813 Operating Cash Flow $1,008 $1,099 $1,198 $1,305 $2,033 Note that there is added debt. This is because debt has grown with revenues and assets. That is, if assets are expected to grow during the coming year, it will be necessary to use more debt to fund capital expenditures to maintain the same debt/equity ratio. Also, it is necessary to increase interest payments in the forecasted income statement to reflect the additional debt outstanding. As a result, additional future debt was added to meet any principal payment coming due and then more debt was taken on to purchase new equipment and maintain the 40/60 debt/equity ratio. An estimate of the terminal value of the equity needs to be added to these operating cash flows in year 5. If the company will grow at 6% per year, then presumably the cash flows will grow at 6% per year. The cash flow to equityholders for year 6 should be: $2,033 x 1.06 = $2,154. If this cash flow grows continually at 6% after year 6, then the value of the equity of the company in year 5 will be: $2,154/(16% - 6%) = $21,540. Hence the total free cash flows are: Year 1 Year 2 Year 3 Year 4 Year 5 Optg Cash Flow $1,008 $1,099 $1,198 $1,305 $2,033 Terminal Value $21,546 Free Cash Flow 1,008 1,099 1,198 1,305 23,579 PV Factor @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761 Present Value $869 $817 $767 $721 $11,226 The sum of these present values is $14,400. Hence an equity investor would be willing to pay $14,400 for the equity of this company today. If the total value of the company is desired, one would add the $9,600 in debt (which we assumed at the beginning) for a total value of $24,000 just as we had before. Discounted Dividend Valuation An alternative approach for Equity valuation is the Discounted Dividend version. In this version of the Discounted Cash Flow approach, dividends are forecast and discounted at a rate appropriate for the risk of the dividends which is the cost of equity. Use the forecasted profits of the previous company and estimate a payout ratio to obtain dividends. Assume a 40% payout ratio during the fast growth years and a 65% payout ratio as capital expenditures adjust to the slower growth after year five. To obtain a terminal value, first use the income statement forecasted earlier and estimate year 6 profit after tax: $3,252 x 1.06 = $3,447 Hence the dividend in year 6 will be: $3,447 x 65% = $2,240 and the terminal value will be: $2,240 / (16% - 6%) = $22,400 Therefore, total cash flows to investors will be: Year 1 Year 2 Year 3 Year 4 Year 5 Profit After Tax $2,304 $2,511 $2,737 $2,984 $3,252 Payout Ratio 40% 40% 40% 40% 65% Dividend 9,22 1,005 1,095 1,193 2,082 Terminal Value $22,400 Total Cash Value 922 1,005 1,095 1,193 24,482 Present Value@16% $794 $747 $701 $659 $11,499 Note that the cost of equity is used to discount the cash flows since dividends represent cash flow to equityholders only. The sum of these present values is $14,400. Hence an equity investor would be willing to pay $14,400 for the equity of this company today. If the total value of the company is desired, one would add the $9,600 in debt (which was assumed at the beginning) for a total value of $24,000 just as we had before. Inexperienced appraisers need to be very cautious using the Discounted Dividend version of the Discounted Cash Flow approach to avoid a couple of common errors. If free cash flow is different than dividends, the appraiser must explicitly state what happens to the difference and adjust the valuation accordingly. For example, if free cash flows exceed the dividend and the value is simplistically determined by discounting the dividend without accounting for the extra cash, the equity will be undervalued. That is, if the excess free cash flows are invested in securities (short term, interest bearing instruments) the riskiness of the firm will decrease (since more of the assets are low risk securities) so the appraiser should discount the dividends at a lower rate to reflect the lower risk. The lower discount rate will result in a higher value than the unadjusted value. If free cash flows are less than dividends, then this approach might result in an overvaluation error. If dividends exceed free cash flow, then the appraiser must say where the additional funds necessary to make the capital expenditures come from. If the difference will be financed with debt, the cash flows to equity holders are more leveraged. The increased leverage would likely justify a higher discount rate on the dividends. The higher discount rate would result in a lower value. Both of these problems can be avoided if the appraiser makes sure that the dividend payout rate exactly corresponds with the growth assumption. A company which pays out most of its earnings in dividends cannot grow as rapidly as one that retains more of its earnings. A company that is maintaining its debt/equity ratio and does not seek external financing can only grow at the sustainable growth rate of Sustainable Growth = Return on Equity x (1 - Payout Ratio). (See "Sustainable Growth and the Interdependence of Financial Goals and Policies," Harvard Business School Case Note #9-282-045, Cambridge, 