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Sudan University of Science & Technology
College of Business studies
Business Valuation for Equity Financing
A Combined approach
By
PhD Scholar
Daoud Abdellafef Jerab
Supervisor
Associate Prof. Ahmed Ali Ahmed
“This is the first part of a PhD thesis in a partial fulfillment of the requirements for PhD in Finance degree at
Sudan University of Science & Technology, August 2009”.
Sudan University of Science & Technology (SUST),
College of Business studies, Western Campus,
Khartoum- Sudan.
Tel: 0024983780687
Fax: 0024983792717
Email: [email protected]
Electronic copy available at: http://ssrn.com/abstract=1821291
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CONTENTS
DEDICATION ………………………………………...…………………………..…………………………………. i
LIST OF FIGURES ……………………………………………………………..…………………………………. v
ABSTRACT ……………………………………………………………...……………………………..……………… vi
ACKNOWLEDGMENTS ………………………………………………...……..……………………………….. vii
LIST OF ABBREVIATIONS ………………………………………………………….………………………… viii
CHAPTER 1: INTRODUCTION …………………………………………..………………………………….. 1
1.1 Problem Definition ………………………………………………………………………………. 1
1.2 Research Questions ……………………………………………………………………………… 2
1.3 Objectives of the Study ……………………………….……………………………………….. 2
1.4 Significance of the Study ……………………………………………………………………... 2
1.5 Methodology, Scope and Limitations of the Study ……………………………… 3
1.6 Organization of the Study …………………………………………………………………….. 3
CHAPTER 2: THEORETICAL FRAMEWORK ………………………………..………………………. 4
2.1 The Meaning of Value …………………………………………………..……………………... 4
2.1.1 The Accounting Based Definitions of Value …….…………..…………… 4
2.1.2 The Discounted Cash Flow Concept of Value ………………..…………. 5
2.1.3 The Market Based Definitions of Value …………………………………….. 6
2.2 Tools and Techniques in Frequent Use in Business Valuation ……...…….. 7
2.2.1 The Accounting Based Approach ………………………………….…………… 8
2.2.2 The Discounted Cash Flow Based Approach ….…………………………. 13
2.2.3 The Market Based Approach ……………………………………………………... 20
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CHAPTER 3: QUALITATIVE ASPECTS OF BUSINESS VALUATION …………….………... 22
3.1 Valuing Management Team …………………………………………….…………………... 22
3.1.1 Valuing Management Team Characteristics .…………………….……….. 22
3.1.2 Valuing Management Team Effectiveness ……………………..………….. 26
3.2 Organization Valuation ……………………………………………….……………………….. 31
3.2.1 Assessing the Effectiveness of the Management Control System .…. 32
3.2.2 Organization Diagnosis Model: Matrix Model ….…………..…………... 37
CHAPTER 4: PROPOSED FRAMEWORK FOR BUSINESS VALUATION ……………...….. 40
4.1 Why Do We Need a Framework for Business Valuation …………………….. 40
4.2 Proposed Framework for Business Valuation ……………………………………… 42
4.2.1 Valuing the Business Historical Performance …………………...………. 44
4.2.2 Valuing the Business Future Outlook ……………………….……………….. 45
4.2.3 Business Market Value …………………………………………….………………… 45
4.2.4 Management Valuation ……………………………………………………………… 46
4.2.5 Organization Valuation ……………………………………………………………… 46
4.2.6 Advantages, Disadvantages, and Limitations of the Framework …... 48
CHAPTER 5: THEORETICAL FINDINGS AND RECOMMENDATIONS ………………………………………….…….
50
5.1 Main Findings ……………………………………………………………….……………………… 50
5.2 Recommendations ………………………………………………….…………………………….. 51
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BIBLIOGRAPHY …...…………………………………………………………………………………………………. 53
APPENDIX I: PROFITABILITY RATIOS ..………………………………………..……………………….. 54
APPENDIX II: ACTIVITY RATIOS ……………………………………………………...…………………... 56
APPENDIX III: LIQUIDITY RATIOS ...…………………………………………….……………………… 57
APPENDIX IV: DEBT RATIOS ………………………………………………………………….……………... 58
APPENDIX V: MAIN DEFINITIONS OF VALUE ……..………………………………………………. 59
APPENDIX VI: SUMMARY OF THE TRADITIONAL BUSINESS VALUATION TOOLS
AND TECHNIQUES ……………………………………………..…………………………... 60
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LIST OF FIGURES
Figure Page
Figure1: Investment Opportunity Schedule …………………………………….……………………...
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Figure 2: Management Effectiveness Analysis Profile, Ian Smith …………………....…. 27
Figure 3: Organization Diagnosis Model: Matrix Model, Noel Tichy ...…………….…... 37
Figure 4: Main Drivers of Business Value ……………………………………..……………………. 41
Figure 5: Proposed Framework for Business Valuation to Decide on
Equity Financing ……………………………………………………………………………………………
43
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ABSTRACT
The variety of the traditional business valuation tools and techniques, the wide range of factors
affecting business value, and the transfer to the knowledge-based economy where intangible assets
are becoming an integral part of any successful business, are complicating the valuation task and
challenging valuators on which method or tool to use for business valuation. Business valuation
plays a key role in reducing the level of investment uncertainty, preserving the value of invested
capital, identifying the sources of value generation and assessing their sustainability.
This study attempts to provide an overview of the traditional business valuation tools and
techniques, their advantages, disadvantages, limitations and shortcomings. It addresses the
qualitative aspects of business valuation and develops an understanding of the tools and techniques
in frequent use for business valuation to propose a framework for valuing existing businesses.
The proposed business valuation framework, answers some of the investor’s basic questions and
concerns about equity financing opportunities, and provides guidelines on the combination of some
tools and techniques that can be used for business valuation. The study uses a mix of quantitative
and qualitative tools and techniques. The quantitative tools and techniques, are used to provide
investors with a sense on how much benefit they are expected to realize in the future, in return of
their willingness to take the investment risk and sacrifice their resources now. The qualitative tools
and techniques are used to enable investors to assess the sustainability of value generation and
identify other sources adding extraordinary value to the business. The framework enables investors
to see the business from different angles and dimensions. The historical valuation is used to enable
investors to assess to what extent the company was taking advantage of market opportunities to
create wealth for its owners. The future valuation is used to provide investors with an assessment of
the business capacity to generate future cash flows that will contribute to add value to its
shareholders. The management valuation is used to provide investors with an assessment of the
management capacity to deploy the company’s resources, draw the road map and lead the whole
people of the organization to achieve its goals and objectives. The organization valuation is used to
enable investors to assess how the different elements and resources of the organization are aligned
and interacting with each other to shape a business landscape that can add value to its customers
and generate wealth for its shareholders. The study also discusses the advantages, disadvantages,
limitations and the conditions under which the proposed framework can be applied.
