Financial Methods in Business Valuation

1. Financial Methods in Business Valuation

Tunlikbayeva Elzira

2. Outline

Business Valuation Introduction
Reasons for a Business Valuation
Valuation Process and Standards of Value
Valuation Methodology
Methods of Corporate Valuation
Private Company Valuation
Discounts and Premiums
2

3. Business Valuations

“The act or process of determining the
value of a business enterprise or
ownership interest therein.”
*International Glossary of Business Valuation.
*IRS Business Valuation Guideline 2006
3

4. What are “Business Valuations?”

ASSET APPRAISAL
Real Estate
Machinery & Equipment
Intangible Assets
BUSINESS VALUATION
Complete Business Enterprise Valuation
4

5. Reasons for Business Valuations

Sale of business or part interest
Ownership Disputes
Financing
Buy-Sell Agreements
Employee Stock Ownership Plans
Condemnation
Divorce
Estate Planning
Change of Business Structure
Recapitalization
Life Insurance
5

6. Business Valuation: Common Uses of Business Valuation

Tax
– Estate/Gifts
– Employee Stock Ownership Plan (ESOP)
– Buy/Sell Agreements
– Internal Revenue Codes (IRC)
Bankruptcy and Litigation
– Liquidation or Reorganization
– Patent Infringement
– Partner Disputes
– Economic Damages
– Solvency and Fairness Opinions
– Damage Assessment
– Dissenting Shareholder Actions
– Dissolutions
Financial Reporting
– Purchase Price Allocation, Impairment Testing and Stock Options and Grants, etc.
Strategic Planning/Transaction
– Value Enhancement
– Business Plan/Capital Raising
– Strategic Direction, Spin-Offs, Carve Outs, etc.
– Acquisitions, Due Diligence
6

7. MAIN VALUATION METHODS

MAIN VALUATION METHODS
BALANCE
SHEET
INCOME
STATEMENT
MIXED
(GOODWILL)
CASH FLOW
VALUE
DISCOUNTING CREATION
OPTIONS
Book value
Multiples PER Classic Union of Equity cash flow
EVA
Black and
Adjusted book
European
Dividends
Scholes
value
Liquidation value Sales P/EBITDA Accounting
Free cash flow Economic profit
Investment
Capital cash
option Expand
flow
the
Substantial
Other multiples
Experts
APV
Cash value
project
value
Abbreviated
added CFROI
income
Others
Delay the
investment
Alternative uses
7

8.

Standards of Value
and Valuation Process
8

9. Business Valuation: Standard of Value

Purpose
– Establish Purpose of the Engagement
» Estate/Gift, Buy/Sell Agreements, etc.
» Standards of Value (i.e. Fair Market Value, Fair Value, etc.)
» Interest Being Valued (i.e. Enterprise, Equity, Marketable, NonMarketable, Control, Minority, etc.)
Valuation Date
– Agree on a Appropriate Valuation Date
» Utilize Data Subsequent to the Valuation Date
» Sometimes can Consider Data After the Valuation Date if it was
Foreseeable as of the Valuation Date
9

10. Business Valuation: Standards of Value

Common Standards of Value
– Fair Market Value (Tax): Fair market value applies to virtually all federal
and state tax matters, including estate, gift, inheritance, income and ad
valorem taxes as well as many other valuation situations.
» “The fair market value is the price at which the property would change hands
between a willing buyer and a willing seller, neither being under any compulsion
to buy or to sell and both having reasonable knowledge of relevant facts.” – IRS
Revenue Ruling 59-60
– Liquidation Value: Orderly; forced.
– Fair Value (Financial Reporting): Can vary but it is generally similar to
Fair market value with some exceptions.
» The amount at which an asset (or liability) could be bought (or incurred) or sold
(or settled) in a current transaction between willing parties, that is, other than in
a forced or liquidation sale.”-FASB (Financial Accounting Standards Board) 157
– Fair Value (Litigation): Fair value may be the applicable standard of
value in a number of different situations, including shareholder dissent
and oppression matters, corporate dissolution and divorce.
10

11. Fair Value (FASB Definition)

Fair Value – is defined in this subtopic as
the price that would be received to sell
an asset or paid to transfer a liability in
an orderly transaction between market
participants at the measurement date.
11

12. Fair Value (Legal Definition)

Fair Value- is often used in court cases to
compensate a party for the involuntary use
of an asset, such as eminent domain, where
there is no reasonable assumption of a fair
market value transaction.
12

13. General Valuation Objectives

There is no one right way to value an asset, and in many cases, the process of
assigning a single dollar value to a complex asset is as much art as it is
science.
Business appraisers strive to achieve results that meet certain general
requirements.
Consistency Ideally, different skilled appraisers should produce a similar
valuation for a given asset.
Defensibility There is always the general possibility that any valuation
could be subjected to legal challenges.
Suitability for purpose Valuations must be suitable to the purposes and
circumstances of the individuals needing the information.
13

14. Misconceptions about Valuation

Myth 1: A valuation is an objective search for “true” value
Truth 1.1: All valuations are biased. The only questions are how much and
in which direction.
Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you.
Myth 2.: A good valuation provides a precise estimate of value
Truth 2.1: There are no precise valuations
Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
Myth 3: . The more quantitative a model, the better the valuation
Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
Truth 3.2: Simpler valuation models do much better than complex ones.
14

15. Professional Organizations: The Appraisal Foundation

The Appraisal Foundation comprises two independent boards.
The Appraiser Qualifications Board (AQB) and the Appraisal
Standards Board, promulgates the widely recognized uniform
standards of professional appraisal practice (USPAP). USPAP
components include the following:
Standards and standards rules
business appraisal reporting.
For example, Standard 10 deals with
Statements on appraisal standards For example, Statement on
Appraisal Standard 2 deals with discounted cash flow analysis.
Advisory opinions These opinions relate to specific subjects. For
example, Advisory Opinion 10 deals with the appraiser-client relationship.
15

16. Standards

Business valuation appraisers follow the following standards and guidelines:
American Institute of Certified Public Accountant’s Statements of
Standards for Valuation Services No. 1 (“SSVS”);
The Appraisal Foundation’s Uniform Standards of Professional Appraisal
Practice (“USPAP”);
The ethics and standards of the American Society of Appraisers; and
The Internal Revenue Service’s business valuation development and
reporting guidelines.
16

17. Revenue Rulings

Revenue Ruling 59-60
Outlines the approaches, methods, and factors to be considered in valuing
shares of stock in closely-held corporations for federal tax purposes.
Revenue Ruling 65-192
Extended the concepts in Revenue Ruling 59-60 to income and other tax
purposes as well as to business interests of any type.
17

18. RR 59-60 Factors

The nature of the business and its history since inception
The economic outlook in general and the condition and outlook
of the specific industry in particular
The book value of the stock and the financial condition of the
business
The earning capacity of the company
The dividend paying capacity
Whether or not the enterprise has goodwill or other intangible
value
Sales of stock and the size of the block of stock to be valued
The market price of stocks of corporations engaged in the same
or in a similar line of business having their stocks actively
traded in a free and open market, either on an exchange or overthe-counter
18

