Business valuations: The art of the science - Part 1
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Business valuations are a combination between well-developed financial principles (science) and professional judgement (art). From the onset there is one principle that needs highlighting:
The best form of a business or any other valuation is the price that a willing buyer will pay to a willing seller in an arm’s length transaction. Please keep this principle in the back of your mind while reading the rest of this article.
It does not really matter what a business is worth on paper if no-one is willing to pay that amount. The danger of business valuations are that one can easily inflate the value of the business with ambitious future projections. Before we explore this statement, the discussion of some of the popular business valuation approaches will lay a foundation.
The Discounted Cash flow (DCF) and Net Present Value (NPV) methods.
These two methods are discussed together as they are closely connected. The basis of the DCF method is the calculation of the present value of future income. The backbone of these two methods is to take the future profits/cash flows that the business will generate and then determine what these profits/cash flows are worth today.
To illustrate by example:
Company A will generate profit of R10 in year 1, R20 in year 2 and R30 in year three. To determine the NPV of these profits you need to discount the profits to today’s value. All that this means is that you should look at what these profits are worth in today’s money. To simplify, say investor X had two options (ignore inflation for simplicity):
- Invest her money in a risk free fixed deposit at Big Bank that earns 10% interest per annum
- Invest her money by buying 100% shares in Company A
If she were to choose option 1 and invest R100, her investment after year one would be worth R110 (R100 x 10% = R10, add the R10 to the original investment of R100). After year two her investment would be worth R121 (R110 x 10% = R11, add the R11 to the value of the investment at the end of year one). Following the same logic the investment would be worth R133.10 at the end of year three. Thus she could increase her capital by R33.10 without taking any risk (not that a risk free investment is really possible, but that that is a topic for another day). Based on this, one can safely say that she would want to earn at least 10% on the investment in Company A. However by investing in Big Bank she does not take on any risk, with Company A she could lose all her money. Thus naturally she would expect additional return for the increased risk (higher risk = higher return). To determine the additional return for the additional risk, one would look at the Beta, Systematic and Unsystematic risky premium for the investment. I will return to this at a later stage. For now assume the additional reward for the additional risk is 5%. Thus a fair rate of return for investing in Company A would be 15% per annum.
You will recall that in order to get from the initial value of the investment in Big Bank to the value after year one, the calculation was ((R100 x 10%) + R100) = R110. An easier way to write this is simply R100 x 1.1 = R110. Thus to now discount the investment from year 1 to today, one needs to do the reverse of the above. That is R110 / 1.1 = R100.00.
Now you know how to discount the future profits of Company A:
Year 1: R10 / 1.15 = R8.69
Year 2: R20 / 1.15 = R17.39, but now we have only moved from year 2 to 1. Thus we must also move from year 1 to year 0. R17.39 / 1.15 = R15.12 (you can also write this as R20 / (1.15)^2, where ^ is “to the power of”)
Year 3: R30 / (1.15)^3 = R19.72
Thus the total value of all three year’s profits discounted to today is R43.53 (R8.69 + R15.12 + R19.72).
If we assume the company will only exist for three years then we can say that the value of the company to this investor is R43.53. Thus if the investor offer R30.00 for the company there will be intrinsic (built-in) value of R13.53. If the seller is willing to accept a price below R43.53 it will be a worthwhile investment for the investor.
At this stage there should be two things bothering you:
- The influence of our fair rate of return/discount rate ( 15% in example )has on the valuation, or how we determine the correct rate
- How long we assume the company will exist (three years in the example)
These points will be address in a follow up to this blog.
Author: Chris Herbst