Difference of Fair Market Valuation in Theory Vs. Practice
The official fair market value definition is "the highest price available in an open and unrestricted market between informed and prudent parties, acting at arm’s length and under no compulsion to act, expressed in terms of money or money’s worth". So this definition represents the perfect world where both the buyer and the seller have all available information, are prudent, etc, etc.In the real world, this is never the case and this where you can arbitrage to drive a better deal. For example, price can be influenced by:
- Your negotiating skills or your size and leverage - if you know more about the marketplace, have a stronger balance sheet giving you financing flexibility, or simply out negotiate the other party it is possible to realize a better price up or down than what the business is really worth.
- How emotionally involved the other party is - buying or selling a business is never an emotionless process. A business owner may be selling the business to regain some balance in their life, or provide a career for family members, etc. so knowing the motivations is critical to achieving a more optimal price.
- The price may not be all cash. Often times, you can negotiate a better price if you are buying by incorporating earnouts, vendor financing, or retained equity components. If you are selling, don’t be tempted to take the highest number without considering what the consideration entails. Often taking a lower but cleaner number; that is, a number where the cash consideration is maximized may be a better option.
- The price may be driven by who the buyer is in case you are selling the business. There are different kinds of buyers including special interest buyers, financial buyers, and even management by way of management buyouts and all of them have different objectives, interests, and ways of valuing a business so you must know who you are dealing with and perhaps more importantly understand who else is out there who may be interested in your business.
So as you can see, there is any number of ways where price and fair market value will differ. However, before you even consider entering a negotiation; always select the right business valuation method first before you commence any negotiation. Knowing your estimate of fair market value will better prepare you bid the price lower or higher depending on whether you are buying or selling.
Reason For Having a Business Valuation and How to Prepare
Usually, the reasons a business valuation would be required would be to a.) bring in a new outside partner or investor, b.) establish the value of a company for management to buy in, c.) for succession purposes, d.) for banking purposes, or e.) if the owner is looking to sell the business and wants to establish a target price.We believe being prepared for your business valuation and having it be a proactive process rather than a reactive process is critical to maximizing value. That is: if you are an owner who knows that 3 to 5 years from now you would like to slow down and maybe exit the day to day operations of your business, then don’t wait until then to start as this approach is surely to generate a lower value.
Preparations for Valuation
Preparing for a business valuation has quantitative, administrative, and qualitative elements to it. Quantitatively, the business is likely to be valued based on two or three metrics being a multiple of EBITDA, a multiple of assets, and perhaps a multiple of cash flow. The potential purchaser may conduct a more comprehensive valuation perhaps using a discounted cash flow method to generate a target price, but ultimately it most always comes back to measuring this value against multiples of EBITDA, assets, and/or EBIT to determine its reasonability. Qualitatively and administratively, there is a number of things that you should to prepare but namely include having your company fully organized to facilitate the due diligence and give the potential purchaser the assurance that your business is not a "one generation" business but rather a scalable business that could be easy to integrate.Top 10 Things to Do
So what should you do to prepare for a business valuation and generate the best value possible? Here are the top 10 that we recommend you want to do as a minimum:- Clean up the organizational structure of the company - if you have subsidiaries or companies that are silent, then wind them up
- Get the company’s minute books, bylaws, and other corporate documents updated and in order
- Develop your organizational structure early so that you have a proper succession plan in place. At a minimum, you want to start grooming your successor now. If you don’t have this person in your company, then go and hire him or her. Purchasers want to acquire commercial goodwill rather than personal goodwill. The simplest way to define the difference between these two is if you can leave for six months and not have your company encounter serious difficulties, then you have commercial goodwill. Alternatively, you have personal goodwill and purchasers are reluctant to buy it.
- In line with the previous point, you wan to develop some decent biographies on your key management team. This doesn’t mean you write a full 2 pages on each manager, just make sure you have a well crafted paragraph that speaks to the strengths of your key people. Relevant experience is more important than education.
- Collect all significant customer and supplier contracts in place. If you have any customer contracts that specify a certain term and set pricing, then make sure you have them available. Purchasers look for certainty in the revenue stream as well as the ability to raise rates post acquisition. When you are promoting your company, you want to make sure you point out the ability to raise the revenue line by potentially increasing price.
- If you don’ already have one, invest in a designated accountant (i.e. a CPA) to act as a full time controller. Notice we use the word "invest". Most small businesses don’t consider this expenditure important, and end up having a family member do the books or their external accountant review the books once a year when a tax return needs to be filed. This is not the way to go if you are looking to max out the value of your business upon sale. A good controller would add credibility to your team and can do a whole subset of things to clean up your business which are discussed in the following points.
- Scrub the last few years of historical performance to make sure that any expenses of a capital nature are identified to put on the balance sheet rather than reduce your EBITDA.