19. National valuation standards of RK

1. Kazakhstan valuation Standard "Valuation of assets acquired and disposed of
by the state on separate grounds"
(Стандарт оценки "Оценка имущества, приобретаемого и отчуждаемого
государством по отдельным основаниям")
2. Kazakhstan valuation Standard "Defining the cadastral value of real estate"
(Стандарт оценки Республики Казахстан "Определение кадастровой стоимости
объектов недвижимости")
3. Kazakhstan valuation Standard of "Determination of fair value in accordance
with IFRS"
(Стандарт оценки Республики Казахстан "Определение справедливой
стоимости в соответствии с МСФО")
4. Kazakhstan valuation Standard "Valuation for lending purpose"
(Стандарт оценки Республики Казахстан "Оценка для целей кредитования" )
19

20. National valuation standards of RK

5. Kazakhstan valuation Standard "Valuation of Intellectual Property and Intangible
Assets"
(Стандарт оценки Республики Казахстан "Оценка стоимости объектов
интеллектуальной собственности и нематериальных активов")
6. Kazakhstan valuation Standard "Databases and the types of value"
(Стандарт оценки Республики Казахстан "Базы и типы стоимости" )
7. Kazakhstan valuation Standard "Valuation of Report reliability"
(Стандарт оценки "Проверка достоверности отчета")
8. Kazakhstan valuation Standard "Business Valuation"
(Стандарт оценки "Оценка стоимости бизнеса")
9. Kazakhstan valuation Standard "Requirements for the form and content of the
valuation report"
(Стандарт оценки Республики Казахстан "Требования к содержанию и форме
отчета об оценке")
20

21. National valuation standards of RK

10. Kazakhstan valuation Standard "Valuation of movable property"
(Стандарт оценки Республики Казахстан "Оценка стоимости движимого
имущества")
11. Kazakhstan valuation Standard “Valuation of real estate’
(Стандарт оценки Республики Казахстан "Оценка стоимости недвижимого
имущества")
21

22. Business Valuation: Valuation Process

1.1 Proposal
and
Engagement
Letter
Signed Engagement
Letter with Retainer
2.1 Company
and Industry
Analysis
1.3 Establish
Valuation
Date
1.2 Establish
Standard of
Value and
Define Purpose
1.4 Data
Gathering
Ongoing Internal Review and Discussion with Other
Professionals and Client
2.3 Adjustments
and Recasts
(Control)
2.2 Analyze
Historical
Financial
Statements
2.4 Financial
Statements
Analysis
(Ratios, etc.)
Ongoing Internal Review and Discussion with Other
Professionals and Client
3.1 Implement
Selected
Valuation
Methodologies
3.2 Narrative
Write-up of the
Report
3.3 Final Internal
Review and QC
Process
Income, Market, Net
Asset Approaches
22
3.4 Finalize

23. Elements of a Business Valuation Packet

1. Engagement Agreement
2. Checklist
3. Site Visit
23

24. Engagement Agreement

Rule 201A, Professional Competence, of the AICPA
Code of Professional Conduct, states that a member
shall “undertake only those professional services
that the member or the member’s firm can
reasonably expect to be completed with professional
competence.”
24

25. Engagement Agreement

In determining to accept an assignment, an evaluator considers,
at a minimum, the following:
Subject entity and its industry
Subject interest
Valuation date
Scope of the valuation engagement
– Purpose of the valuation
– Assumptions and limiting conditions
– Applicable standard of value
– Type of valuation report
Government regulations
25

26. Engagement Agreement

Other factors to be considered
Objectivity and Conflict of Interest
Independence and Valuation
Establishing an Understanding with the Client
Assumptions and Limiting Conditions
Scope Restrictions and Limitations
26

27. Business Valuation: Analyzing Data

Researching Economic and Industry Information
– Economy of Country
– Local Economy
– Target Industry
Financial Statements Analysis
– Adjustments and Recasts (Control Value)
» Extraordinary Items, Shareholders’ Perquisites (Personal
Expenses), Fair Market Value Compensation and Rent, etc.
– Ratio and Trend Analysis
» Growth Rates, Liquidity, Leverage, Profitability, Efficiency, etc.
27

28. Business Valuation: Gathering Data

Gathering Company Data
– Articles of Incorporation; Operating Agreement
– History and Background
– Products and Services
– Shareholders and Key Personnel Compensations and Responsibilities
– Organization/Corporate Structure
– Operations
– Customers/Clients, Target Markets and Suppliers
– Legal, Tax and Other Considerations
– Five Year Historical and Latest Interim Financial Statements
– Other Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if needed)
– Adjustments
– Projections (If applicable)
28

29. Checklist

A basic information checklist includes the following:
Historical financials of the company
Debt schedule
Schedule of fixed assets
Lease agreements for facilities or equipment
Any existing contracts
List of shareholders with shares outstanding
Budgets or projections
Details on any transactions with a related party
Company documents
Other information including list of locations, customers, competitors,
suppliers, contingent liabilities, and regulations
29

30. Checklist

Appraiser should try to derive an answer to the following:
How does the company perceive itself?
– Strengths, weaknesses, prospects, market, etc.
How does the company see the industry?
– Influential factors, trends, growth, competition, etc.
Management and management compensation
– Personal expenses, market rate compensation, etc.
30

31. Valuation Methodologies

32. Balance Sheet-Based Methods (Shareholders’ Equity)

These methods seek to determine the company’s value by
estimating the value of its net assets.
These are traditionally used methods that consider that a company’s
value lies basically in its balance sheet.
They do not take into account factors that also affect the value such as:
the industry’s current situation
human resources or organizational problems
contracts,
company’s possible future evolution
money’s temporary value
accounting criteria are subject to a certain degree of subjectivity and
differ from “market” criteria
all other factors that do not appear in the accounting statements.
32

33. Balance Sheet-Based Method on the basis of Book Value

A company’s book value, or net worth, is the value of the shareholders’ equity
stated in the balance sheet (capital and reserves).
This quantity is also the difference between total assets and liabilities, that is, the
surplus of the company’s total goods and rights over its total debts with third parties.
Balance Sheet of the Company A.
ASSETS
Cash
Amount,
mln KZT
5
Table 1.
LIABILITIES
Accounts payable
Amount,
mln. KZT
40
Accounts receivable
10
Bank debt
10
Inventories
45
Long-term debt
30
Fixed assets
100
Shareholders’ equity
80
Total assets
160
Total liabilities
160
33

34. Balance Sheet-Based Method on the basis of adjusted Book Value

This method seeks to overcome the shortcomings that appear when purely accounting
criteria are applied in the valuation.
When the values of assets and liabilities match their market value, the adjusted net worth
is obtained.
Example:
– Accounts receivable includes 2 million thousands of bad debt, this item should
have a value of 8 million dollars.
– Stock, after discounting obsolete, worthless items and revaluing the remaining
items at their market value, has a value of 52 million dollars.
– Fixed assets (land, buildings, and machinery) have a value of 150 million
dollars, according to an expert.
– The book value of accounts payable, bank debt and long-term debt is equal to
their market value.
34

