Financial valuation Applications and Models phần 2 pot

The problemwith using net income as the economic benefit is that it is more difficult to developdiscount and cap rates relative to net income; cash flow rates of return are morereadily ava

Appendix 79Activity Ratios

Activity ratios, also known as efficiency ratios, provide an indication as to how ciently the company is using its assets More efficient asset utilization indicatesstrong management and generally results in higher value to equity owners of thebusiness Additionally, activity ratios describe the relationship between the com-pany’s level of operations and the assets needed to sustain the activity

effi-Accounts Receivable Turnover

Annual Sales

Average Accounts ReceivableAccounts receivable turnover measures the efficiency with which the companymanages the collection side of the cash cycle

Days Outstanding in Accounts Receivables

365 _

A/R TurnoverThe average number of days outstanding of credit sales measures the effective-ness of the company’s credit extension and collection policies

Inventory Turnover

Cost of Goods Sold

Average InventoryInventory turnover measures the efficiency with which the company managesthe investment / inventory side of the cash cycle A higher number of turnovers indi-cates the company is converting inventory into accounts receivable at a faster pace,thereby shortening the cash cycle and increasing the cash flow available for share-holder returns

Sales to Net Working Capital

Sales

Average Net Working CapitalSales to net working capital measures the ability of company management todrive sales with minimal net current asset employment A higher measure indicatesefficient management of the company’s net working capital without sacrificing salesvolume to obtain it

Total Asset Turnover

Sales

Average Total Assets

Total asset turnover measures the ability of company management to efficientlyutilize the total asset base of the company to drive sales volume.

Fixed Asset Turnover

Sales _

Average Fixed AssetsSales to fixed assets measures the ability of company management to generatesales volume from the company’s fixed asset base

Application to Ale’s

Four of the five activity ratios for Ale’s have steadily declined during the five-yearperiod analyzed The only activity ratio to increase during the five-year period wasAle’s fixed asset turnover

Ale’s accounts receivable turnover has declined from 43.2 turns at December

31, 1997, to 18.8 turns at December 31, 2001 This decline in accounts receivableturnover has resulted in an increase in the average collection period of accountsreceivable from 8.4 days at December 31, 1997, to 19.4 days at December 31, 2001.Ale’s inventory turnover has declined from 23.5 turns at December 31, 1997, to12.8 turns at December 31, 2001 The declines in accounts receivable turnover andinventory turnover indicate that Ale’s management of these critical assets hasslipped considerably during the period analyzed The median accounts receivableturnover and inventory turnover for comparable companies within the industrywere 86.5 turns and 18.0 turns, respectively Consequently, Ale’s has clearly fallenbelow its industry peers in its management of major working capital components Ifthis trend continues, Ale’s working capital could become significantly strained andbecome an obstacle to future growth

Ale’s sales to net working capital turnover has declined from 14.3 turns atDecember 31, 1997, to 7.9 turns at December 31, 2001 The median sales to networking capital turnover for comparable companies within the industry was 37.6turns This decline mirrors the problems in accounts receivable and inventory

A review of the Ale’s total asset turnover indicates a decline from 5.8 turns atDecember 31, 1997, to 4.5 turns at December 31, 2001 The industry-comparabletotal asset turnover was 3.9 turns Ale’s fixed asset turnover actually has increasedfrom 12.5 turns at December 31, 1997, to 13.5 turns at December 31, 2001.However, Ale’s fixed asset turnover of 13.5 turns at December 31, 2001, is far belowthe median fixed asset turnover for comparable companies within the industry of21.5 turns These activity ratios suggest an increase in the risk associated with aninvestment in Ale’s common stock Additional due diligence is necessary to deter-mine the cause of these potential problems

Leverage Ratios

Leverage ratios, which are for the most part balance sheet ratios, assist the lyst in determining the solvency of a company They provide an indication of a com-pany’s ability to sustain itself in the face of economic downturns

ana-Leverage ratios also measure the exposure of the creditors relative to the holders of a given company Consequently, they provide valuable insight into the rel-ative risk of the company’s stock as an investment.

share-Total Debt to share-Total Assets

Total Debt _

Total AssetsThis ratio measures the total amount of assets funded by all sources of debtcapital

Total Equity to Total Assets

Total Equity

Total AssetsThis ratio measures the total amount of assets funded by all sources of equitycapital It can also be computed as one minus the total debt to total assets ratio.Long-term Debt to Equity

Long term Debt

Total EquityThis ratio expresses the relationship between long-term, interest-bearing debtand equity Since interest-bearing debt is a claim on future cash flow that would oth-erwise be available for distribution to shareholders, this ratio measures the risk thatfuture dividends or distributions will or will not occur

Total Debt to Equity

Total Debt _

Total EquityThis ratio measures the degree to which the company has balanced the funding

of its operations and asset base between debt and equity sources In attempting tolower the cost of capital, a company generally may increase its debt burden andhence its risk

Application to Ale’s

The leverage ratios for Ale’s have remained fairly steady during the five-yearperiod analyzed Ale’s total debt to total asset ratio has remained at 0.5 for all fiveyears Ale’s total equity to total asset ratio has also remained stable at 0.5 for all fiveyears The median total debt to total asset ratio for comparable companies withinthe industry was 0.6 Ale’s total debt to equity ratio has been 0.9 to 0.8 historically,

well below the industry average of 1.5 This indicates that the company tends tofinance growth with more equity than debt.

