BUSINESS VALUATION THEORY AND METHODOLOGY

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BUSINESS VALUATIONTHEORY AND METHODOLOGY

• Presented by
• Patricia Cartwright
• Vice President
• Hill Schwartz Spilker Keller LLC

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BUSINESS VALUATION

• Business Valuation is the act or process of
  determining the value of a business enterprise,
  business ownership interest, security or
  intangible asset.
•  
• Source American Society of Appraisers, Business
  Valuation Standards

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BUSINESS VALUATION

• Some of the uses for a business appraisal
• Transaction Support (Acquisition/Divestiture/Merg
  ers)
• Bankruptcy     
• Strategic Alliances (Joint Ventures/Partnerships)
• Estate, Gift and Income Tax
• Litigation Support
• Marital Dissolution
• Partnership Dissolution
• Economic Damages
• Infringement Damages 
• Intercompany Transactions (Transfer Pricing)

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BUSINESS VALUATION
More uses for a business appraisal

• Corporate Federal and State Tax
• Mergers, Acquisitions, Divestitures
• Corporate Reorganization
• Delaware Corporation
• FIRPTA
• Ad Valorem (Tangible and Business Enterprise)
• Employee Stock Ownership Plans

• Financing
• Business Enterprise Investment
• Equity Investment
• Debt Investment
• Asset Based (Collateralized by specific assets)
• Financial Accounting (FASB Standards
  Requirements)
• Asset Impairment Analyses (Tangible and
  Intangible)
• Purchase Price Allocation
• Goodwill

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PROFESSIONAL STANDARDS OF VALUATION

• The Appraisal Foundation
• The Board of Trustees of the Appraisal
  Foundation
• The Appraisal Standards Board
• The Appraisal Qualifications Board
• Uniform Standards of Professional Appraisal
  Practice (USPAP)

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PROFESSIONAL STANDARDS OF VALUATION

• American Society of Appraisers (ASA)
• Institute of Business Appraisers
• Canadian Institute of Chartered Business
  Valuators (CICBV)
• ESOP Association
• American Institute of Certified Public
  Accountants (AICPA)
• Association for Investment Management and
  Research (AIMR)

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PROFESSIONAL STANDARDS OF VALUATION

• Internal Revenue Service
• Revenue Rulings
• (59-60, 68-609, 77-2-87, 83-120, 93-12)
• Department of Labor
• International Standards

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GETTING STARTED

• What do we need to know to get started?
• Description of the business, Business ownership
  interest, or security to be valued.
• If an interest, then a description of the
  specific ownership characteristics
• Size of interest relative to total.
• Degree of marketability (e.g. public, private,
  and related matters)
• The date of value.
• The standard of value.
• The premise of value.
• The purpose and intended use of the appraisal.

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STANDARD OF VALUE

• Without a careful definition of value, valuation
  conclusions will have little meaning.
• Fair Market Value
• Investment Value
• Intrinsic Value or Fundamental Value
• Fair Value

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PREMISE OF VALUE

• Value as a going concern
• Value as an assemblage of assets
• Value in an orderly disposition
• Value in a forced liquidation

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THE ENVIRONMENT OF VALUE

• The appraiser shall gather, analyze, and adjust
  the relevant information necessary to perform a
  valuation appropriate to the scope of work. Such
  information shall include
•  
• Characteristics of the business, business
  ownership interest, or security to be valued,
  including rights, privileges, conditions,
  quantity, factors affecting control, and
  agreements restricting sale or transfer,
• The nature, history and outlook of the business,
• Historical financial information for the
  business,
• The nature and conditions of relevant industries
  that have an impact on the business,

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THE ENVIRONMENT OF VALUE

• Economic factors affecting the business,
• Capital markets providing information for
  example, available rates of return on alternative
  investments, relevant public stock market
  information, and relevant merger and acquisition
  information,
• Prior transactions involving the subject
  business, an interest in the subject business, or
  the securities of the subject business, and
• All other information relevant to the particular
  circumstances and characteristics of the subject
  business.
•  
•  
• Source ASA Business Valuation Standards

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APPROACH TO VALUE

• There are three broad approaches to value
• The Market Approach
• The Cost Approach
• The Income Approach

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APPROACH TO VALUE

• The three basic approaches are not discrete from
  each other, but interrelated.
• The market approach correlates market comparative
  value observations with information from the
  subjects income statements (earnings measures)
  and balance sheets (asset measures).
• The cost approach develops replacement cost
  relying on the assets utility. It reflects
  physical, functional and economic obsolescence
  based on the assets condition, comparative cost
  to operate, and income-generating capacity.
• The income approach relies on discount and
  capitalization rates determined based on market
  information. Moreover, in developing projected
  income, the asset costs must be considered when
  projecting fixed asset investment or
  depreciation.