35. Book Value and Market Value

Figure 1
Evolution of the Price/Book Value Ratio on the British, German and United States
Stock Markets
35

36. Adjusted Book Value

The adjusted balance sheet of the Company A.
Table 2.
ASSETS
Amount,
mln KZT
LIABILITIES
Amount,
mln. KZT
Cash
5
Accounts payable
40
Accounts
receivable
Inventories
8
Bank debt
10
52
Long-term debt
30
Fixed assets
150
135
Total assets
215
Capital and
reserves
Total liabilities
36
215

37. Liquidation Value

This is the company’s value if it is liquidated, that is, its assets are sold and its
debts are paid off. This value is calculated by deducting the business’s
liquidation expenses (redundancy payments to employees, tax expenses
and other typical liquidation expenses) from the adjusted net worth.
Taking the example given in Table 2, if the redundancy payments and other
expenses associated with the liquidation of the company A. were to amount
to 60 million dollars, the shares’ liquidation value would be 75 million dollars
(135-60).
Obviously, this method’s usefulness is limited to a highly specific situation,
namely, when the company is bought with the purpose of liquidating it at a
later date. However, Liquidation Value always represents the company’s
minimum value as a company’s value.
37

38. Substantial Value

The substantial value represents the investment that must be made to form a
company having identical conditions as those of the company being valued.
It can also be defined as the assets’ replacement value, assuming the company
continues to operate, as opposed to their liquidation value. Normally, the
substantial value does not include those assets that are not used for the
company’s operations (unused land, holdings in other companies, etc.).
Three types of substantial value are usually defined:
Gross substantial value: this is the assets’ value at market price (in the
example of Table 2: 215).
Net substantial value or corrected net assets: this is the gross substantial
value less liabilities.
It is also known as adjusted net worth, which we have already seen in the
previous section (in the example of Table 2: 135).
Reduced gross substantial value: this is the gross substantial value reduced
only by the value of the cost-free debt (in the example of Table 2: 175 = 215
- 40). The remaining 40 mln KZTs correspond to accounts payable.
38

39. Income Statement-Based Methods

Income Statement-Based Methods are based on the company’s income statement.
They seek to determine the company’s value through the size of its earnings, sales or
other indicators.
This category includes the methods based on the PER: according to this method, the
shares’ price is a multiple of the earnings.
Description
Sales
Amounts, mln KZT
300
Cost of sales
136
General expenses
120
Interest expense
4
Earnings before tax
40
Tax (25%)
8
Net income
32
39

40. Value of Earnings

According to this method, the equity’s value is obtained by multiplying the annual
net income by a PER (price earnings ratio), that is:
Equity value = PER x earnings
The PER (price earnings ratio) of a share indicates the multiple of the earnings per share
that is paid on the stock market.
Thus, if the earnings per share in the last year has been $3 and the share’s price is $26,
its PER will be 8.66 (26/3).
So Equity value = PER x earnings=8.66*32 mln KZT=277.12 mln KZT
The PER is the benchmark used predominantly by the stock markets. Note that the PER
is a parameter that relates a market item (share price) with a purely accounting item
(earnings).
40

41.

Sometimes, the relative PER is also used, which is simply the company’s PER divided by
the country’s PER.
Evolution of the PER of the German, English and United States Stock Markets markets in
1992 and 2002.
41

42. Value of the Dividends

Dividends are the part of the earnings effectively paid out to the shareholder and, in most
cases, are the only regular flow received by shareholders.
According to this method, a share’s value is the net present value of the dividends that
we expect to obtain from it. In the perpetuity case, that is, a company from which we
expect constant dividends every year, this value can be expressed as follows:
Equity value = DPS / Ke
Where: DPS = dividend per share distributed by the company in the last year; Ke =
required return to equity.
If, on the other hand, the dividend is expected to grow indefinitely at a constant annual
rate g, the above formula becomes the following:
Equity value = DPS1 / (Ke - g)
Where DPS1 is the dividends per share for the next year.
42

43. Business Valuation: Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC)
– WACC = Weight of Equity (Cost of Equity) + Weight of Debt (Cost
of Debt * (1-Tax)) + Weight of Preferred Security (Cost of Preferred
Security)
– Provides Overall Cost of Capital to Whole Company
– Assumes Constant Debt to Capital Over Time
43

44. Sales Multiples

This valuation method, which is used in some industries with a certain frequency,
consists of calculating a company’s value by multiplying its sales by a number.
For example, a pharmacy is often valued by multiplying its annual sales (in dollars) by 2
or another number, depending on the market situation. It is also a common practice
to value a soft drink bottling plant by multiplying its annual sales in liters by 500 or
another number, depending on the market situation.
The price/sales ratio can be broken down into a further two ratios:
Price/sales = (price/earnings) x (earnings/sales)
The first ratio (price/earnings) is the PER and the second (earnings/sales) is normally
known as return on sales.
44

45. Other Multiples

46

46.

Business Valuation:
Cash Flow Discounting Approaches
47

47.

Business Valuation: Cash Flow Discounting Approaches
Cash Flow Discounting-based methods seek to determine the company’s value
by estimating the cash flows it will generate in the future and then discounting
them at a discount rate matched to the flows’ risk.
In these methods, the company is viewed as a cash flow generator and the
company’s value is obtained by calculating these flows’ present value using a
suitable discount rate.
Cash flow discounting methods are based on the detailed, careful forecasts, for
each period, of each of the financial items related with the generation of the cash
flows corresponding to the company’s operations.
48

48. Business Valuation: Cash Flow Discounting Approaches

Cash flow discounting-based valuation methods are valuation
techniques that provides an estimation of the value of an equity (net
asset) based on the present value of expected cash flows.
–The various forms:
» Discounted Cash Flow Analysis (DCF)
» Capitalization of Earnings
» Dividend Discount Model (DDM)
49

49. Business Valuation: Cash Flow Discounting Approaches

Discounted Cash Flow Analysis
The different cash flow discounting-based methods start with the
following expression: more general and flexible than other capitalized
earnings methods
50

50. Business Valuation: Cash Flow Discounting Approaches

Although at first sight it may appear that the above formula is
considering a temporary duration of the flows, this is not necessarily
so as the company’s residual value in the year n (VRn) can be
calculated by discounting the future flows after that period.
A simplified procedure for considering an indefinite duration of future
flows after the year n is to assume a constant growth rate (g) of
flows after that period. Then the residual value in year n is:
VRn = CFn (1 + g) / (k - g).
Although the flows may have an indefinite duration, it may be
acceptable to ignore their value after a certain period, as their
present value decreases progressively with longer time horizons.
Furthermore, the competitive advantage of many businesses tends
to disappear after a few years.
51

51. Business Valuation: Cash Flow Discounting Approaches

The main idea behind a DCF approach is relatively simple: a companies' worth
is equal to the present value of all its estimated future cash flows.
Many variables go into estimating cash flows, but among the most important
are the company's future sales growth and profit margins. Projecting
such variables doesn't involve simply extrapolating present trends into the
future. It's important to consider a variety of factors, including:
the industry’s evolution and trends
economic data
market share of a company
a company's competitive advantages and future position
competitive position of the main competitors
identification of the value drivers
a company’s suppliers and customers
internal and external risks and etc
52