- Get all balance sheet accounts cleaned up particularly those affecting working capital and capital assets. A purchaser is likely to require you deliver a certain level of working capital as part of the purchase price but will likely not take receivables over 90 days or old inventory, so get this cleaned up first. Also, a solid continuity schedule of capital assets is a big plus, as purchasers will want to reconcile the purchase price or enterprise value of the business against the tangible net assets to calculate goodwill paid. Therefore, having a good paper trail to the capital assets acquire is very important.
- Ensure your accounting and information system can deliver accurate and reliable information. What this means is don’t do "cash accounting" once every three months or every year. It means making sure a proper set of financial statements can be produced that is in accordance with U.S. generally accepted accounting principles or international financial reporting standards. This is where a good controller is valuable. Not only can they provide you with more timely information that you can use to run the company, but they can also professionalize the reporting and put in place the processes to deliver this reporting on a more timely basis. This would show a purchaser that the information upon which they will be making their decisions is reliable.
- If you have any hard assets i.e. property or equipment that will be included in the business valuation, then get a full or desktop appraisal. We usually recommend you only include the assets required to generate the business income be included in the transaction. Other assets such as real estate should be excluded and leased back to the company after it has been bought therefore creating a nice passive income stream for you. Regardless of how the transaction is structured though, you need to know right from the go what the fair market value of the assets is, as this would be the price floor in your head. Of course you want to get goodwill for your business, but what that goodwill is will be determined by the value of the assets. You are better off knowing that yourself than letting the purchaser conduct their appraisal and telling you.
Enterprise Value
The term enterprise value (EV) is often used when discussing a company’s valuation. A common valuation multiple used is EV to EBITDA multiple. What is the enterprise value of a company and how is it applicable to private companies?EV represents the total value of a company including both its equity and its debt. If we were to compare the value of a business to the value of a house, the EV would be the total value of the house. The equity that you have in the house is equal to the total value of the home, less any outstanding mortgage.
Math of EV
If you were looking at a public company and see that its market capitalization (share price times the number of outstanding shares) is $200M and it has total debt of $100M, then the EV of the company would be the sum of the two components or $300M. If the company generated $75M of trailing EBITDA, then its EV/ trailing EBITDA multiple would be 4X. If the company anticipates generating $100M in forward EBITDA, then its EV/ Forward EBITDA multiple would be 3X. This illustrates how the EV/EBITDA multiple can be easily manipulated by the EBITDA which is selected.The enterprise value of a company that is being acquired is usually the same as the total purchase price. It would also drive the sources of uses of funds to complete the transaction since enough cash or cash equivalents would have to be raised to make up the entire EV. Suppose the purchase price of a company is agreed at $500 million. This would be its enterprise value. However, this company has $200M of debt on its balance sheet, so its equity value is $300M. The transaction could be structured using $100M injected by a private equity firm, $50M of rollover equity from the previous shareholders, $50M of vendor take back financing, $100 million in mezzanine debt, and the balance of $200 million in conventional bank financing. These would be the source of funds of which $400 million would be cash consideration (the private equity money, the mezzanine debt, and the senior debt), which would be used to pay the existing debt of $200 million leaving $200 million in cash for the seller plus the $50 million of equity rolled over, plus the $50 million in vendor take back. The seller would effective receive the $300M in equity calculated off the enterprise value (EV less debt) with the total funds raised to complete the transaction equaling the enterprise value.
When assessing the reasonability of a company’s EV, compare it against trailing EBITDA (as noted above), trailing EBIT, and net tangible net assets. It is particular important to compare the EV to net tangible assets. Tangible net assets would be defined as capital assets at fair market value plus current assets (excluding cash) less current liabilities. For capital intensive industries, it is important to watch the ratio of EV to tangible net assets since a high ratio would indicate that significant goodwill is being paid for the business. Then the question would be what supports this goodwill being paid? Why is the EV so much higher than tangible net asset?. It could be because this business has a patent on a specific product, or excellent customer relationships, or a barrier to a specific market. However, if you can’t properly define the source of the goodwill, then a high EV/tangible asset ratio could simply mean you are overpaying for the business.
Summary of Business Valuation Methods
Knowing what business valuation methods are available for a business will give you an advantage when you are selling or preparing to sell.Steps Before Selling
The first step in valuation is to determine if the business is a going concern, meaning if the business has sustainable cash flows that can be transferred to a third party buyer. If not, then the liquidation of the assets en bloc or piecemeal may result in a higher value than selling the business as an operating entity.The liquidation method is the least attractive exit option for business owner. Forced liquidation might occur if the business is in default of any its financial obligations. In this case, there is very little time, so you have to assume an immediate shutdown of operations and sale of the assets. A more likely situation may be that the business is not in duress and simply fetches a better price via liquidation rather than a future income or free cash flow based method, and then we are dealing with an orderly liquidation. In this case, the business has time to maximize the proceeds for its assets via liquidation. More importantly, the business can still generate income while its orderly liquidation is occurring, and this income also needs to be taken into consideration when estimating value. An orderly liquidation is definitely the more advantageous business valuation method if the business is not a going concern.
