The Four Value Drivers of a Business
The fair market business value is an estimate of the economic value of an owner’s interest in a business, based on an ‘arm’s length’ transaction where a buyer and seller, freely agree upon a value with access to all information. Three valuation approaches can estimate a business’ fair market value: the income approach which views the income stream; the market approach which views the selling multiples; and the asset approach which views the asset value. Business appraisals are driven by four value drivers: the historic income stream, the future net cash flow, the market value of the stockholders’ equity and the discount rate.
The Income Stream
Let’s begin with the income stream. The value of any business is in its earnings power since an investor expects to earn a return on their investment. A private company often has expenses that another owner might not pay if the business was sold. These discretionary expenses might be: excess owner’s pay, related party transactions, such as, paying above market rents to another company controlled by the business owner, or, promotional or business expenses that were for personal use or simply to reduce the pre-tax profits of the business to lessen the tax bill. To measure the historic income stream, we begin with the ‘accounting net profit’ from the income statement.
To reflect the actual return to the business owner, we add back any adjustments to profit that reflects an accurate representation of the earnings power of the company. All excess owner’s compensation and any discretionary expenses are added back to the profit. If the owner is performing standard management duties, then only the salary above what would be required to hire someone to perform those duties should be added back. It is common to see ‘one-time’ charges in a company’s financials. One-time charges are expenses that are not likely to occur again. This might be a write down of assets, or a one-time sale of an asset, etc. In the event there is a onetime charge, this should be added to the profit base since this expense will not be an on-going expense. It is a common mistake in valuations not to document each adjustment. Have a clear description and explanation of each adjustment.
Future Income Net Cash Flow
The future income net cash flow of a business is the future economic benefit an owner expects to receive. The income stream can be expressed in alternative ways, such as earnings before interest and taxes (EBIT) or EBITDA, if depreciation and amortization are included. Free cash flow (profit plus depreciation and amortization less capital expenditures and the net change in working capital) is sometimes utilized. “Owner’s Discretionary Cash” (ODC) is normally used in business valuations and is defined as EBITDA, less capital expenditures and working capital changes. Depreciation methods are removed from the equation, and cash flow before interest and debt payments are used, which documents the cash available to the shareholders and debt holders. A buyer is purchasing the future cash flow of the business, so the future net cash flow is critical to calculate.
The Market Value Of The Stockholders’ Equity
The market value of the stockholders’ equity is also called book value. This method subtracts the market value of the total liabilities from the market value of the total assets. Most discrepancies will likely be found in the fixed assets, intangibles or investment (securities) accounts. Assets are purchased and recorded at cost and then depreciated over allowable recovery periods. Often, assets have been written down significantly and might even be ‘off’ the balance sheet, but they are still fully utilized in operations. This is particularly true with buildings where they typically appreciate rather than depreciate. Due to traditional accounting practices, we need to make the necessary adjustments to reflect the market value of the assets and liabilities to arrive at the net asset value. The net asset value is usually the lowest valuation when valuing an on-going business as the income stream analysis usually generates a higher value.
The discount rate is the last valuation driver. The discount rate is used to present value the future cash flows. High risk investments demand higher rates of return. The discount rate is an investor’s expected rate of return, given a specific risk level for the investment. Appraisers uses a “buildup” method to determine the discount rate. The US 20-year treasury bill represents a relatively risk-free investment. Equity investments carry an added Equity Risk Premium and is published by financial reporting companies. A single company risk is not diversified and carries added risk. Therefore, a Company Specific Risk Premium is determined by the strengths of the business and their ability to meet long-term obligations. This calculation is perhaps the most challenging number to validate. Each industry has its own risk factor, and the Industry Risk Premium is used. By adding these four risk premiums, we arrive at the Cost of Equity. After applying a weighted average cost of equity, we arrive at the “Discount Rate.” Next, we deduct the growth rate of the company which is usually the mature growth rate of the company. Normally, the growth rate should not exceed the rate of inflation plus GDP growth. Deducting the growth rate from the discount rate gives us the capitalization rate (cap rate) which will be used to capitalize one year of cash flow.
Take time to accurately develop and apply the correct values. If there are discrepancies in a valuation, it is usually found in these four areas.