52. Business Valuation: Cash Flow Discounting Approaches

For example:
A company with strong competitive advantages may grow faster than its
competitors if it is stealing market share.
Chemical companies that are heavily reliant on oil and natural gas, for
example, could see profit margins contract if these materials go up in price
and they cannot pass these cost increases on to customer.
Some companies benefit from operating leverage. Operating leverage
means that as a company grows larger, it is able to spread its fixed costs
across a broader base of production. As a result, the company's operating
profits should grow at a faster rate than revenue. It can add thousands of
customers with only very modest investments to its existing computer
systems.
Likewise, a software company sees most of its costs in development.
Adding an additional customer doesn't change this key cost.
53

53. Business Valuation: Cash Flow Discounting Approaches

Main questions that must be asked of any discounted cash-flow model is exactly what
kind of cash flows are you going to be discounting and which discounting rate shall be
applied?
There are three basic cash flows: the free cash flow, the equity cash flow, and the debt
cash flow.
The free cash flow (FCF) enables the company’s total value (debt and equity: D + E) to
be obtained.
The debt cash flow (DCF), which is the sum of the interest to be paid on the debt plus
principal repayments. In order to determine the present market value of the existing
debt, this flow must be discounted at the required rate of return to debt. In many
cases, the debt’s market value shall be equivalent to its book value, which is why its
book value is often taken as a sufficient approximation to the market value. (This is
only valid if the required return to debt is equal to the debt’s cost)
The equity cash flow (ECF) enables the value of the equity to be obtained, which,
combined with the value of the debt, will also enable the company’s total value to be
determined.
54

54. Business Valuation: Cash Flow Discounting Approaches

Cash Flow Discounting Approaches: discount rates
In cash flow discounting-based valuations, a suitable discount rate is determined
for each type of cash flow. Determining the correct discount rate is one of the most
important tasks and it shall take into account all risks, historic volatilities; in
practice, the minimum discount rate is often set by the interested parties.
CASH FLOWS
ECF. Equity cash flow
APPROPRIATE DISCOUNT
RATE
WACC. Weighted average cost of
capital
Ke. Required return to equity
CFd. Debt cash flow
Kd. Required return to debt
FCF. Free cash flow
55

55. Cash Flow Discounting Approaches: discount rates

Cash Flow Discounting Approaches: The Free Cash Flow
The Free Cash Flow
The free cash flow (FCF) is the operating cash flow, that is, the cash
flow generated by operations, without taking into account borrowing
(financial debt), after tax. It is the money that would be available in
the company after covering fixed asset investments and working
capital requirements, assuming that there is no debt and, therefore,
there are no financial expenses.
In order to calculate future free cash flows, we must forecast the cash
we will receive and must pay in each period. This is basically the
approach used to draw up a cash budget.
56

56. Cash Flow Discounting Approaches: The Free Cash Flow

Company’s free cash flow must not include any payments to fund
providers. Therefore, dividends and interest expenses must not be
included in the free cash flow.
In order to calculate the free cash flow, we must ignore financing for the
company’s operations and concentrate on the financial return on the
company’s assets after tax, viewed from the perspective of a going
concern, taking into account in each period the investments required
for the business’s continued existence.
Finally, if the company had no debt, the free cash flow would be
identical to the equity cash flow.
57

57. Cash Flow Discounting Approaches: The Free Cash Flow

For example the below table gives the income statement for the company X. Using
this data, we shall determine the company’s free cash flow.
Sales
2010
1,000.00
2011
1,100.00
2012
1,210.00
-Cost of goods sold
-650.00
-715.00
- 786.50
-General expenses
-189.00
- 207.90
-228.70
-20.00
-20.00
-20.00
-Depreciation
Earnings before interest
and tax (EBIT)
141.00
-Interest expenses
- 10.00
Earnings before tax
(EBT)
-Tax
131.00
147.10
164.80
- 45.85
- 51.49
- 57.68
85.15
95.62
107.10
- 34.06
- 38.25
- 42.85
51.09
57.37
64.28
Net income (EAT)
-Dividends
Retained earnings
157.10
- 10.00
58
174.80
- 10.00

58. Cash Flow Discounting Approaches: The Free Cash Flow

Free cash flow can be obtained from earnings before interest and tax (EBIT).
The tax payable on the EBIT must be calculated directly; this gives us the
net income without subtracting interest payments, to which we must add the
depreciation for the period because it is not a payment but an accounting
entry. We must also consider the sums of money to be allocated to new
investments in fixed assets and new working capital requirements (WCR),
as these sums must be deducted in order to calculate the free cash flow.
59

59. Cash Flow Discounting Approaches: The Free Cash Flow

WCR = Cash + Accounts Receivable + Inventories - Accounts Payable
60

60. Cash Flow Discounting Approaches: The Free Cash Flow

Balance sheet of a Company X at 01/01/2010.
ASSETS
Amount,
Cash
Accounts receivable
Inventories
Fixed assets
Total assets
mln KZT
5
10
45
100
160
LIABILITIES
Accounts payable
Bank debt
Long-term debt
Shareholders’ equity
Total liabilities and
capital
Amount,
mln. KZT
40
10
30
80
160
Balance sheet of a Company X at 31/12/2010.
ASSETS
Amount,
LIABILITIES
mln KZT
Amount,
mln. KZT
Cash
12
Accounts payable
67
Accounts receivable
31
Bank debt
17
Inventories
55
38
Fixed assets
161
Long-term financial
debt
Shareholders’ equity
Total assets
259
Total liabilities and
capital
61
137
259

61. Cash Flow Discounting Approaches: The Free Cash Flow

WCR = Cash + Accounts Receivable + Inventories - Accounts Payable
62

62. Cash Flow Discounting Approaches: The Free Cash Flow

The below table shows how the free cash flow is obtained from earnings before
interest and tax (EBIT).
Earnings before
interest and tax
(EBIT)
-Tax paid on EBIT
Net income
without debt
+Depreciation
- Increase in fixed
assets
- Increase in WCR
Free cash flow
2010
141.00
2011
157.10
2012
174.80
-49.40
-55.00
-61.20
91.65
102.10
113.60
20.00
20.00
20.00
-61.00
-67.10
-73.80
-11.00
-12.10
-13.30
39.65
42.92
46.51
63

63. Cash Flow Discounting Approaches: The Free Cash Flow

Calculating the Value of the Company Using the Free Cash Flow
In order to calculate the value of the company using this method, the free cash flows are
discounted (restated) using the weighted average cost of debt and equity or weighted
average cost of capital (WACC):
V(E + D) = present value [FCF; WACC]
V = FCF1/(1+ wacc) + FCF2 (1+ wacc)^2+CF3 (1+ wacc) ^3+..
+ FCFn/(1+wacc) ^n
WACC = E*Ke + D*Kd *(1 - T )/ (E + D)
D = market value of the debt. E = market value of the equity.
Kd = cost of the debt before tax = required return to debt.
T = tax rate, Ke = required return to equity, which reflects the equity’s risk.
The WACC is calculated by weighting the cost of the debt (Kd) and the cost of the equity
(Ke) with respect to the company’s financial structure. This is the appropriate rate for
this case as, since we are valuing the company as a whole (debt plus equity), we
must consider the required return to debt and the required return to equity in the
proportion to which they finance the company.
64

64. Cash Flow Discounting Approaches: The Free Cash Flow

Cash Flow Discounting Approaches
The Free Cash Flow
65

65.