If the business is a going concern, then a future income or free cash flow based method is more appropriate as it will yield a higher value. We cannot overemphasize the importance of free cash flow enough. It is the largest contributor of determining value in any business.
Income Based Methods
There are two income based methods that you need to know about. They are:- The capitalization of after tax free cash flows - This approach is good for mature businesses where historical cash flows are considered to be a good approximation of future cash flows. Normalizations are made for unusual or non-recurring income or expenses. These cash flows are tax-effected, and then they are capitalized using a capitalization rate. Adjustments should be considered if sustaining capital expenditures are not consistent with the depreciation expense on the income statement.
- Discounted cash flow - This is the most favored business valuation method. Here we compute the future free cash flow on a year by year basis and then discount each year to its present value. This is the right method to use if the business is ongoing but may have a finite life like say a franchise. It is also the right method for businesses that are growing and have high demands for working capital or growth capital expenditures since both these factors impact each year’s free cash flow.
General Methods
Keep in mind that these are general business valuation methods that each have different nuances and, more importantly, are situation specific. You will want to do as much due diligence on the business to understand it as best as possible.Remember that the valuation of a business is still more of an art than a science, but there is a definite methodology to follow depending on the circumstances. Applied knowledge and preparation is a powerful edge to have.
Discounted Cash Flow
The discounted cash flow method (DCF) is one of the three primary future earnings business valuation methods. business valuation methods. You would use the discounted cash flow method when a 3 to 5 year cash flow projection can be computed, and there are uneven capital expenditures over the time period. It is the preferred method of valuation professionals, so we will provide here some guidelines to help you understand how it works.The method involves essentially the following three steps:
- Calculating the present value of free cash flows for a specific projection period;
- Calculating the present value of terminal value after the projection period; and
- Estimating Equity Value After Considerations for Redundant Assets and Debt.
CALCULATING THE PRESENT VALUE OF FREE CASH FLOW FOR A SPECIFIC PERIOD
A 3 to 5 year projection is critical when conducting a discounted cash flow analysis. The better the assumptions are that go into the projection, the more accurate the final value will be. The projection typically starts with computing normalized and recurring earnings before income taxes and depreciation or (EBITDA). The key assumptions to consider include pricing sensitivity, competition, how elastic demand is for the products and services, operating costs, and production capacity. You also need to think about the growth factor you need to use, and whether or not inflation is factored into the growth factor. In addition, EBITDA needs to be normalized for any one time, non recurring revenues or expenses that do not recur in the future.Upon calculating the normalized EBITDA for the 5 year projection, an effective tax rate would be applied to these figures. The after tax EBITDA is essentially a proxy for after tax operating cash flow.
At this point, it is critical to estimate the balance sheet impact of this projection beyond what operating cash flow is. Since the business is assumed to be in growth mode, there would be capital expenditures both to sustain the current business but also to grow the business. Therefore, both sustaining and growth capex need to be subtracted from operating cash flow making sure they are net of the present value of any tax shield available (if the company resides in a jurisdiction that provides for a tax shield). As well, the incremental net working capital needs of the business would have to be subtracted from the operating cash flow to allow for a growing revenue projection. As revenue increases, accounts receivable increase too which is not immediate cash generated. Therefore, this accounts receivable build-up needs to be subtracted from operating cash flow to determine the free cash flow during the projection period.
CALCULATING THE PRESENT VALUE OF TERMINAL VALUE AFTER THE PROJECTION PERIOD
After the projection period, it is assumed that cash flow stabilizes into perpetuity. At this point, the calculation is not that different than what happens during the projection period. The normalized, perpetual after-tax EBITDA would be computed (typically as a range) and all sustaining capex going forward would be subtracted. We assume at this point that net working capital has stabilized, so there is no addition or subtraction for net working capital.The key here is to take the perpetual after-tax cash flow calculated above, and then apply the correct multiple to it to drive the terminal value. The multiple is the inverse of the capitalization rate. The capitalization rate and also the discount rate are derived from the company’s weighted average cost of capital ("WACC").
ESTIMATING THE EQUITY VALUE AFTER CONSIDERATIONS FOR REDUNDANT ASSETS AND DEBT
Once the present value of the projection cash flows and the terminal value have been calculated, the discounted cash flow calculation is almost complete. At this point, all redundant assets should be added back to the discounted cash flow value. Redundant assets are those assets that are not required to run the business under normal circumstances. For example, a certain level of working capital would be required to operate a business. Any excess over this threshold would be considered redundant and would be added separately to the valuation to determine enterprise value. The enterprise value of the business is therefore the present value of all of its cash flow plus any redundant assets. Since we have assumed all along a valuation that does not incorporate debt, we would then subtract all interest bearing debt from the calculated enterprise value to deliver the equity value of the business. This is the final result you are after as this calculated equity value (which is usually represented as a range) would then be divided by the total outstanding number of shares to compute the equity value per share.The discounted cash flow approach is the preferred business valuation method for companies. It is advisable that at least once a year, a brief DCF valuation be conducted to determine where value is at and how the business is tracking to its projections.