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List of Abbreviations
ASA American Society of Appraisers
DCF Discounted Cash Flow
DVM Dividend Valuation Model
EPS Earnings Per Share
GAAP Generally Accepted Accounting Principles
IRR Internal Rate of Return
MEA Management Effectiveness Analysis
NAV Net Assets Value
NPV Net Present Value
P: E Price Earning
PI Profitability Index
PPS Price Per Share
ROA Return on Total Assets
ROE Return on Equity
WACC Weighted Average Cost of Capital
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CHAPTER 1
INTRODUCTION
1.1 PROBLEM DEFINITION
Investors are always challenged to select from a wide range of investment opportunities as
they look out across the landscape, from where they have to start. First they need to narrow
this variety by careful selection. Most, if not all, of the investment activities share a common
feature: uncertainty. Assessing the risk associated with investment opportunities, preserving
the value of the invested capital, understanding what value the business is going to generate,
and identifying the sources of value generation, are important factors to consider in making
strategic investment decisions. Investors’ ability to reduce investment uncertainty, identify
valuable investment opportunities and adapt to the rapid changes in the market place are
becoming more and more volatile and vulnerable with the transfer to the knowledge based
economy. In today’s economy, businesses are gradually shifting from the tangible to the
intangible assets. People skills, knowledge, innovation, leadership and technology are
becoming an integral part of any successful business.
Business valuation plays a key role in investment decisions. What business valuation
method should an investment analyst use to value an investment opportunity? This question
is becoming more and more difficult to answer in this new world of uncertainty. There is
still no one comprehensive tool or techniques that can answer all the concerns and questions
of an investor. Several methods and techniques have been developed over time. All of these
tools may be misleading if we do not understand their limitations, the purpose for which
they have been developed, and under which conditions they can be applied. Some of these
tools are accounting based to assess the historical performance of the business, others are
cash flow based to assess the future earning capacity of the business and more are concerned
with the market data to compare with similar businesses. Some can be used for valuing an
already established business while others are focused to value a new business. Most if not all
of the traditional business valuation models are concerned with the quantitative valuation of
the business and focused on the tangible assets. As a result of their quantitative approach,
these tools often fail to capture the value that may be generated by the intangible assets of a
business.
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This study will focus on developing an understanding of the most common business
valuation tools and techniques and try to develop and propose a framework that may be used
to value investment opportunities for equity financing.
1.2 RESEARCH QUESTIONS
From the problem statement in section 1.1, the following questions arise:
(i). What do we mean by value?
(ii). What are the tools and techniques that are frequently in use in business valuation?
(iii). What are the advantages and disadvantages of each tool?
(iv). What are the limitations and/or shortcoming of each tool?
(v). In the light of the studied business valuation tools and techniques, what
framework can be developed to conduct a sound and reliable business valuation
for equity financing?
1.3 OBJECTIVES OF THE STUDY
The main focus of this study is to develop a framework for business valuation to facilitate
the decision-making on equity financing. It will have the following main objectives:
(i). Develop an understanding of the most common business valuation tools and
techniques, identify their limitations and shortcoming and under which
conditions each tool can be applied.
(ii). Identify which tools can be utilized to valuate investment opportunities for equity
financing.
(iii). Leverage the understanding and knowledge gained from this research to develop
a business valuation framework for equity financing that can minimize the
shortcomings of the traditional tools, assess the sustainability of value generation
and identify other sources adding extraordinary value to the business.
(iv). Consolidate the knowledge and skills gained in this MBA programme to enrich
the content of this study.
1.4 SIGNIFICANCE OF THE STUDY
In every industry of the new economy, new business models are constantly emerging. In
these models, the intangible assets, including people skills, knowledge, leadership,
relationship, brands, systems, and technology are generating extraordinary value. The
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traditional business valuation tools are gradually failing to provide a sound and reliable
business valuation. In most cases these tools fail to capture the value of the intangible assets.
Moreover, there is still no one comprehensive model the can valuate all the aspects of the
business. Each tool is focused on the valuation of certain area. Investment analysts are
challenged with the question which tool to use and under which conditions and in many
cases they fail to carry a reliable and sound business valuation exercise. This study will
contribute to provide a framework and guidelines for business valuation for equity financing
that go beyond the absolute value itself. It will help to provide a guideline that will enable
the investment analyst to take care about the different sources of value generation and assess
the sustainability of these sources.
1.5 METHODOLOGY, SCOPE AND LIMITATIONS OF THE STUDY
This study will explore some of the theoretical background of business valuation. A desk
research will be conducted to review, study, analyze and evaluate the most common
business valuation tools, techniques, methods and models utilizing all the available literature
including text books, magazines, research papers, articles, internet sources, etc. Given the
short time period and the fragmented material on business valuation, the study in no mean
will be covering all the tools and techniques for business valuation. Also the time limitation
make it very difficult to conduct a field research to get more insight on the practical methods
in use for business valuation. The study will be mainly concerned with the business
valuation models that can be used for valuing existing companies to decide on equity
financing. It will not be concerned with the business valuation models for business
acquisition, selling of business, mergers and acquisitions, liquidation of business, etc. At the
same time, the paper will not be concerned with the business valuation models for new
companies, technology companies, dot.com companies and internet companies. It will be
focused on the valuation of the traditional industries that are gradually changing their
business landscape and moving to the era of intangible assets and knowledge based
economy. The developed valuation framework will have more focus on the qualitative
valuation techniques rather than the quantitative valuation.
1.6 ORGANIZATION OF THE STUDY
This study will consist of five chapters including this introduction chapter. In chapter 2, the
study will review the theoretical framework of business valuation, the tools and techniques
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in frequent use for business valuation, their advantages, limitations and shortcomings. In
chapter 3, the study will address the qualitative aspects of business valuation. In chapter 4, a
framework for business valuation will be proposed. In chapter 5, the study will end with
main findings and general recommendations.
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CHAPTER 2
THEORETICAL FRAMEWORK
2.1 THE MEANING OF VALUE
The concept of value is the heart of investment decisions, but what value we mean. There is
no one single definition for value. Value carries different meanings to different people under
different conditions. Value can mean book value to an accountant, present value to an
economist, market value to a willing buyer, owners’ stake to a shareholder, business value to
a manager, etc. Through out the review of the available literature, I have found the main
definitions of value coming from three sources: the accounting theories, discounted cash
flow theories and the market theories.
2.1.1 THE ACCOUNTING BASED DEFINITIONS OF VALUE
(i). Asset book value
An asset book value is defined as its strict accounting value. It is
calculated by subtracting the accumulated depreciation from the
historical cost of an asset.
(ii). Company’s book value
The company’s book value is derived from its balance sheet. It is
defined as the value of the total assets (gross fixed assets less
accumulated depreciation plus current assets plus any intangible
assets less accumulated amortization). It provides information about
the net value of the firm’s resources. This information is based on
primarily historical market prices and therefore largely independent of
the success with which the firm currently employs its resources. Book
value is only an accounting term and does not recognize a company's
goodwill.
(iii). Owners’ stake book value
Owners’ stake book value in the company (which is called owners’
equity) is defined as the net assets value (NAV) and is calculated by
subtracting the total liabilities form the total assets of the firm in the
balance sheet.