Cash Flow Discounting Approaches: The Equity Cash Flow
The Equity Cash Flow
The equity cash flow (ECF) is calculated by subtracting from the free cash flow
the interest and principal payments (after tax) made in each period to the
debt holders and adding the new debt provided. In short, it is the cash flow
remaining available in the company after covering fixed asset investments
and working capital requirements and after paying the financial charges and
repaying the corresponding part of the debt’s principal (in the event that
there exists debt).
ECF = FCF - [interest payments x (1- T)] - principal repayments + new debt
When making projections, the dividends and other expected payments to
shareholders must match the equity cash flows.
66

66. Cash Flow Discounting Approaches: The Equity Cash Flow

The Equity Cash Flow
Earnings before interest and tax (EBIT)
-Tax paid on EBIT
Net income without debt
+Depreciation
- Increase in fixed assets
- Increase in WCR
Free cash flow (FCF)
- Interest payments after tax
+ New Debt issued
- Debt Paid (Principal)
Free cash flow to Equity
67

67. Cash Flow Discounting Approaches: The Equity Cash Flow

Example:
2010
2011
2012
Earnings before interest and
tax (EBIT)
-Tax paid on EBIT
141.00
Net income without debt
91.65
102.10
113.60
+Depreciation
20.00
20.00
20.00
- Increase in fixed assets
-61.00
-67.10
-73.80
-12.10
-13.30
- Increase in WCR
157.10
-49.40
-55.00
-11.00
174.80
-61.20
Free cash flow (FCF)
39,65
42,92
46,51
- Interest payments* (1-T)
-7.00
-5.00
-6.00
+ New Debt issued
150.00
200.00
185.00
- Debt Paid (Principal)
-145.00
-175.00
-168.00
37,65
62,92
57,51
Free cash flow to Equity
(FCFE)
68

68. Cash Flow Discounting Approaches: The Equity Cash Flow

This cash flow assumes the existence of a certain financing structure in each period, by
which the interest corresponding to the existing debts is paid, the installments of the
principal are paid at the corresponding maturity dates and funds from new debt are
received. After that there remains a certain sum which is the cash available to the
shareholders, which will be allocated to paying dividends or buying back shares.
When we restate the equity cash flow, we are valuing the company’s equity (E), and,
therefore, the appropriate discount rate will be the required return to equity (Ke). To
find the company’s total value (D + E), we must add the value of the existing debt (D)
to the value of the equity (E).
69

69. Cash Flow Discounting Approaches: The Equity Cash Flow

Calculating the Value of the Company’s Equity by Discounting the Equity
Cash Flow
The market value of the company’s equity is obtained by discounting the equity
cash flow at the rate of required return to equity for the company (Ke).
VE = ECF1/(1+ Ke) + ECF2 (1+ )^2+CF3 (1+ Ke) ^3+.. + (ECFn +Vn)/(1+Ke)
^n
When this value is added to the market value of the debt, it is possible to
determine the company’s total value.
V=VE+VD
70

70. Cash Flow Discounting Approaches: The Equity Cash Flow

The required return to equity can be estimated using any of the following methods:
1. Gordon and Shapiro’s constant growth valuation model:
Ke = [Div1 / P0] + g.
Div1 = dividends to be received in the following period
P0 = share’s current price
g = constant, sustainable dividend growth rate.
Div1 = Div0(1 + g).
71

71. Cash Flow Discounting Approaches: The Equity Cash Flow

For example,
if a share’s price is 200 KZT
dividend received last year is 8.62 KZT
dividend’s expected annual growth rate is 11%:
Ke = (10/200) + 0.11 = 0.16 = 16%
V (FCFE)
37,65
62,92
57,51
(1+0,16)^1
(1+0,16)^2
(1+0,16)^3
72
=116,1

72. Cash Flow Discounting Approaches: The Equity Cash Flow

2. Cost of Equity: Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) defines the required return to equity in
the following terms
For larger publicly-traded companies:
Ke = RF + ß (RM - RF)
RF = rate of return for risk-free investments (Treasury bonds).
ß = share’s beta (a systematic risk measure)
(The beta measures the systematic or market risk of a share. It indicates the
sensitivity of the return on a share held in the company to market movements. If the
company has debt, the incremental risk arising from the leverage must be added to
the intrinsic systematic risk of the company’s business, thus obtaining the levered
beta)
RM = expected market return.
RM – RF = equity risk premium
Thus, given certain values for the equity’s beta, the risk-free rate and the market risk
premium, it is possible to calculate the required return to equity.
73

73. Cash Flow Discounting Approaches: The Equity Cash Flow

Cost of Equity: Capital Asset Pricing Model (CAPM). Example:
For example, if
RF =4%
ß =1.3
RM=10%
Growth rate =5%
74

74. Cash Flow Discounting Approaches: The Equity Cash Flow

Cost of Equity: Capital Asset Pricing Model (CAPM). Example:
Ke=0,04+1,3*(0,1-0,04)=0,118 (11.8%)
Vn = CFn (1 + g) / (k - g) – residual value of the company after year n
V(3)=(57,51*(1+0,05))/(0,118-0,05=888,02 - residual value of the
company after year 3
V (FCFE)
37,65
62,92
945,53
(1+0,118)^1
(1+0,118)^2
(1+0,118)^3
75
=676,63

75. Cash Flow Discounting Approaches: The Equity Cash Flow

Cost of Equity and Leverage
– Companies with more debt relative to equity are Riskier and have
higher costs of equity
» Beta (B)
• Beta is a measure of the sensitivity of the movement in returns on a particular
stock to movements in returns on some measure of the market (i.e. S&P 500,
etc.)
• Published and calculated betas typically reflect the capital structure of each
respective company at market values
• Unlevered beta is the beta a company would have if it had no debt
• Lever the beta for the subject company based on one more assumed capital
structure
B
L
Bu (Unlevered Beta)
=
1 + ( 1 - t ) W d / We
BL (Relevered Beta)
= Bu ( 1 + ( 1 - t ) Wd / Wc )
Wd = Weight of Debt
We = Weight of Equity
Wc = Weight of Capital
• The result will be a market-derived beta specifically adjusted for the degree of
financial leverage of the subject company
76

76. Cash Flow Discounting Approaches: The Equity Cash Flow

Cost of Equity: Build-up
–For smaller closely-held companies
–Inputs are same as CAPM except for the application of industry risk
premium instead of Beta coefficient
–Industry risk premium based on Morningstar (Ibbotson) Yearbook
Build-up Cost of Equity Capital
Risk-free rate (Rf)
4.5%
Equity premium (RPm)
5.0%
Size premium (RPs)
Industry risk premium
Company-specific premium (RPu)
6.0%
-1.1%
2.0%
Indicated Cost of Equity Capital
16.4%
–Generally similar to CAPM after adjustments for size and specific
risks
77

77. Cash Flow Discounting Approaches: The Equity Cash Flow

Cash Flow Discounting Approaches
The Capital Cash Flow
78

78.