Profitability Ratios

Profitability ratios measure the ability of a company to generate returns for itsshareholders Profitability ratios also measure financial performance and manage-ment strength

Gross Profit Margin

Gross Profit _

Net SalesThis ratio measures the ability of the company to generate an acceptablemarkup on its product in the face of competition It is most useful when compared

to a similarly computed ratio for comparable companies or to an industry standard.Operating Profit Margin

Operating Profit _

Net SalesThis ratio measures the ability of the company to generate profits to cover and

to exceed the cost of operations It is also most useful when compared to ble companies or to an industry standard

Ale’s operating profit margin has declined from 4.5 percent at December 31,

1997, to 3.7 percent at December 31, 2001 The median operating profit margin forcomparable companies within the industry was 3.7 percent, indicating that the com-pany’s competitive advantage may be adversely affected by a less focused manage-ment team or by some external forces affecting the company

Rate of Return Ratios

Since the capital structure of most companies includes both debt capital and equitycapital, it is important to measure the return to each of the capital providers

Appendix 83

Return on Equity

Net Income

Average Common Stockholder’s EquityThis ratio measures the after-tax return on investment to the equity capitalproviders of the company

Net Income
Interest (1  Tax Rate)

Average Total AssetsThis ratio measures the return on the assets employed in the business In effect,

it measures management’s performance in the utilization of the company’s assetbase

Application to Ale’s

Since RMA only reports pretax returns, that is how Ale’s ratios were computed forthis exhibit only Ale’s rate of return ratios have fluctuated significantly over the five-year period analyzed Its return on equity and return on total assets have been veryinconsistent in spite of fairly steady sales activity However, Ale’s most recent return

on total assets of 16.0 percent is above the industry average of 10.3 percent Ale’srecent return on equity of 29.5 percent is dramatically below the industry average

of 35.7 percent This may have to do with Ale’s leverage being so much lower thanits peer groups, since optimal use of leverage can magnify equity returns Again, this

is cause for further analysis

Growth Ratios

Growth ratios measure a company’s percentage increase or decrease for a ular line item on the financial statements These ratios can be calculated as astraight annual average or as a compounded annual growth rate (CAGR) meas-uring growth on a compounded basis over a specific time period Although it ispossible to calculate growth rates on every line item on the financial statements,growth rates typically are calculated on such key financial statement items assales, gross margin, and operating income, and are calculated through use of thefollowing formulas

partic-Average Annual Sales Growth

{Sum of all Periods[(Current Year Sales / Prior Year Sales)  1] /

# of Periods Analyzed}  100Compound Annual Sales Growth

{[(Current Year Sales / Base Year Sales)(1 / # of Periods Analyzed)] 1}  100Average and compounded annual growth measures for gross margin and oper-ating income are computed in the same manner

Note: Analysts often spread five years of financial statements When ing growth rates on financial statements spread over five years, the analyst should

calculat-be careful to obtain growth rates over the four growth periods analyzed In otherwords, periods = number of years – 1

Application to Ale’s

Ale’s sales growth on a compounded basis is slightly above the rate of inflation (3percent), suggesting that the company’s unit volume (on a case-equivalent basis) isrelatively flat The operating profit of Ale’s decreased over the period, further evi-dence of a flattening in operating performance However, Ale’s showed a dramaticincrease in operating profit within the past year, possibly indicating a rebound

Income Approach

Perhaps the most widely recognized approach to valuing an interest in a privatelyheld enterprise is the income approach As with both the market and assetapproaches, several valuation methodologies exist within the income approach todevelop an indication of value This chapter explores the fundamental theory behindthe approach and its numerous applications

Valuation professionals use a number of terms, such as “economic benefits,”

“economic income,” and “net income.” These terms are used interchangeablythroughout this chapter However, since most empirical data is based on some vari-ation of cash flow, that term is typically used herein to represent the company’s eco-nomic benefit stream

FUNDAMENTAL THEORY

Equity Interests Are Investments

An equity interest in a privately held enterprise is an investment that can be ated in the same basic manner as any other investment that the investor mightchoose to make An investment is:

evalu-the current commitment of dollars for a period of time to derive futurepayments that will compensate the investor for

• the time the funds are committed,

• the expected rate of inflation, and

• the uncertainty of the future payments.1

Investments and Business Valuations Involve

the “Forward-Looking” Premise

An investment requires a commitment of dollars that the investor currently holds inexchange for an expectation that the investor will receive some greater amount ofdollars at some point in the future This “forward-looking” premise is basic to allinvestment decisions and business valuations “Value today always equals futurecash flow discounted at the opportunity cost of capital.”2

85

1Frank K Reilly and Keith C Brown, Investment Analysis and Portfolio Management, 5th ed.

(The Dryden Press, Harcourt Brace College Publishers), p 5.

2Richard A Brealey and Stewart C Myers, Principles of Corporate Finance, 5th ed (New

York: McGraw-Hill, Inc., 1996), p 434.

The income approach to business valuation embraces this forward-lookingpremise by calculating value based on the assumption that the value of an owner-ship interest is equal to the sum of the present values of the expected future benefits

of owning that interest No other valuation approach so directly incorporates thisfundamental premise in its calculation of value

INCOME APPROACH INVOLVES A NUMERATOR

One of the two elements of any income approach method is a numerator,

repre-senting the future economic benefit accruing to the holder of the equity interest.This future economic benefit can take many forms It can represent cash flow ornet income Net income may be on a pretax or after-tax basis It also can repre-sent a single payment or a series or stream of payments Again, although we con-tinue to use the term “economic benefit,” this chapter focuses mainly on cashflow

INCOME APPROACH INVOLVES A DENOMINATOR

The second element, the denominator, is the rate of return required for the

particu-lar interest represented by the cash flow in the numerator The denominator reflectsopportunity cost, or the “cost of capital.” In other words, it is the rate of return thatinvestors require to draw them to a particular investment rather than an alternativeinvestment

This rate of return incorporates certain investor expectations relating to thefuture economic benefit stream:

• The “real” rate of return investors expect to obtain in exchange for letting one else use their money on a riskless basis;

some-• Expected inflation is the expected depreciation in purchasing power during theperiod when the money is tied up;

• Risk is the uncertainty as to when and how much cash flow or other economicincome will be received.3

The first item is essentially rent Any investor forgoing current consumption andallowing another party to use his or her funds would require a rental payment Thesecond item is required due to the time value of money and the decreased purchas-ing power associated with invested funds being spent later rather than sooner Thethird item captures investor expectations about the risks inherent in the specificequity instrument Generally, this risk assessment is developed through analysis ofthe future economic benefit and the uncertainty related to the timing and quantity

of that benefit See Chapter 5 for additional detail on rates of return

3Shannon P Pratt, Cost of Capital: Estimation and Application (New York: John Wiley &

Sons, Inc.), p 5 (Used with permission.)

