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384 Financial Analysis: Tools and Techniques

The added difficulty of forecasting operations beyond the end of the chosen

analysis period suggests that we also find an acceptable shortcut answer for the

ongoing value. A common way of dealing with the problem is to use a price to

earnings multiple that might be warranted at that point, i.e., to set the value of the

business at the termination point based on 10, 15, or 20 times the after-tax earn￾ings in that year. The multiple chosen will depend on the nature of the business

and the trends in the industry it represents. Because of the power of discounting,

such an approximation of the ongoing value will generally suffice at least for an

initial valuation result. At times the ongoing value is simply represented by the

estimated book value of the business, although this is probably a less satisfac￾tory shortcut than the earnings multiple for the reasons we discussed in earlier

chapters.

Once all the cash flow elements have been estimated, they can be assembled

in the form of a spreadsheet as shown in the generalized format of Figure 11–5,

which parallels the various examples we gave in Chapter 8. The resulting annual

net cash flows (free cash flow) represent the cash available to the company to

support its obligations to all providers of the long-term funds, i.e., the payment of

F I G U R E 11–5

Total Company Valuation—A Numerical Example*

Present Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBIT (1  t) . . . . . . . . . . . . . . . . $10,000 $12,000 $13,000 $12,000 $13,500 $ 12,500

Add: write-offs and

noncash items. . . . . . . . . . . . . 6,500 7,000 8,600 9,300 9,900 11,900

Less: net new working

capital . . . . . . . . . . . . . . . . . . . 1,200 1,400 1,800 500 1,600 2,000

Less: net new capital

investments. . . . . . . . . . . . . . . 8,000 15,000 10,200 11,000 22,000 10,000

Add/less: significant

nonoperating items . . . . . . . . . 500 300 400 1,200 800 0

Free cash flow . . . . . . . . . . . . 7,800 2,300 10,000 12,000 1,000 12,400

Ongoing value @ 15 times

earnings . . . . . . . . . . . . . . . . . ————— 187,500

Present value factors

@ 12% . . . . . . . . . . . . . . . . . . 0.893 0.797 0.712 0.636 0.567 0.507

Present values @ cost

of capital . . . . . . . . . . . . . . . . . 6,965 1,833 7,120 7,632 567 101,349

Cumulative present values. . . . . $ 6,965 $ 8,799 $15,919 $23,551 $22,984 $124,333

Firm value . . . . . . . . . . . . . . . . . $124.3 million

Nonoperating assets (cash,

marketable securities, etc.). . . 5.7 million

Total value . . . . . . . . . . . . . . . . . $130.0 million

Value of outstanding long￾term debt . . . . . . . . . . . . . . . . . . . . . 40.0 million

Value of shareholders’ equity . . . $ 90.0 million

*This exhibit is available in an interactive format (TFA Template)—see “Analytical Support” on p. 389.

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CHAPTER 11 Valuation and Business Performance 385

interest, dividends, and potential repayment of debt or even repurchase of its own

shares.

After discounting the pattern of annual cash flows over the chosen time

frame at the appropriate return standard, normally the weighted average cost of

capital, the resulting net present value should be a reasonable approximation

of the value of the total business. Note that the nonoperating assets were added to

the operational firm value to arrive at the total value. In our example we’ve shown

an assumed value of $5.7 million, which raises the total value to $130.0 million.

The quality of the result depends, of course, on the quality of the estimates that

were used in deriving it. The analyst should employ extensive sensitivity analysis

to test the likely range of outcomes, testing different discount rates and especially

different estimates of the ongoing value. In this example the ongoing value based

on the no-growth assumption would be $100 million, when we use a free cash

flow estimate of $12 million, divided by the cost of capital of 12 percent. With a

five percent perpetual growth assumption, the ongoing value would be $12 mil￾lion divided by a net factor of 7 percent, or $171 million. While the impact of dis￾counting moderates the significance of the ongoing value somewhat (the discount

factor in Year 6 at 12 percent is 0.507), the discounted difference between the

earnings multiple assumption of $187.5 million we used, and the no-growth free

cash flow result of $100 million is still a highly significant $44 million ($87.5

0.507), or about one-third of the final result. It’s not unusual to find such sizable

ranges of outcomes in what amounts to a quantification of future expectations, not

historical data.