6
(iv). Book value per share of common stock
The book value per share of common stock is defined as the amount
per share of common stock that would be received if all the firm’s
assets were sold for their exact book (accounting) value and the
proceeds remaining after paying all liabilities (including preferred
stock) were divided among the common stockholders.
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2.1.2 THE DISCOUNTED CASH FLOW CONCEPT OF VALUE
(i). Net Present Value
The net present value (NPV) of any investment project or asset, is defined as,
the present value of all future cash inflows minus the present value of all
anticipated cash outflows discounted at a rate equal to the firm’s cost of
capital or opportunity cost of capital. The concept of the NPV is important
because an investment with a positive NPV increases the owners’ wealth. It
helps investment managers to select projects that will maximize cash flows
over time.
(ii). Shareholders’ Value
Shareholders’ value is defined as “the worth of the net present value of the
business cash flows, discounted at the appropriate cost of capital”.1 Under
this definition, it is assumed that the long-term cash flow determines the
long-term value of the business. This definition tries to provide a link
between management strategies and decisions, and value creation. It defines
the value drivers in business strategy to include sales, margin and planning
horizon. For investment strategy, it defines the value drivers to include
capital investment, working capital and acquisition. In the financing strategy,
it defines the value drivers to include credit rating, tax rate, capital structure
and dividend policy. This definition doesn’t link other intangible assets
(people skills, knowledge, leadership, brand name, etc.) to the value creation.
(iii). Investment Value
The investment value is defined by the Chicago Appraisal Institute as “ the
specific value of goods or services to a particular investor (or class of
investors) based on individual investment requirements”. Investment value
estimates are always accompanied by a market value estimate to facilitate
decision-making. Investment value is based on the earning power of the
business except that the discount rate is the consensus rate of the collective
investors. There can be many valid reasons for the investment value to one
particular owner or prospective owner to differ from the fair market value.2
Among these reasons are:
Differences in estimates of future earning power.
1 R. Pike and P. Neale, Corporate Finance and Investment, 3
rd ed. (Europe: Prentice Hall, 1999), 112.
2 S. P. Pratt, R. F. Reilly and R. P. Schweihs, Valuing a Business, 3
rd ed. (New York: McGraw Hill, 1996), 25.
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Differences in perception of the degree of risk.
Differences in tax status.
Synergies with other operations owned or controlled.
(iv). Corporate Value
Corporate value is defined as “the present value of the expected returns from
the combination of current business strategies and future investment
programs, based on the information available to management”.3 It is the
responsibility of the general management to ensure that the corporate value is
properly presented in the company’s market value.
(v). Intrinsic Value
Intrinsic value is defined as “the amount that an investor considers, on the
basis of an evaluation of available facts, to be the true or real worth of an
item, usually equity security. The value will become the market value when
other investors reach the same conclusions”.4 The various approaches to
determining intrinsic value are based on expectations and discounted cash
flows. The most important variable in the estimation of the intrinsic value is
the expected earnings. However, other variables such as dividends, capital
structure, management quality and so on can be studied. An analyst estimates
the intrinsic value, based on these different variables and compares the value
with the current market price to arrive at investment decision.
2.1.3 THE MARKET BASED DEFINITIONS OF VALUE
(i). Fair Market Value
The fair market value is defined by the American Society of Appraisers
(ASA) as “the amount at which property would change hand between a
willing seller and a willing buyer when neither is acting under compulsion
and when both have reasonable knowledge of the relevant facts”. The
definition implies that the parties have the ability as well as the willingness to
buy or to sell. In most interpretations of fair market value, “the willing buyer
and the willing seller are hypothetical persons and dealing at arm’s length,
3 K. Ward and T. Grundy, “The Strategic Management of Corporate Value,” Industry Week, 4 September 2000, 35.
4 W.W. Coper and Yuri Ijiri, Kohler’s Dictionary for Accountants, 6
th ed. (New York: Prentice Hall, 1983), 285.
9
rather than a particular buyer or seller”.5 This implies a price wouldn’t be
considered representative of fair market value if influenced by special
motivations not characteristics of a typical buyer or seller. The terms market
value and cash value are sometimes used interchangeably with the term fair
market value. The use of these different terms is influenced by the type of
asset, property or business.
5 S. P. Pratt, R. F. Reilly and R. P. Schweihs, Valuing a Business, 3
rd ed. (New York: McGraw Hill, 1996) 24.
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(ii). Liquidation Value
Value in exchange, on a piecemeal basis. This means the assets of the
business enterprise will be sold individually and that they will experience less
than normal exposure to their appropriate secondary market. Liquidation
value can be based upon either an orderly winding down (i.e., over a year to
get the best price) or a quick fire sale. The liquidation value per share of
common stock is the actual amount per share of common stock that would be
received if all the firm’s assets were sold for their market value, liabilities
(including preferred stock) are paid, and any remaining money were divided
among the common stockholders.
(iii). Strategic Value
Strategic value is the price a buyer is willing to pay because of synergies
unique to the two entities.
(iv). Fair Value
Fair value is the statutory standard of value applicable in cases of dissenting
stockholders’ appraisal rights. If a corporation mergers, sells out, or take certain other
major actions, and the owner of a minority interest believes that he is being forced to
receive less than adequate consideration for his stock, he has the right to have his shares
appraised and to receive fair value in cash. Fair value with respect to a dissenter’s
shares, means “the value of the shares immediately before the effectuations of the
corporate action to which the dissenter objects, excluding any appreciation or
depreciation in anticipation of the corporate action unless exclusion would be
inequitable”.6
2.2 TOOLS AND TECHNIQUES IN FREQUENT USE IN BUSINESS VALUATION
The valuation (sometimes called evaluation) of companies is by no means an exact science.
Many tools and techniques have been developed for business valuation. Most of these tools and
techniques provide a quantitative evaluation for the business, give different answers and are
based on one of the following three approaches:
(i). The accounting based approach.
(ii). The discounted cash flow based approach.
6 J. H. Lorie and M. T. Hamilton, The Stock Market: Theories and Evidence (New York: Prentice Hall, 1998), 114.
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(iii). The market based approach.
2.2.1 THE ACCOUNTING BASED APPROACH
The accounting based approach is dependent on the published financial statements
audited according to the generally accepted accounting principles (GAAP). This
approach can provide an estimation of book value, an assessment of the business
historical performance, ranking of investment opportunities using the accounting rate of
return on investment and estimation of payback period.
(i). ESTIMATION OF THE BOOK VALUE
The accounting based approach provides an estimation of two values: the
company’s book value and the book value of the owners’ stake in the company.
The balance sheet shows the recorded value for the total assets and liabilities of a
business. The company’s book value is defined as the total assets value and is
calculated as shown in equation 1 below:
Company’s
book value =
current assets + (gross fixed assets - accumulated depreciation)
+ (gross intangible assets - accumulated amortization)
…………………………………………..E.q. (1)
The book value of the owners’ stake in the company (which is called owners’
equity) is defined as the net assets value (NAV) and is calculated as shown in
equation 2 below:
Net assets value = total assets - total liabilities
= (current assets + fixed assets) – (current liabilities + long term
liabilities) ………………………………………….... E.q. (2)
This accounting based model, can be applied only to valuate existing business and the
financial statements should be audited.