INCOME APPROACH METHODOLOGIES

The business valuation profession commonly uses three primary methods within theincome approach to value privately held business interests These include:

1 Discounted cash flow (DCF) method

2 Capitalized cash flow (CCF) method

3 Excess cash flow (ECF) method

Each of these methods depends on the present value of an enterprise’s future cashflows, often based on historical financial data The ECF method is really a hybridmethod combining elements of both the asset approach and the income approach.Preferably, the financial data is in compliance with generally accepted accounting prin-ciples (GAAP) Valuation analysts, including CPA-analysts, are not responsible forattesting or verifying financial information or certifying GAAP statements when pro-viding valuations Often they are given non-GAAP financial information as a startingpoint to derive income or cash flow; this information is often acceptable However,analysts still should do their best to make appropriate adjustments to income state-ments and/or balance sheets within the scope of their engagement The development

of these adjustments is referred to as the normalization process

NORMALIZATION PROCESS

If the value of any investment is equal to the present value of its future benefits,determining the appropriate future benefit stream (cash flow) is of primary impor-tance Therefore, items that are not representative of the appropriate future cashflow must be either eliminated or adjusted in some manner The process begins withthe collection of historical financial data and includes a detailed review of that data

to determine what, if any, adjustments are required

“Big Five”

The normalization process involves the restatement of the historical financial ments to “value” financial statements, i.e., statements that can be used in the valu-ation process Normalization generally involves five categories of adjustments:

state-1 For ownership characteristics (control versus minority)

2 For GAAP departures, extraordinary, nonrecurring and/or unusual items

3 For nonoperating assets and liabilities and related income and expenses

4 For taxes

5 For synergies from mergers and acquisitions, if applicable

Failure to develop the appropriate normalizing adjustments may result

in a significant overstatement or understatement of value

ValTip

Generally, the second, third, and fourth categories of normalization ments are made in all valuations, whether the ownership interest being valued is aminority or a control interest The first category of normalization adjustments is notalways necessary if the ownership interest being valued is a minority interest Thefifth category is most often used to derive investment value.

adjust-ADJUSTMENTS FOR OWNERSHIP CHARACTERISTICS

Controlling interest holders are able to extract personal financial benefits beyondfair market amounts in a number of ways For instance, in a privately held enter-prise, it is not unusual for the controlling shareholder to take compensation inexcess of going market rates that might be paid for the same services Since the

“willing buyer” of a control ownership interest could reduce compensation to ket levels, often it is appropriate to add back excess compensation to cash flow toreflect the additional economic benefits that would be available to the “willingbuyer.”

mar-Other examples of control adjustments include:

• Excess fringe benefits including healthcare and retirement

• Excess employee perquisites

• Excess rental payments to shareholders

• Excess intercompany fees and payments to a commonly controlled sistercompany

• Payroll-related taxes

• Reimbursed expenses

• Nonbusiness travel and entertainment of shareholders and/or key individuals

• Related party transactions (i.e., leases between shareholder and entity)

• Sales/purchases to/from related entities

By choosing to make certain adjustments to the future economic

bene-fit (i.e., the numerator), the analyst can develop a control or trol value

noncon-ValTip

Normalization adjustments affect the pretax income of the entity beingvalued Consequently, the control adjustments will result in a corre-sponding modification in the income tax of the entity, if applicable

ValTip

The content of the numerator drives the type of value (control or minority) duced As such, if the numerator includes adjustments related to control, the valueconclusion will be a control value By excluding adjustments related to control, thevalue conclusion is a minority value If control adjustments are included in the nor-malization and the resulting value is a control value, a minority interest discountmay be used to adjust from control to minority value There are often situationswhere no control adjustments are necessary and the company’s control owners runthe company to the benefit of the all the owners In this situation, the value would

pro-be same for minority and control However, some analysts still apply a minority count to reflect the risk of a potential change in the control owner or his or her man-agement philosophy See Chapter 24 for various views on the subject

dis-Example

Assume a control shareholder’s salary is in excess of market value by $300,000 peryear and the capitalized cash flow method is used to value the net cash flow of thecompany

NCF= $700,000 (on a noncontrol basis)

Excess Compensation = $300,000 (assume tax-effected)

Ke– g = 20% (discount rate – growth = capitalization rate)

Under these assumptions, the computation of value is:

FMV
_NCF
_$700,000
$3,500,000

Thus $3.5 million is the value of the entity on a noncontrolling basis

Assuming that a normalization adjustment would add back the $300,000 ofexcess compensation to cash flow, the outcome would clearly differ, as illustratedbelow:

FMV
_NCF
$1,000,000 _
$5,000,000

Here, $5 million is the value of the entity on a control basis The difference inthe two conclusions is entirely attributable to those portions of a control benefitstream taken out of the company as excess compensation

Adjustments to the income and cash flow of a company are the primarydeterminants of whether the capitalized value is minority or control

ValTip

If the analyst chooses to make the control normalization adjustment, a ity interest value still could be determined by utilizing a discount for lack of control.

minor-Noncontrol Control _

*Discounts are discussed in Chapter 8.

The debate as to whether to make these control adjustments in a minority uation is ongoing Some analysts prefer to make the adjustments, then apply a

val-minority discount They argue that by not making these adjustments, one could:

• Understate value

• Overstate the minority discount

• Possibly “double count” the minority discount

Those who believe one should not make control adjustments, that is, leave thecash flows on a minority basis, say that:

• Minority interests have no say in compensation and perquisites to controllingshareholders and cash flows must reflect this fact

• The amount of these adjustments may be difficult to justify or verify

• Almost all of the difference in control versus minority value in the incomeapproach is found in the numerator—the expected income—rather than in thedenominator—the discount or capitalization rate

ADJUSTMENTS FOR GAAP DEPARTURES, EXTRAORDINARY,

NONRECURRING, AND/OR UNUSUAL ITEMS

In analyzing historical financial statements, it is important to “smooth” the cial data by removing all items that would not be indicative of future operating per-formance The goal is to present a normal operating picture to project earnings into

finan-When there are controlling interest influences in the benefit stream oroperations of the entity and a minority interest is being valued, it may

be preferable to provide a minority value directly by not making ments Doing this will avoid the problems related to determining anddefending the application of a more general level of minority discount

adjust-ValTip

the future Because conclusions of value are based on future return expectations,and because most analysts use historical financial information as the starting pointfor estimating future returns, it would be appropriate to consider the followingadjustments.