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THE MARKET APPROACH

• The recent sale of a similar asset is the best
  indication of the subject assets value. A major
  factor in applying the market approach is to
  collect reliable market data on the sale of
  similar or comparative assets. Comparative sales
  are analyzed and adjusted to reflect differences
  between the comparative and the subject.
• Strength
• Weakness

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THE GUIDLINE COMPANY METHOD

• This method is most useful in developing fair
  market value. The method is based on making
  comparisons between the subject company and
  active market transactions in or of a guideline
  company in whole or in part.

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THE GUIDLINE COMPANY METHOD

• CRITERIA FOR GUIDELINE COMPANY SELECTIONS
• In analyzing whether or not a particular public
  company should be considered an appropriate
  guideline or which of the guideline companies are
  most comparative there are several important
  factors
•  
• Capital Structure Products
• Credit status Markets
• Depth of management Earnings
• Experience of workforce Dividend-paying
  capacity
• Competitive environment Position of company in
  industry
• Stage of business development Amount and
  condition of underlying assets

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THE GUIDELINE COMPANY METHOD

• VALUE MEASURES
• A value measure is a multiple computed by
  dividing the market value of the guideline
  companys total invested capital (MVIC)all
  equity and interest bearing debtby financial
  statement information. Value measures are
  computed on an operating basis, with nonoperating
  items removed.
• Some income statement and balance sheet variables
  used to develop value measures for total invested
  capital
• Net sales
• Earnings before interest and taxes (EBIT)
• Earnings before depreciation, amortization,
  interest and taxes (EBDITA)
• Debt free after tax cash flow (DFATCF)
• Book value
• Tangible book value
• Adjusted book value
• Adjusted tangible book value

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THE COST APPROACH

• The cost approach is based on the economic
  principle of substitution. That is, a willing
  buyer will pay no more to a willing seller than
  the cost associated with replacing the subject
  asset with an asset of comparable functional
  utility.
• Replacement Cost
• Reproduction Cost
• Historic Cost

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THE COST APPROACH

• Replacement Cost New
• ( - ) Physical Deterioration
• ( - ) External or Economic Obsolescence
• ( - ) Functional or Technological
  Obsolescence
• ( ) Fair Market Value
• Strength
• Weakness

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THE INCOME APPROACH

• When an income-producing asset is purchased, what
  is actually being bought is a stream of
  prospective economic income (typically after tax
  cash flow). The income approach is founded on
  the economic principle of anticipation or
  expectation. As the name of the economic
  principle implies, the investor anticipates the
  expected economic income.

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THE INCOME APPROACH

• There are two principles methods within the
  income approach
• The Discounted Cash Flow Method
• The Capitalization of Cash Flow Method
• In either case the income approach becomes a
  two-step process
• Project future after tax cash flow as of the date
  of value.
• Discount the projected after tax cash flow at a
  risk-appropriate discount rate and sum.

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THE INCOME APPROACH

• The following accounting equation presents the
  fundamental reality of a business balance sheet
  the value of a business total assets is
  equivalent to the value of its total debt and
  equity.
• CA FA IIA UIA CD LTD E

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THE INCOME APPROACH

• BUSINESS ENTERPRISE VALUE
• By deducting current debt from both sides of the
  balance sheet we arrive at the following
  equation
• NWC FA IIA UIA LTD E
• CA Current Assets
• FA Fixed Assets
• IIA Identified Intangible Assets
• UIA Unidentified Intangible Assets
• CD Current Debt
• LTD Long-Term Debt
• E Equity
• NWC Net Working Capital (CA CD)

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THE INCOME APPROACH

• CALCULATING AFTER TAX CASH FLOW
• To develop business enterprise value or total
  invested capital, the projected after-tax cash
  flow must be that available to both debt and
  equity investors

