Archive for the ‘Business Valuations’ Category
Basic Elements of a Quality Business Plan
Entrepreneurs who invest their time and energy to prepare a business plan, will be better prepared to face the risks of doing business competition. In previous editions we’ve talked about the business plan as a road map and a means of getting capital entrepreneurs in building successful businesses.
Although the business plan does not guarantee 100% success, but this plan would increase the chances of business success for entrepreneurs. There are many approaches in the preparation of business plans. However, a quality business plan to include at least eight basic elements, namely:
Executive summary.
General description of the business.
Marketing plan.
Production plan.
Analysis of competition.
Financial plan.
Human resource plans.
The main risks faced.
Weighted average cost of capital (“WACC”)
The weighted average cost of capital is an approach to determining a discount rate. The WACC method determines the subject company’s actual cost of capital by calculating the weighted average of the company’s cost of debt and cost of equity. The WACC must be applied to the subject company’s net cash flow to total invested capital.
One of the problems with this method is that the valuator may elect to calculate WACC according to the subject company’s existing capital structure, the average industry capital structure, or the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics.
Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation.
Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic income stream: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.
Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.
Capital Asset Pricing Model (“CAPM”) The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment. One of the criticisms of the CAPM method is that beta is derived from the volatility of prices of publicly-traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAPM method may be appropriate.
Discount or capitalization rates
A discount rate or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.
In DCF valuations, the discount rate, often an estimate of the cost of capital for the business is used to calculate the net present value of a series of projected cash flows.
On the other hand, a capitalization rate is applied in methods of business valuation that are based on business data for a single period of time. For example, in real estate valuations for properties that generate cash flows, a capitalization rate may be applied to the net operating income (NOI) (i.e., income before depreciation and interest expenses) of the property for the trailing twelve months.
There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements:
- the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus
- a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied.
How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet. Let me say up front that I do not believe that business owners should do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.
So to ensure that you set and get the best price when you’re selling a business, I recommend getting a business valuation done by a professional, such as a Chartered Business Valuator (CBV). In Canada, you can find Business Valuators through the yellow pages or through the website of the Canadian Institute of Chartered Business Valuators.
A Business Valuator (or anyone valuating your business) will use a variety of business valuation methods to determine a fair price for your business, such as:
1) Asset-based approaches
Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.
A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
2) Earning value approaches
These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.
With this approach, a valuator determines an expected level of cash flow for the company using a company’s record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
A business valuation report generally begins with a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the subject business operates. A common source of economic information for the first section of the business valuation report is the Federal Reserve Board’s Beige Book, published eight times a year by the Federal Reserve Bank. State governments and industry associations also publish useful statistics describing regional and industry conditions.
Financial analysis
The financial statement analysis generally involves common size analysis, ratio analysis (liquidity, turnover, profitability, etc.), trend analysis and industry comparative analysis. This permits the valuation analyst to compare the subject company to other businesses in the same or similar industry, and to discover trends affecting the company and/or the industry over time. By comparing a company’s financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends. How the subject company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples.
Standard and premise of value
Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value.[1] The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of business assets).
Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability.
Note, however, that it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally-accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
Normalization of financial statements
The most common normalization adjustments fall into the following four categories:
- Comparability Adjustments. The valuer may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.
- Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.
- Non-recurring Adjustments. The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management’s expectations of future performance.
Discretionary Adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.
Income, asset and market approaches
Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach[2]. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business (discounted cash flow); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.
A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago method which essentially combines the income approach with the market approach.
In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.
When you see someone in a high position to run a business company, what comes first to your mind? Maybe you think the feeling of being this someone. Or maybe, you think about what it takes to be this someone. And due to your thoughts, now you have the courage in yourself to be just like him. You have your own company, one thing you do not have to worry anymore, compared to those who don’t have the business yet.
All you have to do now is to find a way to increase your business and obtain the greatest achievement. If you realize it, all you need to do is to find a new way to see the business. There is a big number of chances and opportunities available. You only have to be sharp enough to see them and have the courage to grab them. Business Valuations come among these available choices. The question is what can you do with your business with their help?
There are so many things you can do. Business valuations give you the chance to develop your business by giving advices. They will learn what your business is all about, see the competitors and the availability to win the competition, and finally they help you to make a better decision for the future both you and the business.