• Departures from GAAP

of catastrophic events such as a plant fire, hurricane damage, labor strikes, and/orinsurance proceed collections due to such events as the death of a key executive.Other adjustment items also can be found in historical balance sheet and cashflow accounts For example, if a company purchased a level of fixed assets farbeyond its historical norm and funded the purchases from cash flow from opera-tions, it may be necessary to “smooth” the depreciation and corresponding cashflow to reflect a more normal pattern

See Chapter 3 for greater detail and examples on financial statementadjustments

ADJUSTMENTS FOR NONOPERATING ASSETS AND

LIABILITIES AND RELATED INCOME AND EXPENSES

The application of most commonly accepted income approach methodologiesresults in a valuation of the company’s operating assets, both tangible and intangi-ble Therefore, it is often necessary to remove all nonoperating items from the com-

Adjustments for Nonoperating Assets and Liabilities and Related Income and Expenses 91

Depending on the situation, statements prepared on a “tax basis” or

“cash basis” may have to be adjusted to be closer to GAAP and/or malized cash flow

nor-ValTip

As with the control-oriented adjustments, extraordinary, nonrecurring,

or unusual item adjustments affect the profit or loss accounts of a pany on a pretax basis Therefore, certain income tax-related adjust-ments may be necessary

com-ValTip

pany’s balance sheet and income statement After the value of the operating assetshas been determined, the net nonoperating assets generally are added back at theirrespective values as of the valuation date.

Examples of nonoperating assets and liabilities might include airplanes, unsoldplant facilities that have been replaced, significant investments in unrelated companies,equity investments, excess cash or working capital, and loans to support any of these.The interest, dividends, and rental income, as well as any related expenses (loaninterest, depreciation, and other carrying costs) associated with these nonoperatingassets must be removed from the operating benefit stream Once again, these types

of adjustments will alter the pretax operating income

Methodologies for the valuation of nonoperating assets and liabilities will varydepending on the nature of the asset or liability Usually more significant fixedassets, such as an airplane or building, are separately appraised Investments in pri-vately held enterprises may require a separate entity valuation In many cases, thenonoperating assets will have appreciated since acquisition and may require a con-sideration of the potential tax implications of any gain associated with this appreci-ation If nonoperating assets exist and are to be added to the operating assets, theymust be adjusted to their respective fair market values, including an adjustment fordiscounts if applicable

When valuing a minority interest, some experts do not add back nonoperatingassets since minority shareholders have little or no control over the assets However,this often results in a very large implied discount on the nonoperating assets, par-ticularly those with low income or high expenses

ADJUSTMENTS FOR TAXES

The question of whether to tax-effect or not tax-effect income in pass-through ties is a highly debated issue in business valuation (see Chapters 3 and 23) However,the selection of tax rates can also be an issue

enti-Income tax expenditures represent a very real use of cash flow and must be sidered carefully If both federal and state taxes are to be reflected, they should bebased on the future income that was determined in the valuation process, includingthe appropriate tax rate(s) to use

con-Tax Rate or Rates to Use

Determining the tax on future income can incorporate the:

• Actual tax rate

Specialists in the valuation of particular nonoperating assets may need

to be hired Engagement letters should clearly set out these ities and the related appraisal expenses

responsibil-ValTip

• Highest marginal tax rate

• Average tax rate

For example, on $1 million of pretax cash flows, the resulting capitalized valuewould vary depending on the tax rates, as shown in Exhibit 4.1

Exhibit 4.1 Taxes and Value

Actual Tax Average Tax Highest Marginal Liability Rate of 35% Rate of 39%

_

The lowest value, which uses the highest marginal rate, is more than 21 percentbelow the highest value, which uses the actual tax liability This is a significant dif-ference Taxes can vary from year to year for a variety of reasons As such, unduereliance on one year may lead to a faulty valuation

The tax issue becomes even more controversial when the entities involved arepass-through entities such as S corporations and partnerships Since these entitieshave little or no federal and state tax liability, applying after-tax discount and caprates to pretax income would result in a higher value for the pass-through entity, allother things being equal (see Exhibit 4.2) See Chapters 3 and 23 for more detail onthis important and complicated issue

Exhibit 4.2 Applying After-tax Cap Rate to Pre-tax Cash Flow

Pass-Through Entity “C” Corporation

_

ADJUSTMENTS FOR SYNERGIES FROM

MERGERS AND ACQUISITIONS

Synergistic adjustments may be needed in mergers and acquisitions engagements.These adjustments will vary in complexity For example, synergy adjustments could

be as simple as adjusting for savings in “office rent” due to the consolidation ofoffice facilities Synergy adjustments also can include the results of in-depth analy-ses of increased sales, decreased production costs, decreased sales and marketingcosts, and other improvements due to anticipated economies of scale

Adjustments for Synergies from Mergers and Acquisitions 93

DETERMINATION OF FUTURE BENEFITS STREAM

(CASH FLOWS)

Under the capitalized cash flow method, a single measure of the “expected” annualfuture economic benefit is used as a proxy for all future benefits Under a discountedcash flow methodology, discrete “expected” future economic benefits are projectedfor a specified number of years in the future and then a single measure of economicbenefit is selected for use into perpetuity after the specified period, which is referred

to as the terminal value

Both the cap rate and the discount rate are intended to encompass investorexpectations regarding the risk of receiving the future economic benefits in theamounts and at the times assumed in the models Given the forward-looking nature

of these methodologies, the valuation analyst will want to properly assess potentialfuture economic benefits to produce a valuation conclusion that is accurate and sup-portable

DEFINING THE BENEFIT STREAM

Both single-period benefit streams (CCF) and multiperiod benefit streams (DCF) can

be defined in a variety of ways, depending on what definition is most appropriate in

a given circumstance The most common definitions of future economic benefits arenet income and net cash flow

Net Income

Net income is the measure of an entity’s operating performance and typically isdefined as revenue from operations less direct and indirect operating expenses Itsusefulness as a measure of economic benefit for valuation purposes lies in its famil-iarity through financial statements It can be either before or after tax The problemwith using net income as the economic benefit is that it is more difficult to developdiscount and cap rates relative to net income; cash flow rates of return are morereadily available using traditional cost of capital techniques

Synergistic value is investment value, which may not be fair marketvalue

ValTip

In many small companies, income and cash flow are the same or similar

ValTip

Net Cash Flow

In recent years, net cash flow has become the most often-used measure of future nomic benefit, because it generally represents the cash that can be distributed toequity owners without threatening or interfering with future operations

eco-Net cash flow is akin to dividend-paying capacity and as such can be seen as adirect proxy for return on investment Finally, it is the measure on which most com-monly accepted empirical data on rates of return are based