Using Valuation Methods Based on Earnings Before Inertest and Taxes (EBIT)
The multiple of EBIT and EBITDA are often used to value companies. EBIT represents operating earnings before interest and taxes, but after depreciation. This is the difference between EBIT and EBITDA is how depreciation is treated. We advise not to use a multiple approach as your primary valuation method, but rather use this approach (whether on EBIT or EBITDA) as a reasonability test or "gut check" to make sure your valuation using a more formal method such as the capitalization of earnings, capitalization of cash flow, or discounted cash flow make sense.Computing
When computing EBIT, with the exception of depreciation, the same adjustments for EBITDA need to be considered, namely adjustments for fair market value rent, shareholder compensation, non recurring revenues and expenses, one time start up costs, one time professional fees, etc. Both calculations remove the debt structure by adding back interest meaning that you are viewing the company as if it had an optimal capital structure, rather than the structure specific for the company under review. This is because it is assumed a corporate buyer will have a stable capital structure with significant borrowing capacity such that the capital structure of the target will look considerably different pre transaction vs. post transaction.Multiples
The multiple of EBITDA approach is the more traditional metric used and is often represented in terms of enterprise value i.e. "EV/EBITDA". However, there are some limitations to using EBITDA. The limitations are all based on the fact that EBITDA does not consider the company’s capital expenditure needs to sustain its business, revenue, and earnings. Moreover, if the company has an asset that depletes until fully utilized (i.e. a gravel pit or a mine), EBITDA also may not consider this depletion in its calculation depending on how it is accounted for on the financial statements even though this is a real cost of doing business and ultimately a future cash outlay if the asset is to be replaced. Using EBIT as basis partially alleviates some of these issues, but not without some exceptions to watch for. By deducting depreciation, this takes into account the sustaining capital expenditure needs of the business but only if annual depreciation and sustaining capex are similar.Often times however, depreciation and capital expenditures are different so this becomes a limiting factor. However, at least with the depreciation subtraction there is an allowance made for capital requirements. Keep in mind that you are looking at what the future potential earnings and capex will be, so taking historical depreciation as a proxy for capex (even if they are basically the same) does not necessarily mean this is correct. You may be better off taking a hybrid calculation being "EBITDA less future capex" which is often used by valuation professionals.
Reasonability Test
If you are using the multiples approach as a reasonability test, you basically want it as a benchmark against some comparables. Which comparables? Basically, you can use either a public company multiple or a transaction multiple. Remember though that companies are like people, and therefore none are created equal. Companies, even in the same industry, vary in terms of size, customer mix, management, product or service mix, etc. it’s worth repeating that you use a multiple of EBIT or EBITDA as a gut check to your primary valuation method, not as the primary method itself.Shortcomings
There are specific shortcomings to using both the public and transaction comparables. With public companies, multiples would typically be higher namely because of the stock’s liquidity. If a stock is more liquid, there should be a premium paid for the ability to sell quickly. Another shortcoming of a public company comparable is the access to information. With a public company, you only have access to information once it has been made public, but before that access is limited which can impact the company’s valuation and its multiple. With a private company, access to information for the parties doing the deal can and should be readily available which would also impact its value and how the multiples ultimately benchmark.With transaction multiples, the biggest shortcoming is the deal structure itself. No deal is created equal, and the company value can be affected by how much cash was paid, if any shares were issued, if there is vendor take back financing, the existence of an earnout, etc. A second shortcoming is based on who the acquirers are - corporate buyers or financial buyers. Corporate buyers usually work in cash flow improvements driven by revenue increases or cost savings, and this may impact the price paid for the business and consequently the multiple. The quantification and valuation of synergies can be as challenging as the actual business valuation.
Using Valuation Methods Based on Earnings Before Inertest, Taxes, Depreciation and Amortization (EBITDA)
EBITDA is a term that is not formally defined by general accounting standards, but is used often to value companies. EBITDA stand for "operating earnings before interest, taxes, and depreciation". It is often used in the capitalization of cash flow or market approach valuation. EBITDA allows for comparison of different business with varying debt structures, tax rates and capital requirements. Because EBITDA is calculated before interest, the multiple applied against it is the inverse of the weighted average cost of capital ("WACC") to compute enterprise value which represents the total value of the company including debt.Computing EBITDA for valuation purposes requires that you do a comprehensive analysis of historical operations as well as future projections. Ultimately, you are trying to determine the EBITDA the business will generate in the future. Historical performance serves only as a benchmark for the anticipated future levels. You want to make sure that there haven’t been any major changes that would result in future EBITDA being different. Watch for technological changes in the industry, major changes in the business such as the loss of a major customer, or loss of a key manager that is significant driver of business. Any of these factors could result in historical EBITDA results being different from future EBITDA, so keep an eye on them.
