CHAPTER V:

BUSINESS VALUATION

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 DEFINITION
- Business valuation is the process of determining the
………………. of a business or company (pricing of firm).
The firm value always exits even when there are no changes
in ownership, merger and acquisition, consolidation
- 5 benefits of getting a business valuation:
• better knowledge of company assets

• understanding of company resale value

• obtain a true company value

• better during mergers/acquisitions

• access to more investors

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 BUSINESS VALUATION METHODS

- Company does not comply with going concern principle

(dissolution, merger, bankruptcy…..): asset-based
approaches

- Company complies with going concern principle:

discount methods
 Dividends

 Cash Flows

 Earnings

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 ASSET BASED APPROACH

- Based on book value:

firm value = total assets – total ……………..
- Based on adjusted book value:
firm value = adjusted total assets – adjusted total liabilities

Notes:
• Verify the quantity, types, condition of each type of assets

• Verify the real creditors, debtors of the company’s

liabilities accounts

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 ASSET BASED APPROACH

Evaluation of the asset based approach:

• Advantage
• Disadvantage: this approach only concerns about the state
of assets at the current time without the firm’s risk and
future potential

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 Discount approach

the value of an investment:

n
P r o je c te d F utur e P a y o ffs t
V0  
t 1 ( 1  D is c o unt R a te ) t

Expected future payoffs can be measured in terms of:

 Dividends

 Cash Flows

 Earnings

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 Dividends-Based Valuation

- The rationale for using expected dividends in

valuation is two fold:
 Dividends measure the cash that investors
ultimately receive from investing in an equity
share.
 Cash serves as a measurable common
denominator for comparing the future benefits of
alternative investment opportunities.

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 Dividends-Based Valuation

 Dividends include all cash flows between firm and

shareholders:
 Periodic dividend payments

 Stock buybacks

 The liquidating dividend

 And “negative dividend” when firm initially

issues stock

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 Dividends-Based Valuation

 Dividends valuation model:


Dt
V0  
t 1 ( 1  R E )
t

D1 D2 DT VT
   ....  
( 1  R E )1 ( 1  R E )2 ( 1  R E )T ( 1  R E )T

W ith Growing Perpetuity :

D1 D2 [NI T  ( 1  g)]  BVT  [BV T  ( 1  g)]

   .... 
( 1  R E )1 ( 1  R E ) 2 (R E -g)  ( 1  R E )T

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 Dividends-Based Valuation

 Involves measuring the following three elements:

 Dividend (Discount rate = R )
E

 Expected future dividends (Dt) for periods 1

through T over forecast horizon.
 Continuing or final (D
T+1), and long-run growth
rate (g).

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 Measuring Periodic Dividends
- Effects of transactions between firm and common
shareholders are included in book value.
- Thus, accounting for common equity is represented
by:

B V t  B V t -1  I t  D t
D t  I t  B V t -1  B V t

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 Forecast Horizon

 Represented by periods 1 through T in the dividends

valuation equation.
 Depending on:
 The industry.

 Firm’s maturity.

 Expected growth and stability.

 Should be until firm reaches steady-state

equilibrium.
 Difficult for young, high-growth firms.

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 Continuing Value of future dividends

-Use long-term growth rate assumption (1+ g)

uniformly on the year T+1 income statement and
balance sheet projections to derive the dividends for
the year T+1 correctly.
-Thus:

D T 1  N I T 1  B V T – B V T 1
 [N I T  ( 1  g )]  B V T – [B V T  ( 1  g )]

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 Evaluation of the Dividends Valuation Method

- Advantages:
 Dividends provide a classical approach to valuing

shares as they reflect the payoffs that

shareholders can consume.
 Reflect the implications of analyst’s expectations

for the future operating, investing, and financing

decisions of a firm.

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 Evaluation of the Dividends Valuation Method

- Disadvantages:
 Continuing value estimates are sensitive to
assumptions made about growth rates after the
forecast horizon and discount rates.
 The projection can be time-consuming for the

analyst.

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 Cash-Flow-Based Valuation

 Focus is on the cash that flows into the firm.

 Measures the cash flows that are “free” to be
distributed to shareholders.
 Cash flows generated by the firm create dividend-
paying capacity.
 Amount of cash flowing into firm differs from
dividends paid in a particular period.
 But over the lifetime of the firm, cash flows into and
cash flows out of the firm will be equivalent.

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 Cash-Flow-Based Valuation

- Rationale for Using Free-Cash-Flows:

• Cash is the ultimate source of value. The free cash

flows approach measures value based on the cash
flows that the firm generates that can be distributed
to investors.
 It is a measurable common denominator for
comparing the future benefits of alternative
investment instruments.

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Measuring Free Cash Flows:
- Cash flow from operations from the projected
statement of cash flows is the most direct starting
point because it requires the fewest adjustments.
- However, some analysts compute free cash flows
using alternative starting points.

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 A conceptual Framework for Free Cash Flows:

A = L + SE
OA + FA = OL + FL + SE
OA – OL = FL – FA
Net OA = Net FL +SE

PV of expected future net CFs from operations

= PV of expected future net CFs available for debt financing
+ PV of expected future net CFs available for shareholder’s
equity

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 Measuring Free Cash Flows
- Free Cash Flows for All Debt and Equity Stakeholders:
Operating Activities:
Cash Flow from Operations
+/- Net Interest after Tax
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for All Debt and Equity

Investing Activities:
+/- Net Capital Expenditures
= Free Cash Flows for All Debt and Equity Stakeholders

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 Measuring Free Cash Flows
- Free Cash Flows for Common Equity Shareholders:
Operating Activities:
Cash Flow from Operations
+/- Changes in Cash Requirements for Liquidity
= Free Cash Flows from Operations for Equity

Investing Activities:
+/- Net Capital Expenditures

Financing Activities:
+/- Debt Cash Flows
+/- Financial Asset Cash Flows
+/- Preferred Stock Cash Flows
= Free Cash Flows for Common Equity Stakeholders

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Cash-Flows-Based Valuation Models
 To value common equity measure:
 Discount rate – R .
E

 Expected future free cash flows – FCFEq for

periods 1 through T over forecast horizon.
 Continuing free cash flows, FCF
Eq(T+1), and long-
run growth rate, g.