DEFINING NET CASH FLOW

Net cash flow is defined differently depending on the method of the incomeapproach selected Whether using a DCF or a CCF, the analyst can elect to rely onthe direct equity method or the invested capital method The next sections presentthe components of net cash flow

Cash Flow Direct to Equity (Direct Equity Method)

Net income after tax

Plus: depreciation, amortization and other non-cash changes

Less: incremental working capital needs

Less: incremental capital expenditure needs

Plus: new debt principal in

Less: repayment of debt principal

Equals: net cash flow direct to equity

The cash flows here are “direct to equity” because debt has been serviced bythe inclusion of interest expense and debt repayment, and what is left is available toequity owners only This is a debt-inclusive model

Cash Flow to Invested Capital (Invested Capital Method)

Net income after tax

Plus: interest expense (tax affected)

Plus: depreciation, amortization and other noncash changes

Less: incremental “debt-free” working capital needs

Less: incremental capital expenditure needs

Equals: net cash flow to invested capital

The cash flows here are those available to service invested capital, i.e., equityand interest-bearing debt The cash flows exclude interest expense and debt princi-ple payment It is a debt-free model in the sense that all interest and related debt cap-ital is removed The value determined by this method is invested capital which istypically interest-bearing debt, capital leases and equity To derive equity value usingthis method the analyst subtracts the actual debt of the subject company

USE OF HISTORICAL INFORMATION

Once the benefit stream has been defined and adjustments have been made, the lyst will want to analyze historical financial information since it often serves as thefoundation from which estimates of future projected benefits are made

ana-The historical period under analysis usually encompasses an operating cycle ofthe entity’s industry, often a five-year period Beyond five years, data can become

“stale.” There are five commonly used methodologies by which to estimate futureeconomic benefits from historical data:

1 The current earnings method

2 The simple average method

3 The weighted average method

4 The trend line-static method

5 The formal projection method

The first four methods are most often used in the CCF method of the incomeapproach or as the starting point for the DCF method The fifth method is the basisfor the DCF method The CCF and DCF methods are explained in greater detaillater in this chapter All of these methods can be used in either the direct equity orthe invested capital method of the income approach

Current Earnings Method

The current year’s income is sometimes the best proxy for the following year andfuture years in many closely held companies Management insights will be helpful

in deciding whether current cash flows are likely to be replicated in the ensuing

years If management indicates that next year will be very similar to last year, thencurrent earnings and cash flow may be used as the basis to value the company It isalso possible that next year’s cash flow will be different from the past but still growinto perpetuity at an average constant rate Any such projection must be supportedwith sound underlying assumptions

Simple Average Method

The simple average method uses the arithmetic mean of the historical data duringthe analysis period The simple average method can be illustrated by the followingexample:

Regardless of the method employed, dialogue with management canprovide critical insight into future projections

ValTip

ACE Corporation—Historical Cash Flow*

*After normalization adjustments

A simple average is used most often in developing the numerator for the talization of cash flow method when historical normalized information does not dis-cern an identifiable trend If the historical analysis period encompasses a fullindustry operating cycle, the use of a simple average also may provide a realistic esti-mate of expected future performance However, it may not accurately reflectchanges in company growth or other trends that are expected to continue

capi-In this example, the simple averaging method may not work well in estimatingfuture cash flows The last three years’ results may be more indicative of the com-pany’s value when the company has been growing consistently and 1997 was per-haps an anomaly A cursory glance would tell you that the next year’s cash flowprobably would be expected to be somewhat higher than $180,000, providing thatthe historical data are representative of the business’s direction and mirror manage-ment’s expectations

Weighted Average Method

When the historical financial information yields a discernible trend, a weighted age method may yield a better indication of the future economic benefit stream, sinceweighting provides greater flexibility in interpreting trends In fact, under certain cir-cumstances, specific years may be eliminated altogether, that is, have zero weight.The computation of the weighted average requires the summation of a set ofresults that are the products of assigned weights times annual historical economicbenefit streams It can be illustrated by the following example:

aver-ACE Corporation Normalized historical Cash Flow

antici-Trend Line-Static Method

The trend line-static method is a statistical application of the least squares formula.The method generally is considered most useful when the company’s past earningshave been relatively consistent (either positive or negative) and are expected to con-tinue at similar levels in the future At least five years of data is suggested

y
a + bxWhere:

y= predicted value of y variable for selected x variable

a= y intercept (estimated value of y when x = 0)

b= slope of line (average change in y for each amount of change in x)

x= independent variable

a
Y  bX or _ –

X = value of independent variable

Y = value of dependent variable

N = number of items in sample

The computation can be illustrated as follows:

ACE Corporation—Historical Cash Flow

The next step requires solving the equations for variables a and b Because variable

b is integrated into the formula for variable a, the value of b must first be mined

Finally, solving the original least square formula,

Formal Projection Method (Detailed Cash Flow Projections)

The formal projection method uses projections of cash flows or other economic efits for a specified number of future years (generally five) referred to as the

ben-“explicit,” “discreet,” or “forecast” period This method is used to determine futureeconomic benefit streams when using the DCF method This method has beenwidely accepted due to the flexibility it allows when estimating year-by-year benefitstreams over the explicit period

With exceptions, three to five years is the standard length of the explicit period.One such exception is for start-up and early-stage companies whose profitabilityoften is not projected until several additional years out The period following theexplicit period is called the “continuing value” or “terminal” period

Projections often are determined by reference to historical financial informationthat has been normalized Used as a foundation for future expectations, normalizedfinancial statements may include both balance sheet and income statementadjustments

Once the analyst has normalized the historical data, when applicable, it may benecessary to review all elements of revenue and expenses to ensure that future oper-ating projections reflect as closely as possible the trends identified in the analysis ofhistorical financial information These trends should be discussed with managementand related to future expectations and economic and industry research undertaken

by the business analyst in conjunction with the engagement

Theoretically, the length of the explicit period is determined by fying the year when all the following years will change at a constantrate Practically, however, performance and financial position afterthree to five years often are difficult to estimate for many closely heldcompanies

identi-ValTip

If the value measure selected is net cash flow, it is necessary to establish jections of working capital needs, capital expenditures, depreciation, and, if using adirect equity method, borrowings, and repayments of debt Each of these items mayrestrict or provide free cash flow, affecting the return on equity.

pro-A question sometimes arises as to why analysts may need future balance sheetsand statements of cash flow when they are using a DCF model The interactivenature of the balance sheet, income statement, and statement of cash flows operate

to ensure that all aspects of future cash flow have been addressed and that tions utilized in the projection of the income statement work properly through thebalance sheet This is not always necessary

assump-DISCOUNTED CASH FLOW METHOD

Definition and Overview

The discounted cash flow method is discussed first because other income methodsare abbreviated forms or variations of this method Therefore, understanding thetheory and application of the discounted cash flow method will make it much eas-ier to understand the other methodologies The most important consideration isthat:

The value of any operating asset/investment is equal to the present value of its

expected future economic benefit stream.