The advantages of the accounting estimation of value include but are not limited to the
following:
It is largely determined by accounting convention and consistent accounting
standards across the firm. It provides a stable and intuitive measure of value.
Completing the evaluation assignment very early because it is easy to get the
required information (company’s published accounts) and it is easy to use.
12
The estimation of value using the accounting based approach, can be supported by
further analysis of the financial statements, to assess the historical performance of
the business. This will give more insight on where the company has excelled and
where it needs to have some improvements.
The disadvantages and shortcomings of the accounting estimation of value include but are not
limited to the following:
The model can only be used for an already existing business.
The model neglects cash flows and the time value of money.
It neglects the capacity of assets to generate earnings. It assumes that the assets will
continue to operate in their current use (going concern bases). This approach of
valuation in many cases may underestimate or overestimate the earning power of the
assets.
The model estimates only the value of assets recorded in the balance sheet. It neglects
the value generated by other sources (e.g., people, knowledge, strategies, leadership,
brand name, etc.).
The fixed assets (equipment, facilities, infrastructure, etc.) may be obsolete or
inefficient and their values in most cases are out of date. Their values are recorded as
historic cost less accumulated depreciation. Depreciation is made to distribute the
historic cost of an asset over its expected lifetime not as attempt to arrive at a market
oriented value.
The values of inventory are often unreliable. In many cases you find obsolete
inventory recorded at their historic cost.
The value of the accounts receivable (debtors figure) may be suspect and worth less
than their face value. This is because not all debtors may be collected and converted
into cash and the provision for bad debts may be very low.
(ii) ASSESSING THE BUSINESS HISTORICAL PERFORMANCE
In addition of providing an estimation of value, the accounting based approach is used to
conduct further analysis of the published financial statements. These analyses provide
ratios for comparison (comparing the ratios of one firm with that of another, with some
other given standard like industrial average, or evaluation of the firm’s performance over
13
time). The comparison can assess the historical performance of the business, identify
areas in which the company has excelled and, more importantly, areas for potential
improvements. The ratio analysis can be divided into four basic categories: profitability
ratios, activity ratios, liquidity ratios and debt ratios.
1). Profitability Ratios
The profitability ratios indicate the economic soundness of the firm’s performance in
periodic operations. They evaluate the firm’s earning with respect to a given level of sales,
a certain level of assets, the owners’ investment, or share value. These ratios include gross
profit margin, operating profit margin, net profit margin, return on total assets, return on
equity, earning per share and price earning ratio. For more details on these ratios and their
calculations see appendix I page 54.
2). Activity Ratios
The activity ratios measure the speed with which accounts are converted into sales or cash.
These ratios include inventory turnover, average collection period, average payment
period and total assets turnover. For more details on these ratios see appendix II page 56.
3). Liquidity Ratios
The liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they
come due. Liquidity refers to the solvency of the firm’s overall financial position and the
ease with which it can pay its bills. These ratios include net working capital, current ratio
and quick ratio. For more details see appendix III page 57.
4). Debt Ratios
The debt ratios measures the firm’s degree of indebtedness (the amount of debt relative to
other significant balance sheet amounts) and the ability to service debts (the ability of the
firm to make contractual payments required on a scheduled basis over the life of a debt).
These ratios include debt ratio, times interest earned and fixed payment coverage ratio.
For more details see appendix IV page 58.
The advantages of the ratio analysis include but are not limited to the following:
Ratios provide a type of benchmarking in which the firm’s ratios are compared to
those of a key competitor or competitors or any predefined standard (e.g., industry
14
average).
Ratios can asses the firm’s past performance and identify areas where it has excelled
and , more importantly, areas for improvement.
Ratios are indicators that can provide alarm signals.
The disadvantages and shortcomings of the ratio analysis include but are not limited to the
following:
A single ratio doesn’t provide sufficient information from which to judge the overall
performance of the firm. Only when a group of ratios is used, can a reasonable
judgment be made.
Ratios may not necessarily reveal the basic causes of the problem. In most cases it
provides the symptoms of the problem.
Ratios are static and indices for one period. They ignore the dynamic forces of the
internal and external environment.
Ratios are based on analyzing financial statements. They carry the same limitation and
problems of the financial statements (e.g., they may not reflect the real financial
situation of a firm).
Ratios have problems of standards. Which standards to use or which industry average.
Industry average is not particularly useful when analyzing firms with multiple product
lines where it is difficult to select the appropriate benchmark industry.
Ratios are deterministic. They provide no consideration for uncertainty, and only,
point estimates are considered.
Comparison problems, where the financial data being compared may not have been
developed in the same way.
(iii). ACCOUNTING RATE OF RETURN ON INVESTMENT
The accounting rate of return on investment is from the most traditional measures used
in practice for business valuation. Some business analysts use this technique as a quick
method for ranking investment opportunities. The accounting return on investment use
financial accounting data and is defined differently, but commonly it is defined as the
average income after tax divided by the average investment as shown in equation 3
below:
15
Accounting rate of return on investment = investmentaverage
taxafterincomeaverage ……………E.q.
(3)
where
average income = yearsofnumber
investmenttheofincometotal
average investment = 2
cosmin taltervaluesalvageinvestmenthistorical
The investment project is accepted if the accounting rate of return on investment is
greater than a minimum predetermined required rate of return defined by investors. In
case of several projects competing for financing opportunities, the projects are ranked in
a descending order according to their accounting rate of return on investment and the
project with highest rate of return on investment is taken first, followed by the next one
until all funds are exhausted.
The advantages of the accounting rate of return on investment include but are not limited to
the following:
Easy and simple method to be used.
It is one of the most popular tools.
The disadvantages and shortcomings of the accounting rate of return on investment include
but are not limited to the following:
This method is crude and unsophisticated.
It ignores cash flows.
It ignores the time value of money.
(IV). PAYBACK PERIOD
The payback period measures the number of periods or years it will take before a project or an
investment generates enough cash flows to equalize the original investment. The method uses
the cash flow as a measurement of benefit and investment. The payback period is calculated as
shown in equation 4 below:
Payback period = flowcashannualnet
investmentialint =
C
I …………………………………… E.q. (4)
where
net cash flow = net profit after tax + depreciation
16
According to payback period, the project is accepted for investment if the payback period is
higher than a predetermined payback period.
The computation of the payback period is simple if the project or investment net annual cash
flows are uniform. In case the generated net cash flows change from period to another, one
has to find out the point in time when the cumulative cash flows of the project or investment
equals the original investment.
The advantages of the payback period include but are not limited to the following:
Easy and simple method to be used.
It is one of the most popular tools used in valuing investment projects.
It is line with the investor’s preference to see when their money is expected to be
generated back.
The disadvantages and shortcomings of the payback period include but are not limited to the
following:
It ignores cash flows beyond the payback period.
It ignores the time value of money.