It’ll be useful to demonstrate visually how the firm value developed by this

present value analysis relates to the company’s capital structure. What we’ve

developed by discounting the net cash flow stream and the assumed ongoing

value, plus nonoperating assets, is the approximate fair market value of the com￾pany’s overall capitalization. Figure 11–6 demonstrates that the total recorded

value of a business is the sum of its working capital, fixed assets, and other assets,

which are financed by the combination of long-term debt and equity. The present

value approach has enabled us to express this accounting value in current eco￾nomic terms—a present value which might be higher or lower than the recorded

values on the balance sheet, and which also depends, of course, on all the assump￾tions implicit in the cash flow forecasts including the ongoing value. Only by

coincidence will the two values be precisely equal, because as we discussed

in Chapter 2, recorded values on the balance sheet reflect historical transaction

values which tend to become obsolete with the passage of time.

It should be evident that to arrive at the market value of the shareholders’

equity, we must subtract the value of the long-term debt from the adjusted present

value result—which is the market value of the total business, also called value

of the firm or enterprise value. In our example, therefore, the value of the share￾holders’ equity is $90.0 million. It might be necessary to restate the value of long￾term debt based on the current yields prevailing for debt of similar risk, as we

discussed earlier in this chapter, rather than the recorded values on the balance

sheet. For example, if current interest rates are higher than the stated rates for the

company’s debt, the value of the debt will be lower than recorded, and vice versa.

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386 Financial Analysis: Tools and Techniques

By observing this principle, we remain consistent with the weighted average cost

of capital yardstick that was applied in discounting the cash flow pattern, a mea￾sure which contains the cost of incremental debt, as we recall from Chapter 9.

A similar deduction must be made for any preferred stock contained in the capital

structure.

We’ve now achieved a direct valuation of the company’s common equity by

means of an economic (cash flow) approach which is conceptually superior to the

simpler devices discussed in the common stock section of this chapter, although

subject to the range of assumptions underlying it. This approach is the basis for

much of the analytical work underlying modern security analysis, where the use

of cash flow analysis has begun to overshadow most other methodologies.

In a multibusiness company, the approach can be refined by developing

operating cash flow patterns for each of the business units, and discounting these

individual patterns at the corporate cost of capital. If the businesses differ widely

in their risk/reward conditions, one can apply different discount standards that

reflect these differences, as discussed in Chapter 8. In recent years, testing the pre￾sent value of individual business units’ cash flow patterns to determine the rela￾tive contribution to the total value of the corporation has become widely accepted.

Yet, given the nature of the estimates underlying the analysis, there’s noth￾ing automatic about the use of such values in an actual transaction involving

the sale of a company or any of its parts. Different analysts and certainly buyers

and sellers will use their own sets of assumptions in developing their respective

F I G U R E 11–6

Present Value of Business Cash Flows and the Capital Structure

Assets Liabilities

Company

book value

History Expectations

Current

assets

Current

liabilities

Long￾term

debt

Working

capital

Fixed

assets

Other

assets

Share￾holders’

equity

> = <

Present value

of company

capitalization

Annual free cash flows

Ongoing

value

Market

value

Time

Represents the basic trade-off of

future cash flows for current value…

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TEAMFLY

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CHAPTER 11 Valuation and Business Performance 387

results. There should also be efforts to test the analytical results against compa￾rable transactions, to the extent these are available and relevant.

The actual value finally agreed upon in any transaction between a buyer and

a seller will depend on many more factors, not the least of which are the differ￾ences in assessing business risk and in the return expectations of the parties in￾volved, as well as the in the negotiating stance and skills used by them. We’ll

return to the subject of valuation of a company or combination of companies

within the context of shareholder value creation in Chapter 12.