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THE INCOME APPROACHDEBT-FREE AFTER TAX CASH FLOW

• Revenues
• Cost of Revenues
• Gross Profit
• Operating Expenses
• Operating Profit
• Depreciation Amortization
• Tangible Asset Depreciation
• Intangible Asset Amortization
• Total Depreciation Amortization

• Net Income Before Taxes
• Federal State Income Taxes
• Net Income After Taxes
• Add Back
• Depreciation Amortization
• Deduct
• Changes in Working Capital
• Sustaining Capital Expenditures
• Debt-Free After-Tax Cash Flow
• Excludes Interest on Long-Term Debt

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THE INCOME APPROACHWEIGHTED AVERAGE COST OF
CAPITAL

• The appropriate discount rate for use with
  debt-free after tax cash flow would be the
  weighted average cost of capital. The weighted
  average cost of capital (WACC) is the cost
  associated with the investments overall capital
  structure--the weighted average of the costs of
  all its financing sources.

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THE INCOME APPROACHWEIGHTED AVERAGE COST OF
CAPITAL

• WACC (Ke x We) (Kd 1 t x Wd)
• WACC Weighted average cost of capital
• Ke Cost of equity
• Kd Cost of debt
• We of equity in the capital structure
• Wd of debt in the capital structure
• t Effective income tax rate

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THE INCOME APPROACHWEIGHTED AVERAGE COST OF
CAPITAL

• Data Sources in Developing a WACC
• The data you will need to develop a WACC will be
  the cost of equity (an equity discount rate), the
  cost of debt, the appropriate capital structure
  for the business being valued and the business
  effective income tax rate.

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THE INCOME APPROACHWEIGHTED AVERAGE COST OF
CAPITAL

• Equity Discount Rate
• The most common method of developing a equity
  discount rate is the Capital Asset Pricing Model
• Ke Kf ß(Km - Kf ) ?
• Ke Cost of equity
• Kf Risk-free rate of return
• ? Beta (Systematic Risk)
• Km Market Return on Equity
• ? Alpha (Unsystematic Risk)

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THE INCOME APPROACHWEIGHTED AVERAGE COST OF
CAPITAL

• Cost of Debt
• The appropriate measure of the cost of debt would
  be the typical yield to maturity available in the
  market on debt securities with a risk profile
  similar to the subject company.
• Capital Structure
• The appropriate capital structure will depend on
  the goal of the valuation analysis.

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VENTURE CAPITAL RETURNS

• In his text on the valuation of early stage
  technologies1, Richard Razgaitis provides some
  general guidelines on the risk-adjusted returns
  required by technology investors. These
  estimates are based on the authors own extensive
  experience. Definitions of the various risk
  levels vary, but generally follow the following
  short descriptions
•  
• 1 Early-Stage Technologies Valuation and
  Pricing, Richard Razgaitis, 1999.

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VENTURE CAPITAL RETURNS

• Expected venture capital returns for investments
  in companies in various stages of development1.
  
• 1 QED Venture Capitalist Report

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THE INCOME APPROACHDISCOUNTED CASH FLOW METHOD

• A discounted cash flow model incorporates the
  quantity, variability, timing, and duration of
  debt-free after-tax cash flows attributable to
  the refinery. The model has a finite time span
  for the analysis, usually five to ten years,
  during which each forecasted annual debt-free
  after-tax cash flow is discounted to its
  date-of-value equivalent and summed. The value
  at the end of the models term, the reversion, is
  also forecast and discounted to its date-of-value
  equivalent. The sum of the discounted annual
  debt-free after-tax cash flows and the discounted
  reversion is the refinerys business enterprise
  value on the date of value.

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THE INCOME APPROACHDISCOUNTED CASH FLOW METHOD

• Present Value Interest Factor
• Each debt-free after tax cash flow is discounted
  to its present value through multiplication by a
  present value interest factor which incorporates
  the WACC
• PVIF 1/ (1 Kw) (t 0.5)
• Where,
• PVIF present value interest factor
• Kw weighted average cost of capital
• t individual year of cash flow

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THE INCOME APPROACHDISCOUNTED CASH FLOW METHOD

• Mid-Year Convention
• The exponent of the denominator in the foregoing
  formula(t 0.5)is termed a mid-year
  convention. Its purpose is to better reflect the
  fact that cash flows are received continuously
  throughout the year and not at the end of the
  year. The mid-year convention assumes that cash
  flows are received in the middle of each year of
  the forecast.