In some circumstances, the past is not indicative of the future Analystsmust exercise care in analyzing projected performance in these situa-tions Adequate support must exist for the assumptions that the pro-jections are based on

ValTip

The valuation analyst uses normalized historical data, managementinsights, and trend analysis to analyze formal projections for theexplicit period These projections take into account balance sheet andincome statement items that affect the defined benefit stream andinvolve not only projected income statements but also may include pro-jected balance sheets and statements of cash flow

ValTip

The reliability of actually receiving future economic benefit streams is differentfrom asset to asset and from entity to entity Asset or entity risk is assessed andmeasured in the form of a rate referred to as a “discount rate,” a “rate or return,”

or the “cost of capital.” These terms are used interchangeably throughout this bookand are covered in detail in Chapter 5

n
The last period for which economic income is expected; n may equal

infinity (i.e., ) if the economic income is expected to continue in petuity

per-Ei
Expected future economic income in the ith period in the future (paid at

the end of the period)

k
Discount rate (the cost of capital, e.g., the expected rate of return

avail-able in the market for other investments of comparavail-able risk and otherinvestment characteristics)

i
The period (usually stated as a number of years) in the future over which

the prospective economic income is expected to be received

The expansion of this formula is5:

En
Expected future economic income in the nth or last period in which

an element of income is expected E1,2, etc.is the first, second, third,and so on expected future economic income for each period beforethenth period (or year)

k
Discount rate

The basic formula for the DCF using net cash flow (direct equity or investedcapital) and a terminal period is shown in Exhibit 4.3

Exhibit 4.3 Basic DCF Formula

Present Value of the

Present Value of NCF’s during Explicit Period Terminal Period

NCF n
(1g)

bottom-Exhibit 4.4 Cash Flow and Growth

Current Year Discounted Rate

This can be modeled and presented as in Exhibit 4.5

End-of-Year and Midyear Conventions

Some DCF models calculate the present value of the future cash flows as if all odic cash flows will be received on the last day of each forecast period (see Exhibit4.6) This is obviously not the case with most companies

Although some models are based on continuous cash flows through the year, ashortcut method has been developed called the midyear convention The midyearconvention DCF model treats periodic cash flows as if they will be received in themiddle of the year This is accomplished by starting the first forecast period (n) atmidperiod (.5n) Each successive forecast period is calculated from midperiod tomidperiod (.5n + 1).

Comparative Example

Assume that a company receives cash flow equal to $100 per month or $1,200per year (see Exhibit 4.7) Using a 6 percent interest factor, we could compute thepresent value of the first $100 received by dividing it by (1 + 06/12)1, dividing thesecond $100 by (1 + 06/12)2, and so on for 12 months, with the total present valueequaling $1,161.88

Exhibit 4.5 DCF with Terminal Year

The Sum of the Present Values of Expected Future Cash Flows Using the Gordon

Assuming the same total received during the year is $1,200, and dividing by (1 + 06)1/2(a midyear convention), the present value equals $1,165.54, a difference

Exhibit 4.6 End of Year Convention

$100,000

The DCF Model Calculates Value Based on the Enterprise “Receiving” Its

Economic Benefit on the Last Day of the Year

_

The midyear convention DCF model (5 years) now looks like Exhibit 4.8,where n = 1 year.

It is important to note that the terminal year begins at 4.5, not 5.

Adjusting the DCF for a Specific Valuation Date

Since the date of valuation is often not the entity’s fiscal year end, adjustments to the

present value calculations may be needed to reflect the “other than year-end” date

Exhibit 4.9 Illustration of Specific Valuation Date

year projection deals only with 4/12thsof $100,000, or $33,333 If the second-yearprojection showed cash flows of $107,000, or a 7 percent increase, then at August

31, 2002, the discount period of the $107,000 is 4/12thsplus one year.

Exhibit 4.8 Midyear Convention DCF Model

Present Value of NCF’s during Explicit Period Terminal Value

NCF n(1g) _

PV
_ + _ + + + _

(1k) n
5 (1 k ) n
1.5 (1k) n
4.5 (1k) n
4.5

Discounted Cash Flow Method 107

For example, let us assume that you are calculating the present value of the

$100,000 and the $107,000 referenced above Exhibit 4.10 presents the schematicview for year 2002 Exhibit 4.11 presents another view

Exhibit 4.10 Schematic View for Year 2002

Valuation Date August 31, 2002

Partial Year Discount

Company's Fiscal Year End December 31, 2002

Fiscal Year Begins on

January 1, 2003

Company's Fiscal Year End December 31, 2003

$107,000 Discount Period is 1 Year + 1/3 of a Year

n 2 = 1.333

$107,000

Exhibit 4.11 Another View

Fiscal Year Ending December 31 st

Times: Present Value Factor ke
20% _0.9410 0.7842

83,909 _

Total Present Value at August 31, 2002 _$115,273

Multistage Explicit Periods

It is possible to have more than one explicit period in a DCF calculation Forexample, a start-up might be expected to experience four years of substantialgrowth, followed by five years of high growth and another four years of growth

at rates still in excess of the norm (see Exhibit 4.12) Although not universallyaccepted, some analysts also apply different discount rates to the different explicitgrowth periods to reflect different levels of risk Most valuations do not includedifferent discount rates

The formula for multistage models is shown in Exhibit 4.13

Exhibit 4.12 Multistage Explicit Periods

Average Equity End of Present

Periods Year To Equity Rates Rate PV Factor Cash Flows

TERMINAL VALUE6

Definition and Overview

The final component of value in the DCF is the terminal value, sometimes referred

to as the continuing value The terminal value is the value of the business after theexplicit or forecast period

(kg 3 )

(1k) n2 Where:

i
a measure of time (in this example the unit of measure is a year)

n1
the number of years in the first stage of growth

n 2
the number of years in the second stage of growth

NCF0
cash flow in year 0

NCF n1
cash flow in year n 1

NCF n2
cash flow in year n 2

g 1
growth rate from year 1 to year n 1

g 2
growth rate from year (n 1 + 1) to year n 2

g 3
growth rate starting in year (n 2 + 1)

The example in Exhibit 4.14 shows that the present value of the terminal valuecould actually be greater than the sum of the interim cash flows (explicit period) aswell as the total value of the common equity.

