The individual valuation techniques described earlier should be combined to form a summary analysis of estimated valuation for Simple Co. Each measure provides a view of valuation that contributes to an overall picture.
The numerical summary shown in Table 3.2 can be converted into a more user friendly visual summary in Figure 3.2.
Simple Co.’s current value is at the high end of the 12-month trading range and near or exceeding the top of the range for comparable compa- nies. In this case, it would be important to understand the underlying performance characteristics of the benchmark group compared to Sim- ple Co. Is Simple Co.’s valuation supported by better performance or higher future expectations of growth? The current market value approx- imates our estimate of the DCF value. This indicates that the market is probably expecting future performance in line with our projections used in the DCF.
56 CREATING CONTEXT AND COVERING THE BASICS
TABLE 3.2 Simple Co. Valuation Analysis: Multiples
Benchmark Range Value Basis Value Simple Co. Low High
Sales 2006 Result $100,000
Multiple 1.9 1.3 2.0
Enterprise Value/Indicated
Range $190,030 $130,000 $200,000 Equity Value/Indicated
Range $180,030 $120,000 $190,000
Earnings 2006 Result $ 9,501
Multiple 18.95 16 20
Equity Value/Indicated
Range $180,030 $152,011 $190,014
Per Share 10.59 8.94 11.18
EBITDA 2006 Result $ 18,750
Multiple 10.13 8.00 10.00
Enterprise Value/Indicated
Range $190,030 $150,000 $187,500 Equity Value/Indicated
Range $180,030 $140,000 $177,500
Price-Earnings/ P/E 18.95
Growth
Estimated
Growth (%) 8
PEG 2.37 1.3 2.0
DCF Equity Value $186,352 NA NA
SUMMARY
While each of the valuation techniques has limitations, they do provide in- sight from a variety of perspectives. It is best to use a combination of mea- sures and techniques in reviewing the valuation of a firm. When an analyst summarizes these measures for a firm and compares them to key bench- marks, significant insight can be gained. Conversely, inconsistencies across the valuation measures for a company are worth exploring and can usually be explained by identifying a specific element of financial performance that the measure doesn’t reflect. For example, a company that consistently meets or exceeds operating plans and market expectations will typically be afforded a higher P/E multiple than its peers. This positive factor is re- flected in a higher P/E multiple, and the company would trade at a pre- mium to the industry norms.
It is useful to develop a broad set of benchmark references, rather than to rely on the selection of direct comparables. In addition to provid- ing more objectivity, it is useful to compare the company to broad market measures as well as best-practice companies from other industries. Typi- cally, more can be learned by understanding why firms differ on key mea- sures than by selecting a peer group that shares common characteristics.
A much richer picture is framed by comparing your firm to market aver- ages and several best-practice companies in addition to a peer group. Fur- ther, the use of a broad set of measures, with appropriate benchmarks, would help to avoid the level of valuation errors that were made in the most recent stock market bubble. Given this foundation in valuation, we turn our attention to a focus on business models and financial projections in Chapter 4.
FIGURE 3.2 Simple Co. Valuation Summary Graph
QUESTIONS FOR CONSIDERATION
1. Utilizing the DCF model (Table 3.1) included on the CD-ROM, esti- mate the value of your company based on your expectations of future performance. If the firm is publicly traded, compare the indicated value in the DCF model to the trading value of the firm.
2. Based on recent performance and the current trading or estimated value of the company, compute the multiples of revenue, earnings, and EBITDA. How do these measures for your company compare to other companies in your industry? What factors account for differences?
3. Summarize the results of the valuation estimates. Do the estimates developed by the different valuation techniques present a consistent picture?
58 CREATING CONTEXT AND COVERING THE BASICS
CHAPTER 4
The Business Model and Financial Projections
Managers often describe the actual and targeted financial performance of their companies as a “business model.” The business model represents the quantification of a company’s strategy and business practices. The busi- ness model concept provides a useful framework for a number of business decisions ranging from pricing to setting investment and expense levels.
However, managers may lock into a single business model concept, limiting their ability to effectively compete or grow into other markets.
The common view of a business model represents a target profit and loss (P&L) model. The manager thinks of the business in terms of the P&L captions and the relationship of each line item as a percentage of sales as il- lustrated in Table 4.1.
59 TABLE 4.1 Business Model Illustration: Traditional View
Simple Co. 2006 % of Sales
Sales $100,000 100.0%
Cost of Sales 45,000 45.0
Gross Margin $ 55,000 55.0%
SG&A $ 32,000 32.0%
R&D 8,000 8.0
Total Expenses $ 40,000 40.0%
Operating Income $ 15,000 15.0%
Other (Income) Expense 605 0.6
Taxes 4,894 4.9
Net Income $ 9,501 9.5%
Using this conceptual framework, managers will set prices, establish business plans, evaluate business proposals, set expense levels, and make other critical business decisions. For example, a company that is develop- ing a product with a cost to produce of $450 would likely set a target sell- ing price of $1,000 to maintain the 55 percent margin. In establishing the research and development (R&D) budget, the company may target spend- ing at 8 percent of projected sales.