Cash Flow Discounting Approaches: The Capital Cash Flow
The Capital Cash Flow
Capital cash flow (CCF) is the term given to the sum of the debt cash flow plus the equity
cash flow. The debt cash flow is composed by the sum of interest payments plus
principal repayments. Therefore:
CCF = ECF + DCF = ECF + I - ∆D
I = D*Kd
It is important to not confuse the capital cash flow with the free cash flow.
79

79. Cash Flow Discounting Approaches: The Capital Cash Flow

Calculating the Company’s Value by Discounting the Capital Cash Flow
According to this model, the value of a company (market value of its equity plus market
value of its debt) is equal to the present value of the capital cash flows (CCF)
discounted at the weighted average cost of capital before tax (WACCBT):
E + D = present value [CCF; WACCBT]
V = CCF1/(1+ WACC(BT) ) + CCF2 (1+ WACC(BT) )^2+CCF3 (1+ WACC(BT) ) ^3+.. +
CCFn+Vn /(1+ WACC(BT) ) ^n
WACC(BT) =(E*Ke + D*Kd)/(E + D)
CCF = (ECF + DCF)
.
80

80. Cash Flow Discounting Approaches: The Capital Cash Flow

Cost of Debt
–Cost of Debt Based on Subject Company’s Credit Rating and
Borrowing Rate (i.e. Prime rate + 1%, BBB, BB, B-, Prime Rate,
etc.) at Valuation Date
– After Tax Cost of Debt
» Cost of Debt x (1 – Target Company’s Tax Rate)
– Debt to Capital Ratio
» Control Value: Target/Optimal or Industry Average Debt to
Capital Ratio
» Lack of Control/Minority Value: Company Specific Debt to
Capital Ratio
81

81. Cash Flow Discounting Approaches: The Capital Cash Flow

Cash Flow Discounting Approaches: The Free Cash Flow
Balance sheet of a Company X at 01/01/2010.
ASSETS
Amount,
Cash
Accounts receivable
Inventories
Fixed assets
Total assets
mln KZT
5
10
45
100
160
LIABILITIES
Accounts payable
Bank debt
Long-term debt
Shareholders’ equity
Total liabilities and
capital
Amount,
mln. KZT
40
10
30
80
160
Balance sheet of a Company X at 31/12/2010.
ASSETS
Amount,
LIABILITIES
mln KZT
Amount,
mln. KZT
Cash
12
Accounts payable
67
Accounts receivable
31
Bank debt
17
Inventories
55
38
Fixed assets
161
Long-term financial
debt
Shareholders’ equity
Total assets
259
Total liabilities and
capital
82
137
259

82. Cash Flow Discounting Approaches: The Free Cash Flow

83

83.

Business Valuation: Cash Flow Discounting Approaches
The DCF model that we will talk about in this article discounts free cash flow, which is
defined as operating cash flow minus capital expenditures. Free cash flow represents
the cash a company has left over after spending the money necessary to keep the
company growing at its current rate. It's important to estimate how much the company
reinvests in itself each year via capital expenditures. Reinvestment can take the form
of a company purchasing machinery to start up a new production line, or retail
companies opening new stores to expand their reach.
Note: There are actually two types of DCF models: "free cash flow to equity" and "cash
flow to the firm." The first involves counting just the cash flow available to shareholders
and is a bit easier to understand.
The second involves counting the cash flow available to both debt and equity holders
and has several additional steps. We will talk about just the first method here, though
both methods should give you roughly the same result for any given company. -
84

84. Business Valuation: Cash Flow Discounting Approaches

Capitalization of Earnings Approach
– Single Period Discounted Cash Flow Analysis
– Simplest for Companies with Stable Growth
– Next Year Free Cash Flow to Firm (FCFF)
– Next Year Free Cash Flow to Equity (FCFE)
– Apply Appropriate Discount Rate
CF1
Value =
(r-g)
CF = Free Cash Flow
(FCFF or FCFE)
r = Discount Rate
Cost of Capital or
Cost of Equity
g = Expected Growth Rate
85

85. Business Valuation: Cash Flow Discounting Approaches

Business Valuation: Market Approach
Publicly-Traded (Guideline) Comparable Company
Analysis
– The Guideline Publicly Traded Company Method indicates the value of
the subject company by comparing it to publicly-traded companies in
similar lines of business
– Valuation Multiples Vary Based on Industry and States of Growth
– Problem is that there are rarely perfect matches
– Equity Multiples
»Fair Market Value of Equity (Stock Price x Outstanding Number of
Shares)
»Common Equity Level Multiples
• Price / Earnings (P/E)
• Price / Tangible Book Value (P/B)
86

86. Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company
Analysis
– Enterprise Multiples
» Enterprise Value = (Stock Price x Outstanding Number of
Shares) + Total Debt/Preferred Securities – Cash and ShortTerm Investments
» Common Enterprise Level Multiples
• EV / Revenue
• EV / EBITDA
• EV / EBIT
87

87. Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company
Analysis
– Other Multiples
» EV / R&D Expenses; # of Phase I, Phase II and Phase III
products in pipeline – Early Stage Biotechnology
» EV / # of Licenses and Rights – Shell Company, etc
» Appropriate Multiple Depends on Company Characteristics
88

88. Business Valuation: Market Approach

Market Transaction (M&A) Approach
– In the Guideline Merged and Acquired Company Method, the value of the
business is indicated based on multiples paid for entire companies or
controlling interests.
– Public Market Transaction Approach
» Public Buyer or Seller Transactions
» Control Value
– Private Market Transaction Approach
» Private to Private Transactions
» Control Value
– Common Transaction Database
» MergerStat, Pratts’ Stat, Biz Comps, Capital IQ
89

89. Business Valuation: Market Approach

Market Approach Adjustments
– Most Companies Differ from the Subject Company
– Need to Adjust for Differences between Market Comparables and
Subject Company
– Common Adjustments are Based on:
» Size
» Growth Rate
» Profitability
» Leverage
» Other Company Specific Factors
» Discounts and Premiums
90

90. Business Valuation: Market Approach

Business Valuation: Reconciling Items
Reconciling Items and Adjustments
– Appropriate Weighting Value Conclusions from Different Approaches
– Non-Operating Assets/Liabilities and Excess Working Capital/Cash
– Pass-Through Entity Tax Adjustments
» Adjustment for Discounted Cash Flow Analysis and Publicly-Traded
Guideline Comparable Company Analysis
» Depends on Hypothetical Buyer (C-Corp.? S-Corp.?, etc.)
– Interest-Bearing Debt and Contingent Liabilities
– Discounts and Premiums
» Apply to Equity Level
» Lack of Marketability and Minority Discounts, Key Person Discount and Control
Premium, etc.
91