Exhibit 4.14 DCF Value (Invested Capital Method)

Discount Rates Cash Flow to to Invested Present Value Year Invested Capital Capital PV Factor of Cash Flows

Less: Fair Market Value of Interest-bearing Debt (40,000)

Growth Rate = 6%

Calculation of the Terminal Value

In a DCF, the terminal value is the value of the company at the beginning of year n+ 1 This value often is calculated by using the Gordon Growth Model, which is thesame math that is used in the capitalization of cash flow method (to be discussedlater) It is as shown in Exhibit 4.15

Exhibit 4.15 Gordon Growth Model for Terminal Year

NCF
Net cash flow commensurate with k, the required rate of return

k
Required rate of return or discount rate commensurate with the net cash flow

g
Long-term sustainable growth rate

n
number of periods in the explicit forecast period

Because making accurate forecasts of expected cash flows after the explicitperiod is difficult, the analyst usually assumes that cash flows (or proxies for cashflows) stabilize and can be capitalized into perpetuity This is an average of futuregrowth rates, not one expected to occur every year into perpetuity Some years

growth will be higher or lower, but the expectation is that future growth will age the long-term growth assumption.

aver-Other Terminal Value Calculations

The Gordon Growth Model is easy to use, considered theoretically sound, and versally applied However, other terminal year models sometimes are used We willlook briefly at the exit multiple model, the “H” model, and the value driver model

uni-Exit Multiple Model

One alternative method for determining the amount of the terminal value is to use amultiplier of an income parameter such as net income, earnings before interest andtaxes (EBIT), earnings before interest, taxes, depreciation and amortization(EBITDA), etc This multiple, which is often used by investment bankers, is generallydetermined from guideline company market data and is referred to as an “exit mul-tiple.” It is applied to one of the income parameters at the end of the explicit period.Because it is sometimes difficult to support the use of a market approach within anincome approach, this method is not used as much as the Gordon Growth Model.However, it can be used effectively as a reasonableness check on other models

“H” Model7

The “H” Model assumes that growth during the terminal period starts at a higherrate and declines in a linear manner over a specified transition period toward a sta-ble-growth rate that can be used into perpetuity The “H” Model calculates a termi-nal value in two stages The first stage quantifies value attributable to extraordinarygrowth of the company during the forecast period The second stage assumes stablegrowth and uses a traditional Gordon Growth formula (see Exhibit 4.16)

Exhibit 4.16 H Model

Stable Growth
_ CF (0) (1 + g S )

Plus Extraordinary
CF(0) h (gi– gS)

Where:

Cf0
Cash Flow (Initial Cash Flow)

h
Midpoint of high growth (transition period/2)

g i
Growth rate in the “initial high growth period”

gS
Growth rate in the “stable period”

7For further information on the H Model see Aswath Damodaran, Damodaran on Valuation: Security Analysis for Investment and Corporate Finance (New York: John Wiley & Sons, Inc.,

1994), p 387.

Value Driver Model8

The value of continuing cash flows also can be calculated using the value drivermodel In the Gordon Growth Model, the analyst must estimate continuing incre-mental investment (capital expenditures and working capital) in order to determinethe continuing free cash flow of the company The free (net) cash flow is then dis-counted at the weighted average cost of capital (WACC) less the growth rate todetermine the value of the continuing operating cash flows of the entity The valuedriver model, on the other hand, discounts or capitalizes the adjusted net income ofthe company directly by the cost of capital The analyst does not have to estimatethe level of incremental investment of the entity This method also eliminates theuncertainty surrounding the estimation of perpetual growth that is a major influence

on the value using the Gordon Growth Method

“For many companies in competitive industries, the return on net new ment can be expected to eventually converge to the cost of capital as all the excessprofits are competed away In other words, the return on incremental invested cap-ital equals the cost of capital.”9 When this occurs, the resulting valuation model isknown as the value driver (convergence) model and is defined as:

invest-NOPLAT T 1Continuing Value(CV)

WACCWhere:

NOPLAT = Net operating profit less applicable taxes

WACC = Weighted average cost of capital

T 1 = First year after explicit forecast period

NOPLAT is often equal to debt-free net income, which is net income aftertax plus tax-effected interest expense It is also normalized EBIT times one minusthe tax rate When using the value driver model, NOPLAT is divided by the cost

of capital By contrast, in the Gordon Growth Model, cash flow is divided by thecompany’s cost of capital minus its perpetuity growth rate The value drivermodel assumes that the company’s return on capital and cost of capital are thesame regardless of the growth rate There is no subtraction of a long-termgrowth rate

The growth term has disappeared from the equation This does not meanthat the nominal growth in NOPLAT will be zero It means that growthwill add nothing to value, because the return associated with growth justequals the cost of capital This formula is sometimes interpreted asimplying zero growth (not even with inflation), even though this is

8Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd ed (New York: John Wiley & Sons, Inc., 1995), p 282.

9Ibid See this work for further information on the value driver model.

clearly not the case The average return on invested capital movestoward the weighted average cost of capital (WACC) as new capitalbecomes a larger portion of the total capital base.10

The expanded value driver formula is:

NOPLATT + 1(1 – g / ROIC)Continuing Value =

WACC – gWhere:

NOPLATT1
Normalized level of NOPLAT in the first year after explicit

fore-cast period

g
Expected growth rate in NOPLAT in perpetuity

ROIC
Expected rate of return on net new investment

When ROIC is equal to the WACC, then the convergence formula, previouslydisplayed, is the result

In certain circumstances, the value driver model can be used to test the implicitreturn on net new investment (ROIC) that is within the Gordon Growth Model Thefollowing equations for continuing value illustrate this

CF1 NOPLATT + 1(1 g / ROIC)

CV
CV
_

CF1 NOPLATT + 1(1 g / ROIC ) _

CF1
NOPLATT1(1 g / ROIC )

g

NOPLATT + 1This formula can assist the analyst in determining whether the assumed return

on net new investment (capital) is above, below, or at the cost of capital

The value driver method can result in a lower terminal value than theGordon Growth Model This is sometimes due to inaccurate assump-tions in the Gordon Growth Model

ValTip

10Ibid., p 283 – 284.