When you look at historical results, you are looking to normalize EBITDA to a recurring, predicable level free of one time anomalies. All of this is theory, the key is that if you are a business owner looking to sell your business, you want to a) ensure your historical EBITDA is as high as possible over the review period and b) ensure your EBITDA is predictable from month to month and from year to year, which lends credibility to any future projection.
If you are buying or selling a business, some of the non recurring items that you would normalize or watch for to compute EBITDA are:
- Revenues or expenses that are not "arms length" - this basically means that the company may be transacting with related parties such as one of the major shareholder’ company at a price that is lower or higher than if these transactions happened with a regular third party. EBITDA would have to be adjusted or "normalized" to the fair market value of these transactions.
- Revenues or expenses that are being generated by redundant assets of the business - this is because redundant assets are added to enterprise value after the multiple of EBITDA has been applied.
- Owner salaries - often these salaries are either higher or lower than the normal salary that would be drawn by a third party manager. When owners also manage the business, a large bonus may be declared at the end of the year to reduce income taxes. This bonus needs to be isolated and added back to calculate recurring EBITDA.
- Rent of facilities at prices above or below fair market value - in some businesses, the company does not own the facilities it occupies, but rather rents them often times from a related party such as a holding company owned by one of the shareholders. The rent may therefore be higher or lower than it would be if rented from an independent landlord.
- Start up costs - if a new business line or division has been started within the historical results being analyzed, these costs should be added back to normalize EBITDA. This is because the costs are essentially "sunk" and will no longer be incurred going forward unless a new business line is introduced with its respective start up costs.
- Lawsuits, arbitrations, insurance claim recoveries, and one time disputes - any of these which may have been settled during the review period would not recur. Therefore, they would be deducted (in the case of income i.e. an insurance claim recovery) or added back in the case of lawsuit settlement.
- One time professional fees - look out for expenses incurred that relate to specific matters that do not recur in the future. An example is legal fees you would have incurred in settling a legal dispute. Not only would you add back to EBITDA the settlement expense, but you also need to ensure the related legal expenses are added back. Neither the settlement nor the legal expenses are recurring so they should not affect the valuation. The same applies for accounting fees on special transactions or marketing consultant fees if you did a one-time professional campaign. Keep your eyes open for these types of professional fees; they are often left as a recurring expense when selling a business resulting in a lower valuation than you would have obtained had you scrubbed these accounts.
- Repairs and maintenance - one of the most overlooked categories to review is repairs and maintenance. Often, private business owners will categorize capital expenses as repairs in order to minimize taxes. While this practice definitely keeps the annual cash taxes down, at time of sale this will hurt the valuation as it reduces historical EBITDA. Therefore, an adequate review to separate and add back any of these capital items back to EBITDA is a must.
- Inventories - if your company provides services using equipment, often times there is inventory such as parts required to repair the equipment. Often, private business owners will carry a general allowance of parts inventory throughout the year (say $25,000 for a small warehouse) and expense all parts acquired during the year again as part of the tax planning strategy. If you have more inventory than the general allowance being carried, it would be smart to count and value this inventory as close to the time of business sale as possible. This would have the effect of improving the company’s balance sheet and results.
- Other income and expenses - this category in a company’s financial statements can be loaded with items that may or may not be added back to EBITDA. Pay careful attention to this, and make sure that anything that is not recurring gets added back. For example, some companies record in this category one time employee bonuses or special donation expenses so be sure to segregate those and add them back when conducting your EBITDA calculations.
What is Weighted Average Cost of Capital (WACC) an Why Does it Matter?
The weighted average cost of capital (WACC) needs to be computed for a valuation. It represents the discount rate that used to present value cash flows when using the discounted cash flow valuation method.When you think about cost of capital, think about what return an investor would expect to earn on your company based on its risk profile. This return has to be higher than the cost of capital for value to be created for the investors. Therefore, the cost of capital is the hurdle rate, or the minimum return expected.
The cost of capital is "weighted" because it takes into account how much equity and debt is in your business, and how much each of these components cost on an after tax basis. However, the weighting for debt is based on a normalized capital structure rather than how much debt your specific business has.