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Free-Cash-Flows-Based Valuation Models
 For common equity shareholders:
T  FCFE t 
V0    t 
 [FCFE T 1 ]  [ 1 /(R E –g)]  [ 1 /( 1  R E )T
]
t 1  ( 1  RE ) 

Where,
V0  Present value of the common equity of a firm
FCFE  Free cash flows for common equity shareholde rs
RE  Required rate of return on equity capital
g  Growth rate

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 Free-Cash-Flows-Based Valuation Models

- For all debt and equity capital stakeholders:

 FCFAt 
T
VNOA0    t 
 [FCFA T 1 ]  [ 1 /(R A –g)]  [ 1 /( 1  R A )T
]
t 1  ( 1  R A ) 

Where,
VNOA0  Present value of net operating assets of a firm
FCFA  Free cash flows for all debt and equity capital
stakeholde rs
RA  Expected future weighted average cost of capital
g  Growth rate

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Continuing Value
- Represented by last term of equation:

[ F C F A T  1 ]  [ 1 /( R A – g ) ]  [ 1 /( 1  R A ) T ]
- Use expected long-term growth rate, g, to project all
items on Year T+1 income statement and balance
sheet.
 RA must be greater than g for this formula to work.

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 Evaluation of the Free-Cash-Flows-Valuation method

Advantages:
- Focuses on free cash flows, believed to have more economic

meaning than earnings.

- Results from projections of future operating, investing, and

financing decisions of a firm made by the analyst.

- Focuses directly on net cash inflows available to be

distributed to capital providers. This perspective is

especially pertinent to acquisition decisions.
- Widely used in practice.

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 Evaluation of the Free-Cash-Flows-Valuation method

Disadvantages:
• Can be time-consuming making it costly.

• Continuing value tends to dominate the total value

but is sensitive to assumptions growth rates and

discount rates.
• Free cash flow computations must be internally

consistent with long-run assumptions regarding

growth and payout. And is affected by estimation
errors.

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 - Economic theory:
n
E xp e cte d F uture P a yo ffs t
V0  
t 1 (1  D isco unt R a te ) t

 Expected Future Payoffs - Approaches:

Dividends Wealth distribution (or liquidation)

Expected future free Free cash flow realization
cash flows
Earnings Residual income valuation (or wealth
creation)
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 Role of Earnings

- Primary measure of firm performance under accrual

accounting system and hence, provide a basis for
valuation.
- Has a direct impact on the capital markets and the
pricing of shares.
- Used for internal capital allocation.
- Used for aligning the incentives of managers with
shareholders.

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 Earnings – Based valuation

- Advantages
 Earnings align more closely to the capital markets

and company management’s focus.

 Residual Income valuation requires fewer steps

than free cash flows valuation.

- Concerns
 Earnings are not as reliable or as meaningful as

cash or dividends.
 Accrual accounting earnings reflect accounting
methods and not underlying economic values.

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 Earnings – Based valuation

Value Relevance of Earnings

- Most widely followed measure of firm performance.
- Share prices react quickly to earnings announcements.
- Accruals and deferrals in earnings figure.
- Measures wealth created for shareholders by the firm.

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 Earnings – Based valuation

Residual Income Valuation

- Basis is dividends-based valuation model.
- Assumes Clean surplus accounting:
 Net income includes all income items

 Dividends include all direct capital transactions

between the firm and the shareholders

- Use finite horizon residual income model with
continuing value computation.

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 Earnings – Based valuation

Residual Income
- Normal earnings of the firm = RE × BVt-1
 RE = Required rate of return
 BVt-1 = Book value at the beginning of the year
‾ Residual income is the excess earnings over required
(or normal) earnings i.e., “abnormal earnings”.
= Nit – (RE × BVt-1)
- Measures the amount of wealth creation (or
destruction) by firm for common equity shareholders.

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 Earnings – Based valuation

Residual Income Calculation Steps

- Forecast expected future net income for each period.
- Forecast expected book value of common
shareholders’ equity at the beginning of each period.
- Compute expected future required income.
- Subtract future required income from expected net
income.

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 Residual Income Valuation Model

- Basic Model

NI t  (R E  B V t -1 )
V0  B V 0  
t 1 (1  R E ) t

- Continuing Value
T
NI t  (R E  B V t -1 )
V0  B V0   
t 1 (1  R E ) t

 1 1 
 NI T  1  g   (R E  BV T )   T 
 R E  g  1  R E  
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Continuing Value
- Analyst should forecast over a foreseeable finite
horizon, until the firm achieves “steady-state” growth
pattern.
- Apply growth rate to Net Income (NIT).
- Apply perpetuity-with-growth factor and present
value factor to Residual Income (RIT+1).
- Discount continuing value to present value.

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 Sensitivity Analysis

- Use to get a range of firm values.

- Value estimate will be inversely related to discount rate.
- Value estimate will be positively related to growth rate.
- Cannot compute continuing value if growth rate >
discount rate.

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 Conclusion

- Different methods → firm values.

- Optimal method? increase the reliability
- Each method has its own advantages and disadvantages
(depend on available data and cost)
- Combine both financial and nonfinancial information

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