Using Shortcuts in Valuing an Ongoing Business

In the previous example, an earnings multiple based on EBIT was used to derive

the ongoing value of the business. This multiple simply indicated what a par￾ticular level of current or projected earnings was “worth” at the termination point

of the analysis. After-tax earnings or after-tax operating profit are often used as

well. Closely related to the price/earnings ratio, this rule of thumb is often applied

to quickly value a company, and the result can be an “opener” in initial nego￾tiations. Never precise, the earnings multiple is derived from rough statistical

comparisons of similar transactions, and from a comparative evaluation of the

performance of the price/earnings ratios of companies in the industry. Other mul￾tiples encountered at times, especially with smaller companies or new businesses,

include multiples of sales, or even derived sales volumes based on an estimated

customer group.

When an actual earnings multiple is turned into a ratio of estimated earnings

to value, it provides a rough estimate of the rate of return on the purchase or sell￾ing price—assuming that the earnings chosen are representative of what the future

will bring. When taken as only one of the indicators of value within a whole array

of negotiating data, the earnings multiple and the related crude rate of return have

some merit.

Other shortcuts in valuing an ongoing business involve determining the

total market value of common and preferred equity from market quotations—in

itself somewhat of a challenge in view of stock market fluctuations—and adjust￾ing this total for any long-term debt to be assumed in the transaction. One issue

involved in this approach is the question of how representative the market quo￾tations are depending on the trading pattern and volume of the particular stock.

At times, when no publicly traded securities are involved, the book value of the

business is examined as an indicator of value. Needless to say, the fact that

recorded values don’t necessarily reflect economic values can be a significant

problem.

All of these results can at one time or another enter into the deliberations,

but considerable judgment must be exercised to determine their relevance in the

particular case. In most situations, the discounted cash flow approach will be the

conceptually most convincing measure, despite the difficulties of estimating

the cash flow pattern in specific terms.

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388 Financial Analysis: Tools and Techniques

Key Issues

The following is a recap of the key issues raised directly or indirectly in this chap￾ter. They are enumerated here to help the reader keep the techniques discussed

within the perspective of financial theory and business practice.

1. The concept of value is not independent of the purpose for which it is

used, and its definition and meaning can vary widely with respect to

the conditions and circumstances to which it is applied.

2. The value of a security is a function of the expectations about future

performance placed upon it, which can be individual judgments as

well as collective judgments representing a market.

3. Investors approach the valuation of an investment proposition in

terms of their individual risk preferences and thus will differ widely

in assessing the attractiveness of an investment.

4. While the securities markets provide momentary indications, the

relative value of a share of common stock in the market at any time is a

combination of future expectations, residual claims, and assessments of

general and specific risk, subject to economic and business conditions

and the decisions of management and the board of directors. It’s also

affected by the breadth of trading in the security.

5. Valuation techniques are essentially assessment tools that attempt to

quantify available objective data and estimates. Yet such quantification

will always remain in part subjective, and in part impacted by forces

beyond the individual parties’ control.

6. Valuation of a security or a business is distorted by the same elements

that distort other types of financial analysis: price-level changes,

accounting conventions, economic conditions, market fluctuations,

and many subjective intangible factors.

7. Validation of results achieved from valuation projects ultimately has to

await actual performance in the future; this is why the importance of

sound judgments at the time of the analysis cannot be overstated.

Summary

In this chapter, we’ve brought together a whole range of concepts and basic tech￾niques to provide the reader with an overview of how to value assets, securities,

and business operations. To set the stage, we discussed key definitions of value,

and then took the viewpoint of the investor assessing the value of the three main

forms of securities issued by a company. After covering both value and yield in

these situations, we expanded our view to encompass the valuation of an ongoing

business. Our purpose was to find basic ways of setting the value in transactions

such as sale of a business, restructuring, or the combination of companies in the

form of a merger or acquisition.

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