Right WACC for a Company
The right WACC for any company is a moving target. One of the driving factors is the risk and return profile of each company. This is because cost of capital actually goes down the more debt a company has since debt is cheaper than equity. In addition, the interest you pay on debt is tax deductible. Hypothetically then, you should keep adding debt to continue reducing your cost of capital. However, this adds financial risk to your balance sheet because the company may not be able to pay the principal and interest related to this debt. Therefore, the right balance of debt and equity is required to balance out a low cost of capital with financial risk.Typically, a company can use a lower cost of capital if it has lower perceived risk for investors. Defining risk is can also be a moving target. Risk can increase or decrease depending on the number of competitors, new technology, cyclicality in the industry the company operates in, cost increases in major inputs, and the list goes on. The size and stage of the company also factors in when assessing risk and WACC. The larger companies usually have a better ability to absorb shocks and therefore have a lower risk profile than a start-up. This means that in general terms, the larger and more diverse the company is, the lower the cost of capital will be since lower risk drives a lower return expectation for investors. Conversely, the smaller and riskier the company is, the higher the return expectation and therefore the higher the WACC should be. Think about a start up technology company that gets venture capital financing. For every technology company that succeeds, there are many others that don’t make it. Venture Capitalists know this and value these businesses expecting a high return to make up for this risk. This results in a lower valuations and a high return expectation, typically 40% - 50% as a minimum.
Computing WACC
In order to compute the WACC, you have to know two things: 1) the unlevered return on equity, and 2) the normalized capital structure for your business.The simple formula for computing the weighted average cost of capital is as follows:
WACC = UE x (1 - T x D) where:
UE = the return on unlevered equity which essentially reflects the business risk that the Company is exposed to.
T = the specific, effective tax rate for the country and state the company resides in. Including tax is important because debt should be shown on an after tax basis since interest on debt is tax deductible.
D = the normalized debt to enterprise value of the company. This would reflect the normalized capital structure regardless of how much debt the company actually has.
Let’s relate the formula using some simple numbers.
Assume Company XYZ has an unlevered return on equity of 20% and operates in a jurisdiction where the effective tax rate is 30%. Also assume that the company the normal debt to enterprise value of the company is 50% in the industry. The WACC would be 17% for this company calculated as follows:
20% x (1 - 30% x 50%)
The cost of capital of a company reflects the level of normalized financial leverage or debt a business can put on. It tells you what an investor would use as a return on the particular business. Therefore, in the example above, 17% would be the discount rate used on a discounted cash flow valuation. Note that the discount rate does not include a growth factor. This is because it is assumed that the cash flows computed for the DCF have already incorporated a growth factor.
Unlevered Return on Equity
The weighted average cost of capital (WACC) needs to be computed for a valuation. It represents the discount rate that used to present value cash flows when using the discounted cash flow valuation method.When you think about cost of capital, think about what return an investor would expect to earn on your company based on its risk profile. This return has to be higher than the cost of capital for value to be created for the investors. Therefore, the cost of capital is the hurdle rate, or the minimum return expected.
WACC in Use
The cost of capital is "weighted" because it takes into account how much equity and debt is in your business, and how much each of these components cost on an after tax basis. However, the weighting for debt is based on a normalized capital structure rather than how much debt your specific business has.The right WACC for any company is a moving target. One of the driving factors is the risk and return profile of each company. This is because cost of capital actually goes down the more debt a company has since debt is cheaper than equity. In addition, the interest you pay on debt is tax deductible. Hypothetically then, you should keep adding debt to continue reducing your cost of capital. However, this adds financial risk to your balance sheet because the company may not be able to pay the principal and interest related to this debt. Therefore, the right balance of debt and equity is required to balance out a low cost of capital with financial risk.
Typically, a company can use a lower cost of capital if it has lower perceived risk for investors. Defining risk is can also be a moving target. Risk can increase or decrease depending on the number of competitors, new technology, cyclicality in the industry the company operates in, cost increases in major inputs, and the list goes on. The size and stage of the company also factors in when assessing risk and WACC. The larger companies usually have a better ability to absorb shocks and therefore have a lower risk profile than a start-up. This means that in general terms, the larger and more diverse the company is, the lower the cost of capital will be since lower risk drives a lower return expectation for investors. Conversely, the smaller and riskier the company is, the higher the return expectation and therefore the higher the WACC should be. Think about a start up technology company that gets venture capital financing. For every technology company that succeeds, there are many others that don’t make it. Venture Capitalists know this and value these businesses expecting a high return to make up for this risk. This results in a lower valuations and a high return expectation, typically 40% - 50% as a minimum.
Computing WACC
In order to compute the WACC, you have to know two things:- The unlevered return on equity, and
- The normalized capital structure for your business.
The simple formula for computing the weighted average cost of capital is as follows:
WACC = UE x (1 - T x D) where:
UE = the return on unlevered equity which essentially reflects the business risk that the Company is exposed to.
T = the specific, effective tax rate for the country and state the company resides in. Including tax is important because debt should be shown on an after tax basis since interest on debt is tax deductible.
D = the normalized debt to enterprise value of the company. This would reflect the normalized capital structure regardless of how much debt the company actually has.