1982, for a more detail discussion of this topic.) In addition to choosing which Discounted Cash Flow version to use, an appraiser must decide whether to forecast real or nominal (including inflation) cash flows. As long as the appraiser makes consistent assumptions (nominal cash flows paired with nominal growth and real discount rates, or real cash flows paired with real growth and real discount rates) both the nominal and real approaches will yield the same present value. Special Considerations in Discounted Cash Flow In a merger or acquisition situation, the appropriate value is determined by the way the acquirer will operate the business. A common problem could occur when a privately held company is acquired and the expenses may change dramatically. For example, family owned businesses have a tax incentive to pay unusually large salaries rather than take cash out of the company in the form of dividends. By paying large salaries and reporting small profits the family only pays one layer of taxes rather than paying taxes at the business level and again when the dividends are reported as income. To correctly value the business, the appraiser must reconstruct the forecasted financial statements to reflect the salaries that would be paid to managers rather than the off-market salaries paid to family. Another valuation difference rising in a merger or acquisition stems from synergies. The most frequently cited reason for mergers and acquisitions are synergies such as increased revenues through joint-product development and sales, reduced cost through economies of scale, increased growth through greater negotiating power with distribution channels and a variety of other revenue-enhancing or cost-reducing opportunities. To determine the maximum possible price that could be paid without harming the acquirer=s share price, sometimes referred to as the walkaway price, the cash flows from these synergies should be included in the forecast. IV. Valuing Companies Using Price/Characteristic Ratios One of the most commonly used approaches to value companies involves the use of ratios from similar companies with known stock prices. The Price/Characteristic Ratio technique appears to be very simple and straight forward since the appraiser does not need to make an explicit forecast of cash flows. However, this approach is fraught with hidden difficulties which can result in significant mis-estimates of value. For these reasons, many bankers will generally start with a Discounted Cash Flow approach to valuation and then use a variety of ratios to check whether the Discounted Cash Flow approach is producing valuations similar to other companies. The cash flow forecast is necessary since the bank is often a participant in the financing and wants to make sure that the cash flows are sufficient to meet debt repayment schedules. The other advantage of the Discounted Cash Flow approach is that it provides the finance specialist with critical information necessary to structure the optimal financial policy and securities to issue. The key to the Price/Characteristic Ratio approach is to find a set of companies that are very similar or Acomparable@ to the business being valued, and which have traded stock prices. After finding a comparable business, the appraiser computes the total market value. The total market value is computed as: Total Value = Market value of debt + Market value of equity Although this appears simple, there are a couple of tricky issues. The ATotal Value@ refers to the value of the fixed assets plus net working capital. Usually net working capital is computed as current assets less current liabilities. However, an appraiser must be more detailed than simply using all current assets and all current liabilities. The Liability and Equity side of the balance sheet is divided into Acapital@ and Aspontaneous financing.@ Spontaneous financing refers to liabilities that arise purely as part of the operations of company. These include accounts payable, wages payable, taxes payable, accruals, etc. For valuation purposes, net working capital is calculated as current assets less spontaneous financing. For example, suppose a company has the following balance sheet: Balance Sheet of XYZ Company ($=s in thousands) Assets: Liabilities and Equity: Cash $10,000 Accounts Payable $90,000 Accounts Receivable 80,000 Wages Payable 15,000 Inventory 95,000 Bank Loan 240,000 Total Current Assets $185,000 Total Current Liabilities $345,000 Gross Fixed Assets $460,000 Long Term Debt 100,000 Acc. Depreciation 85,000 Common Stock 45,000 Net Fixed Assets $375,000 Retained Earnings 70,000 Total Assets $560,000 Total Liabilities and Equity $560,000 The net working capital of this company is $80,000 (185,000 -90,000-15,000), not negative $160,000 ($185,000-345,000). The bank loan is considered part of the capital and is therefore treated as part of the financing. The market value of the debt would be the market value of the $240,000 face-value loan and the market value of the long term debt with face value of $100,000. Often, the debt is not traded and it is not possible to determine market value directly. If the payment terms of