91. Business Valuation: Reconciling Items

Discounts and Premiums
Control Premium
Lack of Control/Minority Discounts
Lack of Marketability/Illiquidity Discounts
Others Discounts

92. Discounts and Premiums

Business Valuation: Lack of Marketability Discounts
Let the Fireworks Begin!!
– Often subject to wide disparity among practitioners
– Determination based on analogy
– Data sources problematic
– Reasonable range
93

93. Business Valuation: Lack of Marketability Discounts

Lack of Marketability Discounts (LOM)
– Marketability (liquidity) is valuable. Other things equal, investors will pay
more for the more liquid (marketable) asset
– The discount for lack of marketability is the largest money issue in many,
if not most, disputed valuations of minority interests in closely-held,
private companies
– The U.S. Tax Court normally allows discounts for lack of marketability for
non-controlling interests in closely held companies, but the size of the
discounts varies greatly from one case to another
– Need to carefully study the recent case law in the relevant jurisdiction
– The quality of the expert evidence and testimony presented in the Tax
Court makes a big difference in the outcome
– The Tax Court expects good empirical evidence, relevant to the subject
at hand; simple averages are insufficient
94

94. Business Valuation: Lack of Marketability Discounts

Lack of Marketability Discounts
– The highest discount that the Tax Court has allowed purely for
lack of marketability is 45%, and most discounts have been
considerably less
– The ESOP discounts for lack of marketability are generally low
because most ESOP stock has a “put” right to sell the stock back
to the sponsoring company, thus enhancing its liquidity and value.
– Dissenting shareholder and shareholder oppression cases are
quite mixed on the matter of discount for lack of marketability
– There is little case law on discount for lack of marketability in
divorce cases, and what exists is also quite mixed
– If the standard of value is clearly stated as fair market value, then
a discount for lack of marketability is appropriate
95

95. Business Valuation: Lack of Marketability Discounts

Lack of Marketability/Illiquidity Discount for Minority
Interest
– Restricted Stock Studies
» Restricted stocks are, by definition, stocks of public companies that are
restricted from public trading under SEC Rule 144
» Although they cannot be sold on the open market, they can be bought
by qualified institutional investors. Thus, the “restricted stock studies”
compare the price of restricted shares of a public company with the
freely-traded public market price on the same date
» Price differences are attributed to liquidity
» Many feel the discounts are a reliable guide to discounts for LOM
» Empirical Studies: McConaughy, SEC Institutional Investor, Gelman,
Trout, Moroney, Maher, Standard Research Consultants, Siber, FMV
Opinion, Management Planning, Johnson, Columbia Financial Advisors
Studies
96

96. Business Valuation: Lack of Marketability Discounts

Restricted Stock Studies
– General Findings
» Show that restricted shares are worth less than unrestricted shares – generally
ranging from 10 to 30%. Discounts as high as 55% have been observed
» Discounts are larger for smaller companies and companies with more volatile
stocks and more debt
» These data are most appropriate for valuing restricted stocks and are difficult to
apply to private companies
» The value of the studies is that the comparisons are apples to apples (i.e. liquid
stock value vs. illiquid stock value of the same company at the same time).
» Restrictions have been relaxed and discounts have dropped
» Statistical studies can explain at best 1/3 of the discount
97

97. Business Valuation: Lack of Marketability Discounts

Pre-IPO Stock Studies
–A pre-IPO transaction is a transaction involving a private company
stock prior to an Initial Public Offering (IPO)
– The pre-IPO studies compare the price of the private stock
transaction with the public offering price. The percentage below
the public offering price at which the private transaction occurred is
a proxy for the discount for lack of marketability
–The application of pre-IPO studies heavily debated and criticized
because comparisons are apples to oranges
» The dates of the transaction differ at a time when the company is
changing rapidly (in the year before the IPO)
–Discounts are very large
–Discounts/premium should be based on specific to the subject case
and not past court cases
98

98. Business Valuation: Lack of Marketability Discounts

Other Studies
–Modified put option model (i.e. Finnerty and Chaffee)
–Modified cost of capital – total beta (McConaughy and Covrig)
–“Private Company Discount” by Koeplin, Sarin & Shapiro, Journal
of Applied Corporate Finance Winter 2000.
» Find approximately a 30% discount. Perhaps the best study, but limited
sample size makes it difficult to apply to a specific case.
99

99. Business Valuation: Lack of Marketability Discounts

Factors Affecting Discounts for Lack of Marketability
– Company’s Financial Performance and Growth
– Size of Distributions
– Prospects for Liquidity (Expected Liquidity Event)
– Restrictions on Transferability
– Company’s Redemption Policy
– Costs Associated with a Public Offering
– Pool of Potential Buyers
– Nature of the Company, Its History, Other Risk Factors
– Amount of Control in Transferred Shares
– Company’s Management
100

100. Business Valuation: Lack of Marketability Discounts

Lack of Marketability/Illiquidity Discounts for Controlling
Interests
– Still a controversial concept
– A company with control can be marketable, but illiquid
– More marketable and liquid than the minority interest; Higher lack
of marketability discount for smaller blocks (for closely held
companies)
– Super majority requirement for certain States
– Typically, private companies sell in 6 months which is shorter than
the restriction period of restricted stocks
101

101. Business Valuation: Lack of Marketability Discounts

Business Valuation: Control Premium and Minority Discount
Control Premium
– Other things equal, an interest with control is worth more than
one that lacks control
– An amount by which the pro rata value of a controlling interest
exceeds the pro rata value of a noncontrolling interest in a
business enterprise that reflects the power of control often
associated with takeovers of public companies
– Some suggest that valuations of controlling interests be
adjusted upward if they are based on publicly-traded stock
prices which are minority interests
– Hubris and synergy may explain premia
– Not needed if cash flows are estimated at the control level
102

102. Business Valuation: Control Premium and Minority Discount

Control Premium
– Common Prerogatives of Control
» Elect directors and appoint management
» Determine management compensation and perquisites
» Set policy and change the course of business
» Acquire or liquidate assets
» Select people with whom to do business and award contracts
» Make acquisitions
» Liquidate, dissolve, sell, leverage or recapitalize the company
» Sell or acquire treasury shares
» Register the company’s stock for a public offering
» Declare and pay dividends
» Change the articles of incorporation or bylaws or operating
agreement
103

103. Business Valuation: Control Premium and Minority Discount

Control Premium Database
– Control Premia Based on Market Transactions
» Identify one month to six months control premium prior to
announcement date for public and private transactions from
Mergerstat, Capital IQ, etc.
» Control premia should exclude potential synergies associated with
selected transactions, but this is extremely difficult
» Appropriately adjust for other qualitative factors based on control
prerogatives
104

104. Business Valuation: Control Premium and Minority Discount

Lack of Control/Minority Discount
– Some feel that the control premium and the minority discounts should have
the relationship as shown below:
1
Minority Discount
=
1
1 + Control Premium
– This is overly simplistic. Ignores hubris and synergy and other factors that
impact take-over premia
– Must deal with negative “premia” in databases
105