Let’s relate the formula using some simple numbers.
Assume Company XYZ has an unlevered return on equity of 20% and operates in a jurisdiction where the effective tax rate is 30%. Also assume that the company the normal debt to enterprise value of the company is 50% in the industry. The WACC would be 17% for this company calculated as follows:
20% x (1 - 30% x 50%)
The cost of capital of a company reflects the level of normalized financial leverage or debt a business can put on. It tells you what an investor would use as a return on the particular business. Therefore, in the example above, 17% would be the discount rate used on a discounted cash flow valuation. Note that the discount rate does not include a growth factor. This is because it is assumed that the cash flows computed for the DCF have already incorporated a growth factor.
Net Present Value
When valuing a business, there is a lot of confusion between the terms net present value, present value, internal rate of return, and discount rate. We will try to dispel the mystery in all this terminology starting with net present value. First let’s clarify and say that the net present value and present value of a future cash flow stream are almost the same, but not quite. What is the difference? It is the inclusion or exclusion of the initial investment.Net Present Value
Simply put, the net present value is calculated by taking the present value of a future cash flow stream and subtracting from it the initial investment.Calculating
Let’s use an investor example to illustrate this. Assume you are considering buying a bond that has a face value of $10,000, pays an 8% annual coupon, matures in 4 years, and is currently trading at $9,500 (it is therefore trading at a discount). What would be the net present value? Let’s see.The initial investment today would be $9,500
At the end of year 1 to 4, you would receive a coupon payment of $800
At the end of year 4, you would receive the principal of $10,000.
Let’s say you have a return on investment threshold of 9% meaning you invest in securities that earn you a minimum of 9% over their life. Would you take this investment on? The first thing you would do is compute the present value of this bond using 9% as your discount rate. When you do this, the present value of the coupon payments is $9,676. How do you do this? The mathematical formula would be:
PV = FV divided by (1+R)t
where R stands for rate and t stands for the term. In this case, the future value is 10,000, R is 9%, and t is 4 years. Therefore you would have PV = 10,000 divided by (1+9%) to the 4 power. This formula would yield $9,676. However, if you want to easily compute this the present value then you can just use any number of PV calculators on the internet or use a financial calculator. With a financial calculator, you would punch in 10,000 for "FV, 800 for "PMT", 4 for "N", 9 for "I/Y", and the compute for "PV". Make sure your financial calculator is fully cleared first of previous calculations.
Ok great, so you now you know the present value is $9,676, what is the NET present value. It would simply be the difference between $9,676 and the initial investment of $9,500 or $176. If the net present value is positive, this means you that you would go forward with this investment whereas if negative, you would not go forward.
The reason the net present value is positive is because, in this case, the yield to maturity on the bond is actually higher than your 9% threshold. The actual YTM on the bond is 9.56%. Since the bond is being bought at a discount, the YTM is higher than the coupon rate. This is the rate that would make the future cash flow stream (being the coupon payments and bond principal) equal exactly $9,500. If you used 9.56% as your discount rate, the present value would be exactly $9,500 and the net present value would be zero (because the present value and the initial investment is the same).
Analysis
Of course, computing the net present value on bonds is not the only useful application. For business owners, understanding net present value is especially important on capital projects. Let’s say you are considering the addition of additional capacity for your manufacturing plant and the initial investment is $100,000. Your business’ WACC would be the discount factor you would use to present value the net future cash flows of this addition including its estimated terminal value. You would then compute the net present value in the same fashion as the bond, and if this number is positive you would proceed with the addition. If the number is negative, you would not because the investment would not earn you a return that is above your weighted average cost of capital.Patent Valuation
Patent valuation is one of the most challenging asset valuations to conduct. Patents form part of a group of intellectual property assets that are difficult to value and account for using traditional accounting methods.So does how patent valuation work? Simply, put there are various widely recognized methods that derive off the standard valuation approaches. These can be categorized basically into three different types: the market based approach, the cost based approach, and income approaches.
Market Based Approach
A market based approach is a simple method that has been favoured by the accounting profession. It aims to derive a multiple off a recent transaction which would include both tangible and intangible assets such as a patent. This multiple could be off sales, free cash flow, or EBITDA, and then it is applied to each asset including the intellectual property. The challenge with this approach is that tangibles and intangibles carry different levels of risk. Therefore, a dual capitalization approach may be necessary whereby different multiples or discount rates are used for the tangible assets and for the patents being valued. The free cash flow belonging to the patent is then capitalized using the higher discount rate to account for the higher level of risk. You can simplify the process and value the patent by comparing it to a similar patent used in a similar circumstance. This is similar to the market approach used for real estate where comparable sales are identified and used. However, finding true comparables can be challenging when conducting patent valuations.Cost Method
The cost method focuses on determining what it would cost to replace the patent by either buying it or reproducing it. This is not the same as the patent’s historical cost as the future cost to recreate may very well be different than historical cost. This is a simple approach; however it is fraught with risk simply because what it costs to reproduce something may not be at all its value. For example, significant cost is spent in research and development to create drugs with patents. Yet, these drugs don’t always prove out and the value is written off to nil despite the cost to produce them.Income Approaches
There are three primary income approaches used generally that may be more conducive to assess proper patent valuation:- The incremental cash flow method - in this case, the life of the patent, the free cash flow it can generate, and the discount rate are all calculated. The life of the patent is important to estimate as generally patents expire. In this case, you are trying to do is isolate the incremental cash flow that the patent in question delivers over the business cash flow without the patent included. Therefore, you end up computing two discounted cash flows - one with the patent in and one with the patent out - to essentially isolate the incremental cash flow which is then present valued.