the debt instruments are known, the appraiser will discount the cash flows of the loans at prevailing market rates (which depend upon the riskiness of the debt) to obtain the market value of the debt instruments. Often, the terms of the debt are not known and appraisers will estimate the market value as book value. Suppose that the market value of the total debt in this example is $330,000. That is, suppose market interest rates have risen slightly since the issuance of the debt and the debt is selling at a discount from its book value of $340,000. The market value of the equity is estimated as price times the number of shares outstanding. Suppose XYZ company has 10 million shares which are trading at $22 each. This would be a market equity value of: $22 x 10 million shares = $220,000 which is more than the book value of equity of $115,000 (Common Stock plus Retained Earnings). Hence the total market value of this comparable would be $550,000 = $330,000 + $220,000. The $550,000 represents the market value of XYZ company which is one of the Acomparable@ companies used to value the subject company. This market value is then divided by some characteristic of the company to compute a Price/Characteristic Ratio. One of the common characteristics is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization--one estimate of pretax cash flow). Suppose XYZ company has EBITDA of $88,000. This would lead to a Price/EBITDA, ratio of $550,000 / $88,000 = 6.25 The price/EBITDA ratio would then be computed for all of the companies selected as comparable to the company being valued. At this point, the appraiser would look at each of the similar companies selected and compare them to the subject company and make an adjustment for any differences. For example, suppose the appraiser had five comparables with Price/EBITDA ratios of the following: Company Price/EBITDA Company A 6.2 Company B 7.5 Company C 5.7 Company D 8.0 Company E 5.0 At this point the appraiser must use his or her own judgment. The appraiser might say, for example, that even though Companies B & D are in the same industry, their earnings are expected to grow more rapidly than the company we are trying to value because they are in faster growing regions of the country or have new, hot products. The faster growth would raise the price of their shares compared to current earnings (since current earnings do not reflect the future potential) and raise their Price/EBITDA ratio compared to the subject company. The appraiser might decide that since company E is facing litigation, its stock price is low. Our subject company, which is not facing such litigation, should trade at a higher Price/EBITDA ratio. After making all such adjustments, suppose the appraiser feels comfortable with a Price/EBITDA ratio of 6.0 and that the subject company has EBITDA of $12 million. The appraiser would then estimate the asset value of the subject company (fixed assets plus net working capital) as: $12 million x 6 = $72 million. A variety of ratios are commonly used in the Price/Characteristic Ratio approach, each with a different set of considerations. A fundamental principle in valuation is that assets are worth the present value of their future benefits. For investors, those benefits are usually cash flows and therefore an asset should usually sell for the present value of its future cash flows. An appraiser thinking of using a price/characteristic multiple to value a business must answer the question: Under what circumstances will the assets of two firms sell for the same multiple? The answer comes from the fundamental principle: two firms will sell for the same price relative to the characteristic if they have substantially similar cash flows in all future periods relative to the characteristic. Of course, it could be the case that two firms with substantially different cash flows may happen to sell for the same price relative, but that would be a coincidence an appraiser should not rely on. For example, a clothing manufacturer may sell for the same P/E as a steel company, but one would not rely on that coincidence for valuation purposes. Even firms within the same industry can, do, and should sell for different multiples of reported earnings. The fact that, in principle, one must forecast all the future cash flows of the subject company as well as any >comparable= to justify its use introduces a great deal of subjectivity and judgment into the analysis. Some of the issues that must be addressed to determine comparability are the following. First, it is dangerous to use the ratio of a conglomerate to estimate the stock price of a less-diversified firm such as a single division. Unless one can >back out= the earnings and values of the non-comparable businesses in the conglomerate, an appraiser cannot have much confidence in the usefulness of the conglomerate's ratio as an estimate. Second, since the characteristic used comes from the accounting system of the subject or comparable companies, the accounting systems employed need to be highly similar. This problem is particularly acute when small companies are involved since small companies have great capacity to mold