2.2.2 THE DISCOUNTED CASH FLOW APPROACH
In the 1970s, discounted cash flow (DCF) analysis emerged as best practice for valuing
corporate assets. The DCF techniques are derived from the economic theory that
acknowledges the time value of money and is known as the time-adjusted measure. It is
frequently utilized to estimate the present value of a business or an asset based on its future
earning capacity. Other models have been developed based on the concept of discounted cash
flow. From these models are the net present value, the internal rate of return, the profitability
index and the dividend valuation model.
(i). PRESENT VALUE MODEL
According to this model, the value of a business or an asset, equals its expected future
cash flows the owner expects to get overtime discounted to present value at the
weighted-average cost of capital (WACC) or opportunity cost of capital. A discounted
cash flow analysis regards business as a series of risky cash flows stretching into the
future. The analyst’s task is first, to forecast expected future cash flows, period by
17
period; and second, to discount the forecast to present value at the WACC or the
opportunity cost of capital. The opportunity cost is the minimum rate of return a
company (or its owners) could expect to earn on an alternative investment entailing the
same risk. Opportunity cost consists partly of time value7 (the return on nominally risk-
free investment) and a risk premium (the extra return you can expect with the risk you
are willing to bear). The cash flow forecast and the WACC or opportunity cost of capital
are combined in the basic discounted cash flow relationship8 as shown in equation 5 next
page:
Present Value =
n
ttratediscount
ttimeatflowcash
1 )1( =
n
ttK
CFt
1 )1( ……………………….…. E.Q. (5)
WHERE
CFt : net cash flow at time t, usually it is the net profit after tax +
depreciation
K : the discount rate that can be the WACC or the
opportunity cost of capital or any other rate based on
the investor’s perception of risk and return.
Some analysts estimate the cash flow at time t in terms of the free cash flow. The free
cash flow is the cash left in the company after making all operating expenditures, all
mandatory expenditures (interest and taxes) and all investment expenditures (including
both replacement and discretionary or strategic investments). It is calculated as shown in
equation 6 below:
Free Cash Flow = revenues – operating costs+ depreciation – investment expenditures
E. Q. (6)
The above definition of the free cash flow include revenues from both existing and
future operations and allow investment expenditures required to generate enhancement
in revenues. Other analysts prefer to narrow the definition of the free cash flow to
exclude the strategic investment expenditures.
The free cash flow concept is preferred by some analysts because it focuses on what
remain for the directors to appropriate either as:
Dividends payments.
Repayment of debt.
7 T. Luehrman, “ What’s It Worth?”, Harvard Business Review, May - June 1997, 132.
8 R. Pike and P. Neale, Corporate Finance and Investment, 3
rd ed. (Europe: Prentice Hall, 1999), 105.
18
Acquisition of other operations.
Build up cash balances.
The main assumptions in present value model are:
The model requires credible and reliable forecast of the company’s income stream when
looking a head at the future.
The yearly estimates of cash flows should be based on a sound business plan.
The approach needs an assumption about the business residual value (i.e., what it will be
worth at the end of the period), either the termination of the business activity, or that it will
continue to be operated as going concern.
The final assumption is which discount rate should be applied. Usually the weighted
average cost of capital is used as the discount rate. Other analysts use the opportunity cost
of capital or other rates based on their own perception of risk.
The advantages of the present value model include but are not limited to the following:
The model is familiar to the investment and business analysts.
The model is in line with the economic value concept. It acknowledges cash flows and
the time value of money.
It attaches value to the future cash generating capacity of the business rather than the
historical earnings registered in the accounting records.
The model has a good prediction of quantitative value when the business has
reasonably predictable sources of income, such as long-term rental agreements or
royalties from intellectual property.
The disadvantages and limitations of the present value model include but are not limited to the
following:
The credibility of the model is affected by the reliability of forecasting the company’s
income and the availability of a sound business plan.
The revenues and the operating cost used in estimating the yearly cash flow are taken
from the accounting data. They may fail to reflect cash flows due to movements in the
various items of working capital and taxation.
There is no one single rule on which discount rate to be used. The rate is subject to the
investor or analyst perception of risk. Some of them use the weighted average cost of
19
capital, others use the opportunity cost of capital and more use their own figures. This
may result in over or underestimation of the present value.
(ii). NET PRESENT VALUE MODEL
The net present value (NPV) model is one of the most frequently used discounted cash flow
techniques in business valuation. The model is seen as a tool for maximizing the owners’
wealth. It is defined as the present value of all the future cash inflows minus the present value
of all future cash outflows discounted at the weighted average cost of capital or the
opportunity cost of capital. It measures the future economic benefits in relation to the sacrifice
and commitment of resources now. The model links the cash flows and the appropriate
discounting rate as shown in equation 7 next page:
Net Present Value =
n
ttratediscount
ttimeatflowcash
0 )1( =
n
ttK
CFt
0 )1( ……………………….
E.Q. (7)
WHERE
CFt : includes investment outlay, periodic cash flow, salvage value and/or terminal
cost.
Investment outlay: includes land, equipment, buildings and facilities, patent and
process, additional working capital, interest on construction, property taxes
before the yare in use, etc.
Periodic cash flow: net profit after tax + depreciation
K : The appropriate discount rate that can be the weighted
average cost of capital or the opportunity cost of
capital or any other rate based on the investor’s
perception of risk and return.
According to this model, the investment project is accepted if it adds positively to the
firm’s current value. This means the net present value should be greater than zero. This
model can be used to valuate one single investment opportunity or to select from a range
of investment opportunities. The selection is based on ranking the projects on
descending order according to their net present value. The combination of projects with
the highest overall net present values are taken.
20
The model has the same similar advantages, disadvantages and limitation of the present value
model presented earlier in the previous section page 15.
(iii). INTERNAL RATE OF RETURN
The internal rate of return (IRR) is defined as the discount rate that reduces the net present
value to zero. In other words it is defined as the rate of discount that equates the present value
of cash inflows to the present value of the cash outflows. The IRR is estimated by solving
equation 8 for IRR:
0 =
n
ttIRR
CFt
0 )1( …………………………………………………… E.q. (8)
where
CFt : net cash flow at time t and usually it includes investment outlay, the periodic
cash flow (net profit after tax + depreciation), terminal cost and salvage value.
Equation 8 in the previous page, is solved for IRR by trial or intrapolation keeping in mind
that as the rate of discount rises the net present value decreases; and vice versa. The
spreadsheets or some electronic calculators make the model much easier.
According to this model, the investment project is accepted if the internal rate of return is
greater than a minimum rate of return required by investors or in some cases greater than the
weighted average cost of capital.
The internal rate of return model can be used to value single investment opportunity or to
select from a range of investment opportunities using the investment opportunities schedule.
According to this method, the IRR and the initial investment outlay for each project is
computed. The projects are ranked according to IRR in a descending order and presented
graphically as shown in figure 1below:
Internal rate of return IRR
Weighted average cost of capital (WACC) Project 1
Project 2
Project 3
Project 4
%
21
Figure 1: Investment opportunity schedule.