- The relief from royalty method - this method computes what it would cost a company to license the patent, and then uses the discounted cash flow method to compute the present value of this licensing relief. The PV of the royalty represents the value of the patent because this is a cost that is being saved by owning the patent. This is a challenging method to apply simply because royalty rates are seldom made public so it is important to do some due diligence into these rates and what has gone into it.
- The cost savings approach - this method computes the future savings that the patent will generate for the businesses (for example, a unique technology that is patented) over its life and then computes the present value by discounting these savings. It differs from the royalty method in that here what is being present valued is the estimated cost savings as a proxy for free cash flow rather than the amount it would cost the business to license the IP.
Ultimately the choice of patent valuation boils down to how the owner will use it to generate value. Sometimes, the patent generates higher revenue or reduced costs which may drive a different valuation method. If looking at mobility assets, the recent purchase of Nokia’s patents by Google may provide a great market benchmark for similar assets that may be acquired by another technology giant attempting to bolster the patent pipeline. In this case, a market approach may be the primary intellectual property valuation method rather than an income approach. However, in other more specific cases some form of discounted cash flow approach is typically more applicable to patent valuation.
The Liquidation Approach
The liquidation approach is one of the primary business valuation methods available. It is used when the company is determined to no longer be a going concern and liquidating the assets would yield a higher value than the present value of its future earnings and cash flow potential.The final after tax proceeds available from a liquidation approach requires that all assets and liabilities in a balance sheet be assessed. The net realizable value of the assets minus the disposition costs is first estimated.
New Realizable Value
The net realizable value (NRV) of the assets may include the following components:- Marketable securities at present value minus disposition costs - this would include today’s value of any stocks, treasury bills, and other investments that the company has. Disposition costs such as broker commissions or early redemption penalties need to be subtracted to determine the marketable securities’ NRV.
- Accounts receivable - the NRV of accounts receivable would be based on what is likely to be collected in the immediate future. If there are any bad debts or customers that may be in financial difficulty, then these receivables would not yield any value. A simple way to assess the NRV of existing receivables is to sell them to a company and use the price provided as a floor to assess their value.
- Inventory at resale - there are essentially three kinds of inventory: raw materials, work in progress, and finished goods. For raw materials and finished goods, the NRV would be the value expected to be realized minus selling costs of the inventory sold either individually or altogether. For work in progress, you need to determine if the inventory would yield a higher value as is or after it is finished appreciating that finishing it would likely mean some costs incurred.
- Prepaid expenses - these would be assumed as if realized into cash. For example, if there is insurance that has been prepaid for the year, the amount left for the year (say six months) would be its cash value.
- Real estate - would be valued at the current market price net of selling costs which would include commissions and legal expenses.
- Operating assets - equipment, furniture, fixtures would be assumed sold as is in an auction either on a piecemeal or enbloc basis. The net book value of these assets is not generally representative of NRV that can be achieved, so taking them to the auction would be the only way to determine their real value.
- No value assets - assets on the balance sheet such as leasehold improvements and intangibles are not assigned any value under the liquidation approach.
Subtractions
From this balance, you would need to consider subtracting the following costs unique to the liquidation of a company:- Professional fees including a receiver, legal, and final accounting and tax advise
- Severance payments to your employees and any vacation pay that is owed to them
- Shutdown and mobilization costs which include cleaning the equipment and getting it ready for sale as well as transporting it to the sale
- Outstanding commitments which would include any obligations under contracts that still need to be met
After subtracting liquidation costs from NRV, the proceeds would have to be tax effected before computing the final proceeds on sale using the liquidation approach. The tax effect would depend on the country and state where the company is located, but typically the following matters would be considered:
- Any tax due on capital gains realized on the sale of investments and marketable securities
- Any tax due on capital gains realized on the sale of fixed assets
- Tax due or refundable on the recapture or terminal loss of tax depreciation
- Any refundable taxes available to the shareholders (in some countries such as Canada, 26.67% of the taxable capital gain is refundable to shareholders if dividends are paid).