the accounting numbers. (See Levin, Richard I. and Travis, Virginia R., "Small Company Finance: What the Books Don't Say," Harvard Business Review, November/December 1987 for examples of major distortions caused by accounting systems.) Third, comparability in size, management philosophy, competitive position, geographical location, regulators (if any), industry environment, customer base, age of assets, marketing and operational strategies, and a host of other variables may also be necessary. The financial conditions of the firms should also be highly comparable as measured by a variety of financial ratios such as debt/equity, current, quick, inventory turns, sales/assets, payout, return on sales, return on equity, return on assets, as well as working capital ratios (e.g. working capital/assets, days in receivables, payables period, etc.). Be aware that most cases in which price/characteristic ratios are used are those in which the appraiser is valuing only the equity of the company. If one sees AP/E ratio@ referred to in a newspaper, report, or magazine it almost always means the stock price divided by the earnings per share of the company. Appraisers that are only valuing equity will use ratios computed using only stock price. However, if it is the value of the assets (fixed assets plus net working capital) that is desired, the total market value of the company is used in the numerator, rather than just stock value; of course, in this case, the denominator must also reflect value or earnings for both stock and debt holders as well. Price/Earnings Ratios The Price/Earnings Ratio is used so commonly that the Wall Street Journal actually uses valuable space to list the P/E ratios of stocks traded on the New York Stock Exchange. Three P/E ratios are frequently used: Lagged, Leading, and Straddle. The Lagged P/E is the most common and is the current stock price divided by the previous four quarters of earnings. The Leading P/E is current stock price divided by a forecast of the next four quarters earnings. This ratio is used when past earnings are negative or are seriously distorted due to extraordinary losses or gains. The Straddle P/E, which is used by Value Line and a number of other reporting services is current stock price divided by the sum of the past two quarters of earnings plus a forecast of the next two quarters. Of course, the appraiser must compute the ratio the same way for all the comparable companies and multiply the corresponding earnings (past four quarters, forecasted four quarters, or straddle earnings) for the subject company. When an appraiser uses a P/E ratio, a number of the factors mentioned earlier become particularly critical. For example, the same debt/equity ratio is required since interest payments are subtracted to obtain net earnings. A company with identical assets but a different debt level to the subject firm should have a different P/E ratio. The firm with higher debt will have more interest and relatively less total earnings to common (although it may have higher earnings per share since the number of shares outstanding would be fewer). The lower firm=s earnings will also have greater risk or volatility due to the increased leverage. A riskier earnings stream should not sell at the same price/earnings as a less risky one. Using a conglomerate's P/E to value a subsidiary can create a number of potential errors. Often a conglomerate will have a new subsidiary that is expected to generate substantial cash flows in the future, but is currently showing small or even negative earnings. A subsidiary which has value but has negative earnings (which will reduce the conglomerate's reported earnings) can dramatically distort the P/E ratio of the conglomerate compared to the operating subsidiary. For example, suppose a company has a profitable operating division and a new division which is currently experiencing startup losses: Unit Value Earnings P/E Ratio Operating Division $100 million $10 million 10 Start up Operations $20 million ($2 million) n.a. Combined Operations $120 million $8 million 15 Since divisions do not usually have separately traded stock prices, the only ratio that is observable for this company is the combined ratio of 15. If an appraiser were to use the only observable ratio to value the operating division, the value would be estimated as P/E x Earnings = 15 x $10 million = $150 million. This $150 million is a 50% overvaluation to the actual value of $100 million. Appraisers must be very careful to adjust for the distortions caused by other subsidiaries when computing the ratios of the comparables. Often these conditions will affect all of the comparable companies in exactly the same direction since the comparable companies may have similar subsidiaries. For example, consider the regional telephone companies; all have residential phone service divisions and cellular telephone operations. Since the cellular operations have much greater growth potential, they will raise the observed P/Es of all of the regional telephone companies. To use the observed P/Es to value the residential phone service divisions would result in significant over-valuations. When