CAPITALIZED CASH FLOW METHOD

The capitalized cash flow method of the income approach is an abbreviated version

of the discounted cash flow method where growth (g) and the discount rate (k) areboth assumed to remain constant into perpetuity

Its formula is:

NCF1 _

(k g)Where:

NCF1 = Net cash flow in year 1

k = Discount rate

g = Growth rate into perpetuity

Other than this constancy of growth and risk, the same theory and assumptionshold true for the CCF method as for the DCF method with regard to the economicbenefit stream, measurement of risk, the affects of growth, and so forth See thebeginning of this chapter for additional details

Relationship of Discounted Cash Flow Method to

Capitalized Cash Flow Method

The CCF Method formula above works if the numerator, that is, the net cash flow,

at the end of the first year divided by the capitalization rate (k – g) in the GordonGrowth Model equals the product of the DCF model with constant growth Assume

a constant growth rate of 6 percent and initial cash flow of $10,000 The “proof”would look something like Exhibit 4.17

Since the CCF method is an abbreviated form of the DCF method, the theorythat assets are worth the present value of their future economic income streamsholds true with the CCF method Moreover, as stated in the DCF method section,the economic income stream is a generalized term for any type of economicincome (E) including but not necessarily limited to various types of cash flows,dividends, net income, earnings before taxes, and so on Obviously, the moreassured one is of receiving that future cash flow, the higher the value The detail

on determining the appropriate cash flow to be capitalized is discussed elsewhere

in this chapter

The present value factor for the denominator in the CCF method is called acapitalization rate and is made up of two components, the discount rate (k) and thelong-term sustainable growth rate (g)

Where: k
Discount rate commensurate with the future economic income

g
Long-term sustainable growth rate

The future economic benefit selected for the CCF model is the expected cashflow (or its equivalent) in the period following the valuation date For example, if

CF is $100,000 and the valuation date is December 31, 2001, then CF1is expected

on December 31, 2002, as shown in Exhibit 4.18

The Sum of the Present Values of Expected Future Cash Flows Using the Gordon Growth

Exhibit 4.18 Expected Cash Flow

$100,000

Midyear Convention for CCF

Like the DCF, the CCF method also can reflect cash flows being received evenlythroughout the year with a short cut using the midyear convention

The formula is:

NCF° (1 g) (1 ke).5

EXCESS CASH FLOW METHOD

History of the Method

The excess cash flow method, referred to in many texts as the “excess earningsmethod,” the “Treasury method,” and the “formula method,” is a blend of the assetand income approaches It was introduced to estimate the intangible value of brew-eries and distilleries lost as a result of Prohibition in the 1920s This method firstappeared in a 1920 publication by the Treasury Department, Appeals and ReviewMemorandum Number 34 (ARM 34), but was later updated and restated inRevenue Ruling 68-609

Over the years, this method has become popular in valuing businesses fordivorce cases, especially in jurisdictions where goodwill is considered a nonmaritalasset and is therefore segregated In addition, this method is sometimes used for cor-porate C to S conversions and other scenarios where there is a need to isolate cer-tain intangible assets Its popularity is somewhat surprising, however, in light of thevery first sentence of Revenue Ruling 68-609: “The ‘formula’ approach may be used

in determining the fair market value of intangible assets of a business only if there

is no better basis available for making the determination” (emphasis added).

Revenue Ruling 68-609 and ARM 34 discuss using the ECF to estimate thevalue of the intangible assets of a business rather than the total business assets Theruling is often misread Of particular concern is the ruling’s reference to various per-centage returns The ruling states:

A percentage return on the average annual value of the tangible assetsused in a business is determined, using a period of years (preferable notless than five) immediately prior to the valuation date The amount ofthe percentage return on tangible assets, thus determined, is deductedfrom the average earnings of the business for such period and the

remainder, if any, is considered to be the amount of the average annualearnings from the intangible assets of the business for the period Thisamount (considered as the average annual earnings from intangibles),capitalized at a percentage of, say, 15 to 20 percent, is the value of theintangible assets of the business determined under the “formula”approach.

The percentage of return on the average annual value of the ble assets used should be the percentage prevailing in the industryinvolved at the date of valuation, or (when the industry percentage is notavailable) a percentage of 8 to 10 percent may be used

tangi-The 8 percent rate or return and the 15 percent rate of tion are applied to tangibles and intangibles, respectively, of businesseswith a small risk factor and stable and regular earnings; the 10 percentrate of return and 20 percent rate of capitalization are applied to busi-nesses in which the hazards of business are relatively high

capitaliza-The above rates are used as examples and are not appropriate in allcases In applying the “formula” approach, the average earnings periodand the capitalization rates are dependent upon the facts pertinentthereto in each case

The ruling is very clear, however, that these rates are merely suggested rates andshould not be used without one’s own analysis of risk/reward

The ECF method can be prepared using either equity or invested capital returnsand cash flows The procedures, using an invested capital method are shown inExhibit 4.19

Exhibit 4.19 Procedures for ECF

_

1 Determine the fair market value of the “net tangible assets.”

2 Develop normalized cash flows.

3 Determine an appropriate return (WACC) for the net tangible assets.

4 Determine the “normalized” cash flows attributable to “net tangible asset” values.

5 Subtract cash flows attributable to net tangible assets from total cash flows to determine cash flows attributable to intangible assets.

6 Determine an appropriate rate of return for intangible asset(s).

7 Determine the fair market value of the intangible asset(s) by capitalizing the cash flows attributable to the intangible asset(s) by an appropriate capitalization rate determined in step 6.

8 Add the fair market value of the net tangible assets to the FMV of the intangible assets.

9 Subtract any interest bearing debt to arrive at a value conclusion for equity.

10 Observe the overall capitalization rate for reasonableness.

Subtract the cash flows attributable to the net tangible assets from the total normalized cash flows