Assuming there is no budget constraint, and according to the investment opportunity schedule
in figure 1, the projects with IRR above the weighted average cost of capital (WACC) are
accepted. In this case project 1, 2 and 3. However this method may fail to maximize the
owners wealth in case of budget constrain. To avoid the problem, the combination of projects
lying above the WACC with the highest net present value are accepted.
The advantages of the internal rate of return model include but are not limited to the
following:
The model acknowledges cash flows and the time value of money.
The model is very helpful for investors looking to generate minimum rate of return on
their investments.
The disadvantages and limitations of the internal rate of return model include but are not
limited to the following:
The model generate imaginary values for the internal rate of return particularly in the
case of non-conventional pattern of cash flows (different cash flows each year).
The model may fail to rank mutually exclusive projects (i.e., projects that are used for
the same purpose where the selection of one project which result in the elimination of
the other project).
(iv). PROFITABILITY INDEX
The profitability index (PI) is a derivative of the net present value approach. However in this
case it is represented as a ratio. It is defined in two ways. According to the aggregate
definition, it is calculated as shown in equation 9 below:
22
PI = outflowscashofvaluepresent
lowscashofvaluepresent inf …………………………………………. E.q. (9)
But more commonly according to the net definition, it is calculated as shown in equation 10
below:
PI = 0
1
)1(
C
kCFn
t
tt
………………………………………….. E.q. (10)
where
CFt : net cash flow at time t and usually it is the periodic cash flow (net profit after tax
+depreciation).
C0 : net cash flow at time zero and usually it is equal to the initial investment outlay.
According to the profitability index model, the investment project is accepted in case the
profitability index is greater than 1.
The advantages, disadvantages and shortcomings of the model are similar to that of the
present and net present value presented in page 15.
(v). VALUATION OF SHARES: THE DIVIDEND VALUATION MODEL
Shareholders attach value to shares because they expect to receive a stream of dividends and
hope to receive an eventual capital gain. The dividend valuation model (DVM), is appropriate
for valuing shares of a company rather than the whole enterprise. The DVM is mainly based
on the projection of the past dividend policy. It assumes that companies are known to prefer a
steadily rising dividend pattern or constant dividend pattern rather than more erratic payouts.
This model defines the value of shares now, P0, as the sum of the stream of future discounted
dividends plus the value of the share as and when sold, in some future year (n) as shown in
equation 11 below:
P0 =
n
t 1t
t
Ke
D
)1( +
n
n
Ke
P
)1( ……………………………………………… E.q. (11)
where
P0: is the value of the share now.
Dt: is the dividend at time t.
Ke: is the shareholders required rate of return.
Pn: is the value of the share when sold at time n.
23
If the projected stream of dividends are expected to be constant over time (i.e., D1 = D2 etc.)
and the life span is expected to be infinite the model can be reproduced as shown in equation
12 below:
P0 = eK
D1 …………. …………………..………………………………………. E.q. (12)
In case the projected stream of dividends are expected to include a constant rate of
growth, the value of share now will be calculated as shown in equation 13 below:
P0 = )(
)1(0
gK
gD
e
=
)(1
gK
D
e as long as Ke > g ……… ……………………. E.q. (13)
where
D0: is the dividends now.
g: is the dividend annual growth rate.
The advantages of the dividend valuation model include but are not limited to the following:
The model is a frequently in use to estimate the value of a company’s shares now
given that the stream of dividends are quite predictable.
The model is based on the discounted cash flow principal that acknowledges the time
value of money.
The disadvantages and limitations of the dividend valuation model include but are not limited
to the following:
The dividend valuation model is appropriate for valuing part shares of a company
rather than the whole enterprise.
Capital investment strategy and taxation may cloud the relationship between dividend
policy and share value. This is because minority shareholders have limited or no
control over dividend policy.
The model is mainly based on the projection of the past dividend policy. It assumes
that companies are known to prefer a steadily rising dividend pattern or constant
dividend pattern rather than more erratic payouts. The model fails in case the company
pays no dividend.
The model implies sufficient supply of positive net present value projects to match the
earnings available for retention. It is most unlikely that there will always be sufficient
attractive projects each offering a constant rate of return sufficient to absorb a given
fraction of earnings in each future year.
The model fails to estimate the value of shares in case the growth of dividends exceeds
24
the shareholders required rate of return.
2.2.3 THE MARKET BASED APPROACH
One of the most popular market based approaches is the price earning multiple model. It
estimates the value of a business based on estimating its maintainable profit and multiplying it
by a capitalization factor known as the price-earning (P: E) ratio. The price-earning ratio (P:
E) is defined as the price per share (PPS) divided by the earnings per share (EPS) and is
calculated as shown in equation 14 below:
Price earning ratio = shareperearning
shareperprice =
EPS
PPS ……………………………….. E.q. (14)
In its reciprocal form, the P:E ratio measures the earnings yield of the firm’s shares (i.e.,
current rate of return) as shown in equation 15:
EP :
1 =
vlauecompany
earnings=
V
E ………………………………… ………………. E.q. (15)
Based on equation 15, the value of the company, is estimated as shown in equation 16 next
page:
Value of the company = earning x price earning ratio = E x P:E …………………. E.q. (16)
where
Earnings: is the company’s long-term maintainable profit. Usually it is estimated as
the average of the past 3 t o5 years profit.
P:E ratio: is the average price-earning ratio of similar companies in the same
industry whose stocks are publicly traded.
The advantages of the price-earning model include but are not limited to the following:
It is one of the most simplistic methods for business valuation. It requires only the
estimation of the company’s average earning over the last few years and multiplying it
by the industry price-earning ratio.
It provides a link between the share’s price and earning. It estimates the price paid to
the company’s current earning.
It eliminates the need to make assumptions about risk, growth and payouts ratios.
The use of the average price-earning multiple of other firms is more likely to reflect
market moods and perceptions.
25
It is a simple benchmark for comparison that links the industry average and the
company’s earning .
The disadvantages and limitations of the price earning multiple model include but are not
limited to the following:
The earnings of the firm are expressed in the current and historical earnings not the
prospective earning capacity of the business.
The earning figure is based on the accounting concept and doesn’t follow the cash
flow concept. Therefore it has the same limitations and disadvantages of the
accounting based methods and it doesn’t acknowledge the time value of money.
The validity of estimating the average price earning multiple where you find
differences between the companies within the same industry. These companies may
have different leverage ratios, and consequently they have different levels of risk for
their shares. This in addition to the differences between the historical and prospective
multiple.
The P:E ratio is sensitive to changes in the economic cycle. If there is an anticipation
for a downturn in the economy, the P:E ratio starts to fall thus resulting in lowering the
firm value.
The price earning multiple may fail to value a loss making firms where the earnings
are negative. This will result in a meaningless value for the firm.