an appraiser is trying to value the assets (fixed assets plus net working capital), rather than just equity, the Aearnings@ used in the denominator must reflect total earnings capacity. Appraisers will use pre-tax operating earnings or EBITDA or some other measure to total earnings before interest in the denominators; the numerator in this case should be total market value as discussed earlier. When significant differences in debt/equity ratios exist, the total market value ratios should be used rather than ratios computed share prices only. Price/Cash Flow Ratio Price/Cash Flow ratios have become very popular in recent years due to the focus on cash flow to place securities in the capital markets. One difficulty in the use of the Price/Cash Flow ratio is in the definition of >cash flow.= The definition employed by Value Line, for example, is earnings plus noncash charges. Although this definition overstates cash flow that is available to shareholders (since much of this must be reinvested to maintain operations and is not available for distribution to shareholders) the Value Line definition is easy to compute. Bankers will frequently use total market value to EBITDA or pretax operating earnings as the key ratio for valuation and will sometimes refer to this ratio as price/cash flow. Most of the dangers in the price/earnings ratio discussion above also apply here as well. However, since much of the cash flow under this definition stems from noncash charges, such as depreciation, comparability in asset mix and age and comparability in accounting systems becomes more critical. Market/Book Ratios If one is just valuing equity, the Market/Book ratio is computed as the total value of the equity divided by net worth on the balance sheet. In the example of XYZ company cited earlier, it is: $22 x 10 million shares / ($45 + $70 million) = 1.9 Perhaps more than any of the other ratios, the Market/Book Ratio requires extreme comparability in the accounting systems of the subject and comparable companies. The accounting number for this ratio comes from the balance sheet and not the income statement. The balance sheet reflects not only the current accounting system, but the aggregated history of accounting systems employed. Any difference that may be small on a year-by-year basis may be large when accumulated over several years. In particular, comparability in the age of the assets is critical in the use of the Market/Book Ratio since the use of accelerated depreciation can create major differences in book value between companies with differences in the historical pattern of purchasing assets. Hence a company which has new assets will have a dramatically different ratio than a company with older, depreciated assets. In a buyout or acquisition, the assets are typically revalued and goodwill may be reflected on the balance sheet. Consequently, the Market/Book Ratio of a recently purchased company will be very different from a company which has not had a recent revaluation of assets. The Market/Book Ratio is often used for specific industries such as banks and retailers. Banks with questionable or substantial nonperforming loans will sell for low market/book ratios. Before the writeoffs of LDC (less developed country) debt portfolios, many US banks sold for market/book ratios of .5 to 1.0. Since a large portion of assets are current assets, retailers will often use the Market/Book ratio to measure the value of their locations and reputations. A common misconception about Market/Book Ratios is that if a company is just expected to earn its cost of capital on future reinvestment of earnings, then the market/book ratio should be 1.00. If a company is expected to earn less than its cost of capital on future reinvestment, then the Market/Book Ratio should be less than 1.00; if a company is expected to earn more than its cost of capital on future reinvestment, then its Market/Book Ratio should be more than 1.00. Although the Market/Book ratio should be one for a company having just purchased all its assets, in general this notion that the Market/Book ratio should be one is false since the books reflect not only assets purchased this year but also the accumulated experience of the company. For example, consider a company just starting out with $100 in assets and equity and which is just expected to earn its cost of capital, 10%, for a yearly return of $10 per year. However, during the first period the assets become obsolete due to the introduction of a new technology. Suppose the company's obsolescence is reflected with higher variable costs than the new technology and so earnings are only expected to be $5 per year. Because of the lower earnings, the assets are only worth $50 ($5/10%), even though the books still record them at $100. If the company is expected to just earn its cost of capital on all future investments, the equity will only sell for $50 for a Market/Book Ratio of 0.50. That is, the books still reflect a past mistake even though the company is not expected to repeat the mistake in the future. Price/Sales Ratios The greatest errors in valuing equity often occur from the use of the Price/Sales Ratio (PSR) to estimate value. Perhaps one of the most significant reasons for the large errors stems from the assumption of comparability in capital structure. To illustrate the importance of the comparable companies having similar capital structures, consider the following example. Two companies have identical assets costing $100 and generate identical sales of $200. The first company finances the assets with $100 in equity for a Price/Sales Ratio of $100/$200 or 0.5. The second company finances the assets with $50 in debt and $50 in equity for a Price/Sales Ratio of $50/$200 or 0.25. The companies are identical in all aspects except capital structure and the PSR is, and should be, dramatically different. The use of the PSR of either company to value the other company will result in dramatic biases. The use of total market value of the company (total debt plus total equity) will eliminate much of this problem. The comparability requirements for the use of the Price/Sales Ratio not only include all those discussed earlier, but also include similarity in expense ratios as well. The huge errors that can result from the use of this ratio reflect the critical need for great comparability between companies before it can be used. This ratio has been used frequently for a number of specific industries. When media companies such as newspapers, radio stations or television stations sell, the PSR is frequently used. For example, recently a consolidation of small to medium size newspapers had taken place. A buyer would purchase several newspapers in a close geographical area, install a central printing facility which took advantage of economies of scale from new technology. Since the historical cost structure and profits were irrelevant, the key benchmark for the purchase price became the Price/Sales Ratio. The revenues were critical since it reflected the ability of the newspaper to obtain advertising revenues. The PSR has also been used for new businesses which may have start-up losses, negative book equity, and a variety of other distortions to accounting numbers but do have a history of demand for their product as reflected by sales. Price/Operating Characteristic Ratios Sometimes little reliance can be placed on accounting numbers at all. This is particularly true for closely-held corporations or foreign companies which have not been constrained by generally accepted accounting principle (GAAP) reporting systems. In these instances, the appraiser may use an operating characteristic rather than an accounting number to compute a valuation ratio. Hotels will often sell on a price/room basis. Conference hotels with swimming pools and exercise facilities may sell for $200,000 to $400,000 per room. A Motel 6 in a small town may sell for $50,000 to $100,000 per room. The industry keeps statistics on recent sales, transaction price, and operating statistics of the hotels sold to assist in these appraisals. Oil exploration and production companies will sell based on price to barrel of oil equivalent (BOE) ratios. When oil is discovered, the total reserves are estimated. Often when oil is found, natural gas is also found. One barrel of oil is the energy equivalent of 6,000 to 7,000 cubic feet of natural gas depending on purity and other characteristics. The natural gas reserves are converted to barrel of oil equivalents and then added to total reserves and the transaction price divided by this total. Transactions have occurred between $5 and $20 per BOE in recent years, mostly dependent on the then current oil price. Breweries will sell for price per barrel of brewing capacity. Telephone companies will sell for price per line in use. Cellular phone companies will sell for price per APOP,@ which is the population in the license area; metropolitan areas with heavy traffic congestion will often sell for $200/POP, whereas rural areas may sell for only $50/POP. Such price/operating characteristic ratios are particularly useful in cross border transactions in which there may be no comparables within the same country for comparison. An appraiser can compute these ratios for companies throughout the world where prices are known and then adjust for local economic circumstances. V. Conclusion There is probably no more difficult problem in finance or economics than valuing a company. It requires not only a thorough understanding of economic and financial theory, it also requires a thorough understanding of the company, the industry, and the economic environment at the time of the appraisal. Although the cost approach may provide a reasonable estimate for a company in a competitive environment under normal economic circumstances, the value of any company will depend on its future. Forecasting the future is required by both the discounted cash flow and price/characteristic ratio approaches. In the discounted cash flow approach, the appraiser must explicitly forecast the cash flows of the subject company. In the price/characteristic ratio approach, the appraiser must adjust the observed ratios of comparable companies for differences in the future expected cash flows of the subject company and the companies chosen as comparables.