105. Business Valuation: Control Premium and Minority Discount

Lack of Control/Minority Discount
– Supermajority Requirement – About a quarter of the states require
something more than 50% plus 1 share vote to approve certain major
corporate actions, such as selling out or merging. Thus, a discount for a
lack of supermajority may be appropriate
– Swing Vote Potential – Depending on distribution of the stock, a minority,
swing block could have the potential to gain a premium price over a pure
minority value
– Interest of 50% - Discount from lack of control value should be less for the
interest with some control prerogatives and a little greater for the interest
without the control prerogatives
– Many experts feel that publicly-traded stocks generally sell at a control
value
106

106. Business Valuation: Control Premium and Minority Discount

Business Valuation: Other Discounts
Other Discounts
– Key Person Discount
» Measure potential negative impact to the projected cash flows in the
absence of Key Personnel
– Trapped-in Capital Gains
» A company holding an appreciated asset would have to pay a capital
gains tax on the sale of the asset. If ownership of the company were to
change, the liability for the tax on the sale of the appreciated asset
would not disappear
» Use with Caution, it depends on expected time of liquidity event (usually
applied when liquidity event is imminent
» Consult a tax expert to analyze the situations
– Block Discount
» A large interest may be less liquid than a smaller one
107

107. Business Valuation: Other Discounts

Other Discounts
– Voting vs. Non-Voting
» If a company has both voting and nonvoting classes of stock, there
may be a price difference between the two, usually in favor of the
voting stock
» Based on level of influence by the voting shareholders, restrictive
agreements, state laws and policies and the total number of block of
shares between voting and non-voting
» Empirical studies indicates premium for voting shares
• Lease, McConnell and Mikkelson Study – 5.4%
• Robinson, Rumsey and White Study – 3.5% ~ 4.5%
• O’Shea and Siwicki Study – 3.5%
• Houlihan Lokey Howard & Zukin Study – 3.2% (average), 2.7%
(median)
108

108. Business Valuation: Other Discounts

Business Valuation: Discounts and Premiums
Common Errors in Applying Discounts and Premiums
– Greed produces inconsistencies with economic reality
– Low value desired
» Conservative projections
» High discount rate
» Large DLOM, etc.
– Higher value desired
» Aggressive projections
» Low discount rate
» Small DLOM, etc.
– Conservative projections should be accompanied by a lower discount rate
– Aggressive projections should be accompanied by a higher discount rate
109

109. Business Valuation: Discounts and Premiums

Common Errors in Applying Discounts and Premiums
– Using synergistic acquisition premia to quantify premiums for control
– Assuming that the discounted cash flow valuation method always produces a
minority value
– Assuming that the guideline public company method always produces a minority
value
– Valuing underlying assets instead of the stock or partnership interests
– Using minority interest marketability discount data to quantify marketability
discounts for controlling interests
– Using only pre-initial public offering studies and not restricted stock studies as
benchmark for discounts for lack of marketability
– Indiscriminate use of average discounts or premiums applying (or omitting) a
premium or discount inappropriately for the legal context
– Applying discounts or premiums to the entire capital structure
– Quantifying discounts or premiums based on past court cases
– Using a tangible (real property, fixed assets, etc.) appraiser to quantity discounts
and premiums
110

110. Business Valuation: Discounts and Premiums

References
Brealey, R.A. and S.C. Myers (2000), “Principles of Corporate Finance,” 6th edition,
McGraw- Hill, New York.
Copeland, T. E., T. Koller and J. Murrin (2000), “Valuation: Measuring and
Managing the Value of Companies”, 3rd edition, Wiley, New York.
Copeland and Weston (1988), “Financial Theory and Corporate Policy,” 3rd edition,
Addison- Wesley, Reading, Massachusetts.
Faus, Josep (1996), “Finanzas operativas,” Biblioteca IESE de Gestión de
Empresas, Ediciones Folio.
Fernández, Pablo (2001a), “Internet Valuations: The Case of Terra-Lycos”, SSRN
Working Paper n. 265608.
Fernandez, Pablo (2001b), “Valuation using multiples. How do analysts reach
their conclusions?,” SSRN Working Paper n. 274972.
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111. References

Fernández, Pablo (2001c), “Valuing real options: frequently made errors,” SSRN
Working Paper n. 274855.
Fernández, Pablo (2002), “Valuation Methods and Shareholder Value Creation,”
Academic Press, San Diego, CA.
Miller, M.H. (1986), “Behavioral Rationality in Finance: The Case of Dividends,”
Journal of Business, No. 59, october, pp. 451-468.
Sorensen, E. H. and D.A. Williamson (1985), “Some evidence on the value of the
dividend discount model,” Financial Analysts Journal, 41, pp. 60-69.
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112. References

termins
Patent infringement is the commission of a prohibited act with respect to a patented
invention without permission from the patent holder. Permission may typically be
granted in the form of a license.
A buy–sell agreement, also known as a buyout agreement, is a legally binding
agreement between co-owners of a business that governs the situation if a co-owner
dies or is otherwise forced to leave the business, or chooses to leave the business.
An employee stock ownership plan (ESOP) is an employee-owner scheme that
provides a company's workforce with an ownership interest in the company. In an
ESOP, companies provide their employees with stock ownership, often at no up-front
cost to the employees. ESOP shares, however, are part of employees' compensation
for work performed. Shares are allocated to employees and may be held in an ESOP
trust until the employee retires or leaves the company. The shares are then sold.
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113. termins

An engagement letter defines the legal relationship (or engagement) between a
professional firm (e.g., law, investment banking, consulting, advisory or accountancy
firm) and its client(s). This letter states the terms and conditions of the engagement,
principally addressing the scope of the engagement and the terms of compensation
for the firm.
Equity carve-out (ECO), also known as a split-off IPO or a partial spin-off, is a type of
corporate reorganization, in which a company creates a new subsidiary and
subsequently IPOs it, while retaining management control. Only part of the shares
are offered to the public, so the parent company retains an equity stake in the
subsidiary. Typically, up to 20% of subsidiary shares is offered to the public.
Corporate spin-off, a type of corporate transaction forming a new company or entity
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114.

Corporate spin-off, a type of corporate transaction forming a new company or entity
115

115.

Everything You Should Know
1. Understand the Standard of Value
2. Involve the Appraiser Early on
3. Distinguish Between a Business Appraisal and a Real Estate Appraisal
4. Establish a Reasonable Time Frame
5. Insist on an Appraisal Firm with Experience and Credentials
6. Know the Primary Business Valuation Methods
7. Consider the Appraisal as a First Line of Defense
8. Litigation Support Issues
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116. Everything You Should Know

СРСП
Define the Company for your Project , give the below description
– Articles of Incorporation; Operating Agreement
– History and Background
– Products and Services
– Shareholders
– Organization/Corporate Structure
– Operations
– Customers/Clients, Target Markets and Suppliers
– Legal, Tax and Other Considerations
– Five Year Historical and Latest Interim Financial Statements
– Other Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if
needed)
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