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THE INCOME APPROACHDISCOUNTED CASH FLOW METHOD

• The Reversion
• While the cash flows are discretely forecast over
  a finite time period, the refinery will typically
  have value at the end of that term. This value
  is called the reversion and is calculated using
  the Gordon Model
• Vt CF(t 1) / (Kw G)
• Where,
• Vt value at the end of the models term
• CF(t 1) cash flow in the year following the
  end of the models term
• Kw weighted average cost of capital
• G projected long-term growth rate
• t final year of the model

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SAMPLE DCF
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THE INCOME APPROACHCAPITALIZATION OF CASH FLOW
METHOD

• Capitalizing, for which a capitalization rate is
  used, is a process applied to normalized annual
  after-tax cash flow to convert that after-tax
  cash flow into an estimate of value. The
  capitalization of cash flow method, then,
  involves two steps
• Estimating a normalized annual after-tax cash
  flow
• Applying an appropriate capitalization rate.

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THE INCOME APPROACHCAPITALIZATION OF CASH FLOW
METHOD

• Normalized after-tax cash flow reflects the
  true cash-flow generating capacity of the
  investment uninfluenced by extraordinary,
  unnecessary or nonrecurring factors.
  Furthermore, an average of all necessary expenses
  at the projected revenue level must be reflected
  in the calculation of normalized after-tax cash
  flow.
• If growth is expected from the base level of
  normalized after-tax cash flow, that expected
  growth must be reflected in the capitalization
  rate or denominator of the capitalization rate
• C Kw G
• Where,
• C Capitalization rate
• Kw Weighted Average Cost of Capital
• G Expected annual compound growth rate of
  projected normalized after-tax cash flow being
  capitalized

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SAMPLE CASE

• NewTechCo
• Pro Forma Income Statements
• (000s)
• Year Ending
• 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec
  -07 31-Dec-08 31-Dec-09 31-Dec-10
• Sales 5,160 7,740 11,610 17,415 26,123 39,1
  84 58,776 88,163
• Cost of Sales 3,939 5,121 6,657 8,654 11,250 14,62
  5 19,013 24,717
• RD 1,032 1,548 2,322 3,483 5,225 7,837 11,755 1
  7,633
• Gross Profit 189 1, 071 2,631 5,278 9,648 16,722
  28,008 45,814
• Operating Exps.
• Dep. Amort. 510 663 862 1,120 1,457 1,894 2,462
  3,200
• S, G A 374 486 632 822 1,068 1,389 1,805 2,347
• Other Expense 25 34 46 62 83 112 151 204
• Total Operating Exps. 909 1,183 1,540 2,004 2,608
  3,394 4,418 5,751
• NIBT lt720gt lt112gt 1,092 3,274 7,040 13,327 23,589
  40,063
• Tax Expense 284 44 431 1,293 2,781 5,264 9,318 15,
  825
• NIAT lt436gt lt68gt 660 1,981 4,259 8,063 14,2
  72 24,238

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SAMPLE CASE

• NewTechCo
• Discount Cash Flow Model
• (000s)
• Year Ending
• 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-
  07 31-Dec-08 31-Dec-09 31-Dec-10
• NIAT lt436gt lt68gt 660 1,981 4,259 8,063 14,2
  72 24,238
• Add Back
• Depreciation Amort. 510 663 862 1,120 1,457 1,89
  4 2,462 3,200
• Deduct
• Increases to Wkg Cap. 32 516 774 1,161 1,742 2,612
  3,918 5,878
• Capital Expenditures 510 873 1,172 1,580 2,157 2,9
  34 4,032 5,550
• Debt-Free ATCF lt468gt lt794gt lt424gt 360 1,818 4,
  411 8,783 16,010
• PVIF .8839 .6905 .5394 .4214 .3292 .2572 .2009 .
  1570
• PVATCFs lt413gt lt548gt lt229gt 152 598 1,134 1,765 2,5
  13
• Sum of PVATCFs 4,973
• Reversion 11,470
• Business Enterprise Value 16,443

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BUSINESS VALUATIONTHEORY AND METHODOLOGY

• Presented by
• Patricia Cartwright
• Vice President
• Hill Schwartz Spilker Keller LLC