26
CHAPTER 3
QUALITATIVE ASPECTS OF BUSINESS VALUATION
From the review of the available literature on business valuation tools and techniques presented in
chapter 2, we can see that most of the traditional business valuation tools and techniques are
quantitative and focused on the valuation of the business tangible assets. This chapter will present
some tools and methods that can be used to valuate some of the business qualitative aspects and
mainly management team and the organization. These qualitative tools and methods will be drawn
from some management and organization diagnosis tools and techniques gained throughout the
knowledge gained from this MBA programme and the review of some business articles and
literature.
3.1 VALUING MANAGEMENT TEAM
Management valuation is very crucial to assess its capabilities to deploy the company’s
resources in away that will boost the corporate value. “When management clearly identifies
milestones and resources are properly deployed, the path to value (P2V) becomes an
effective tool for significantly increasing the worth of a business”.9 Management team
provides leadership, draw the road map and provide direction for the whole people of the
organization to achieve the organization goals and objectives. Management valuation is
highly subjective and there are no direct ratios or models to predict or evaluate the strength
and effectiveness of management team. Despite the high subjectivity in valuating the
management team, a business valuator can focus on key characteristics and behavioural sets
that can help to identify the management style and effectiveness. In the coming two sub
sections, two models will be presented for management valuation. The first model,
developed by Walter Schuppe, will focus on valuing management characteristics and style.
The second model, developed by Ian Smith, will focus on valuing management team
effectiveness and behaviour.
3.1.1 VALUING MANAGEMENT TEAM CHARACTERISTICS
The ability to identify management characteristics can be quite valuable in
predicting the management behaviour and reducing the level of investment risk.
In his article, “Management: The Most Subjective Valuation”, Walter Schuppe
9 C. Malburg, “The Path To Value,” Industry Week, 4 September 2000, 47.
27
has identified the following characteristics that can be analysed to valuate
management style:
1) Proactive vs. reactive management
A strong management team anticipates problems. Internal systems and
procedures are established to prevent and minimize the effects of problems. This
philosophy helps to avoid regular crisis modes. Devoting management time to
reversing the effects of avoidable problems (reactive management) detracts the
attention from improving operations and negatively affects morale throughout all
levels of the company.
In a proactive environment, strong internal systems and processes generally
results in continuous operational improvements, all clearly visible to
management, employees and outsiders. However, even the best internal systems
cannot prevent all problems. In those cases, the internal systems enable
management, in advance, to predict the problem and point to the need, to quickly
develop an aggressive plan to minimize or eliminate the problem.
Proactive managers do not rely on sales growth to solve problems or improve
profitability and cash flows. Instead they develop strategies where the company
can be profitable at its current sales volume, while developing a strategy for
growth. If management team consistently explains away negative financial
variances and offers reasons why the company has been unable to implement its
business plan, or if management tries to convince investors that the company can
grow out of current problems, it may be an indication of “reactive” rather than
“proactive” management.
2) Hands-on vs. hands-off
A strong management will be proactive and hands-on. Senior management may
leave the day-to-day implementation of strategy to lower level management, but
the senior management team provides leadership and direction. This is done by
identifying the organization vision and mission, sharing them with the whole
people of the organization, establishing goals, communicating these goals
throughout the organization, translating goals into objectives within time frames,
empowering people and holding them accountable for results.
The physical presence of the senior managers cannot be overstated. Strong
managers spend time walking through the company and getting first-hand
28
feedback on critical issues from employees. The senior management team should
be always informed, know where the company stands, to what extent it is
achieving its intended goals and objectives and the reasons for success or failure.
Senior management should be able to tell investors, with precise explanations, if
timetables will be met or the action plan to get back on schedule.
If management team seems to be operating without measurable deadlines for the
implementation of critical strategies, or if it seems to miss its deadlines, it may
indicate weak management. This becomes a critical issue when the company
must work through a serious problem and time is of the essence.
When you tour the prospective company operations, notice if the senior
managers are clearly visible rather than isolated in their offices. A demonstrated
philosophy of “managing by walking around” is often reflective of an active,
hands-on management style. When you tour the facility with a senior manager,
the rank and file employees should readily recognize him/her. You can learn a
great deal about your prospective investor by just walking around the facility.
3) Business strategy: focused vs. scattered
A strong management team can identify core competencies, market niche,
targeted customers and direct competitors. Top managers will then be able to
explain their strategy to leverage their strengths and improve their position
within their niche. This strategy should be consistent with trends within the
industry and focus on the company competitive advantages.
A focused management team will not attempt to enter new markets to chase a
“big payday” when it has not solidified its position within its target market. It
will especially not be doing this without a well thought-out operational plan.
Adequate internal resources or expertise and the proper financing. Good
managers will not enter new markets unless they intend to be competitive. For
example, entering a counter cyclical market is of little value unless the company
can be profitable and attain a reasonable return on investment required to enter
that market. There is little value in a strategy that cannot be fully executed due
to in adequate capital resources.
4) The spirit of teamwork
Although you may be provided with a detailed organization chart and impressive
resumes, this does not mean there is truly a management team. The answer lies in
29
how the business strategy is set and how decisions are made. A strong company
will have the manager of each discipline providing input into the development of
the company’s strategy. Although the final decision may be made by a senior
manager, input should be sought, and come from throughout the organization.
Each manger should be able to explain in great details the business strategy for
the organization, the goals and objectives of his her area, the operational strategy
to achieve these goals and the financial impact of these goals.
Ask enough questions to determine if the managers understand the strategy or if
they are just well coached in giving presentations to outsiders. Focus too, on
management succession. Is there a clear chain of command and is it understood
by the senior management team? Is a carefully considered management plan in
place? Are the managers who are next in line to run the company on a day-to-day
basis well capable in all areas of operations.
5) Continuous improvement strategy
Management and employees should always be looking to improve upon a
process, product, service or practice. This philosophy can mean looking to take
hard costs out of production or streamlining a process, or take many other forms,
all designed to improve operations, products, and customer satisfaction and post
profits. Look for tangible evidence of the application of this continuous
improvement philosophy before you accept that it is a real and active focus of
management.
Senior management must continuously monitor the results of a continuous
improvement program. There are many signs that such a philosophy exists. Is
there an employee suggestion program? How often are suggestions reviewed and
implemented? Check to see that all employees know the tangible payoff of each
suggestion. Does the company maintain a continuous improvement team? What
is its goal and how each manager’s performance is evaluated? Is there a measure
of improvements that have been implemented and the total economic impact on
the organization? Ask senior management for a list of improvement projects
currently underway and discuss them in detail with the managers. Ask for the
quantitative impact on the company (cost reduction, return on investment,
increased profits, etc.) and the qualitative impact (improved employees morale
and commitment, improved customers satisfaction, etc.).
30
6) Integrity
Of all the previous characteristics mentioned, the most difficult to evaluate is
integrity. From an investor perceptive, integrity is measured by how forthright,
accurate and timely management is with its disclosure of information deemed
critical from the investor’s standpoint. It is also measured by management’s
willingness to work cooperatively, with the investor as well as management’s
willingness to work to preserve the value of the business or its assets.
Unfortunately, an investor often learns the level of integrity of its financed
company’s management team when the company has suffered serious
deterioration and the risk profile may have shifted beyond the investor’s original
level of comfort. Ask key managers if they have ever managed difficult
situations and what was the final outcome, e.g., “How did your investor come out
when the dust settled? References can be helpful, but how you received negative
feedback? An investor first-hand experience with the company and its
management team is always the best mean of assessing character and integrity.
The main advantages of the model include but are not limited to the following:
(i). It helps to identify a set of management characteristic useful to identify a part
of the management style and characteristics.
(ii). The identification of the management characteristics helps in predicting
management team behaviour that may help in reducing the investment
uncertainty.
The main disadvantages and limitations of the model include but are not limited to the
following:
(i). The implementation of the model is not direct and straightforward. The
model provides only guidelines, and requires the valuator to develop a
questionnaire to identify the management characteristics.
(ii). The model may fail to valuate the effectiveness of the management team in
drawing the organization strategies to achieve its goals and objectives.
3.1.2 VALUING MANAGEMENT TEAM EFFECTIVENESS
31
The effectiveness and behaviour of the management team can be valuated using the
management effectiveness analysis (MEA) model developed by Ian Smith. This is a
scientific approach that uses a questionnaire of hundred and eleven items (the questionnaire
needs the author license to be inserted in the study). The model is based on measuring the
following sixth management functions:
(i). Evaluation function.
(ii). Decision making function.
(iii). Implementation function.
(iv). Leadership function.
(v). Follow through function.
(vi). Public relation function.
These functions are valuated and measured in terms of twenty one behavioural sets as shown
below in figure 2:
Behavioural Set Low Low - Mid Mid - Range High - Mid High
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95+
Evaluation Function
Traditional
Innovative
Technical
Decision Making Function
Directive
Consensual
Strategic
Implementation Function
Tactical
Structuring
Delegation
Communication
Team
Individual
Leadership Function
Management
Focus
32
Production
People
Excitement
Restraint
Follow - Through Function
Control
Feedback
Public Relation Function
Persuasive
Cooperation
Figure 2: Management effectiveness analysis profile, Ian Smith.
The application of the management effectiveness analysis requires the valuator to build the
mind set under each function as follows:
1) Evaluation function
The management evaluation of situations and problems is measured in terms of the
following behavioural sets:
Traditional
A high score under this item, indicates the management team tendency to
look at problems within their past experience. They do not like to change,
they like to keep things as they are and they try to learn from mistakes.
Innovative
A high score under this item, indicates a fresh looking management team.
They are innovative, creative and adaptive to change.
Technical
A high score under this item, indicates the management team tendency to
look for details in handling any problem or situation.
In valuating this function, the evaluator has to make sure that there is no conflict
between the results. For example, a high score under the traditional item should be
accompanied by a low score under innovative, otherwise it will give an indication of
inconsistent management behaviour.
2) Decision making function
33
The management decision making is measured in terms of the following behavioural
sets:
Directive
A high score under this item indicates management tendency to take
decisions directly by themselves. They like to take decisions and they don’t
move it to others.
Consensual
A high score under this item indicates that management listens to what other
people say and takes their opinion into consideration.
Strategic
A high score under this item indicates management tendency to take the long-
term consequences into consideration in decision-making.
3) Implementation function
The management implementation function is measured in terms of the following
behavioural sets:
Tactical
A high score under this item indicates that management keeps strong contact
with its people and work with them to get things done.
Structuring
A high score under this item indicates that the management has established
rules, procedures to get things done. It also indicates that employees know
what they are supposed to do and how to get things done.
Delegation
A high score under this item indicates that management empowers its
employees to take decision and get things done on real time.
Communication
A high score under this item indicates the possibility of two-way
communication between management and employees. It indicates that
management informs people on what they are expected to do.
Team
A high score under this item indicates that management like to get work done
through teams. It also indicates that people are rewarded according to their
team performance.
Individual
34
A high score under this item indicates that management like to get things
done though individuals and people are rewarded according to their
individual performance.
In valuating the implementation function, the valuator has to make sure that there is
no conflict between the different items. For example, a high score under delegation
should be accompanied by a high score under communication, because if you
delegate you have to inform people on what you expect from them. Also, a low score
under individual should accompany a high score under team.
4) Leadership function
The management leadership function is measured in terms of the following
behavioural sets:
Management Focus
A high score under this item indicates that management is responsible,
accountable and committed to take the role of management.
Production
A high score under this item indicates that management sets targets, stimulate
people to achieve targets and goes for results and performance.
People
A high score under this item indicates that management pays attention to its
people, understands their needs, interest and feelings.
Excitement
A high score under this item indicates that management is present and
dynamic.
Restraint
A high score under this item indicates that management does not show
feelings and you can’t read from their faces to understand what is going
inside.
5) Follow-thorough function
The management follow-through function is measured in terms of the following
behavioural sets:
Control
A high score under this item indicates that management monitors the
proceedings, knows what is going on and pay attention on how work is being
done.
35
Feedback
A high score under this item indicates that management provides its people
with feedback on what they think about them.
In analysing the follow through function, the valuator has to pay attention to the
potential conflict. For example, if there is a low score under control and a high score
under feedback, this means that management is giving wrong feedback to its people,
simply because they actually don’t know what is going on.
6) Public relation function
The management public relation function is measured in terms of the following
behavioural sets:
Persuasive
A high score under this item indicates that management has strong argument,
power and influence on convincing people about its ideas.
Cooperation
A high score under this item indicates that management looks for the others
interest, selfless and provide support and help for others.
In using the management effectiveness analysis model, the following point have to be taken
into consideration:
(i). The items under each management function are first analysed and linked together
to develop the management mind set for each management function.
(ii). The valuator has to check to see if there is any conflict between the different
items under the same function or between the different functions.
(iii). After analysing all the functions, the valuator has to link all the items together to
paint the big picture for the whole management effectiveness and behaviour.
The main advantages of the model include but are not limited to the following:
(i). The model helps to valuate the effectiveness of the management team by
valuating a set of six management functions.
36
(ii). The model enables the valuator to predict management behaviour by valuating
twenty-one behavioural sets. This is very valuable in helping the investor to build
some trust and confidence in the company’s management team.
The main disadvantages and limitations of the model include but are not limited to the following:
(i). The model requires the valuator to have some communication and social skills,
important to establish relationship with the management team to develop trust
and get the required information.
(ii). The model is using a questionnaire of hundred and eleven elements. The
questionnaire is long, time consuming and needs the licensing of the author.
However the valuator can develop his own questionnaire to develop the required
management profile.
3.2 ORGANIZATION VALUATION
Organization valuation is important to identify how the whole organization is setup and how
the different resources are deployed and aligned to take advantage of market opportunities to
add value to customers and to generate wealth for shareholders. There is no one single tool
or method that can be used to complete this task. However, a part of this can be done using
some organization diagnosis tools and techniques. In the coming two sub-sections, two
models will be presented for organization valuation: assessing the effectiveness of the
management control system to achieve the organization intended goals and objectives and
the organization diagnosis model: matrix model, developed by Noel Tichy.
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3.2.1 ASSESSING THE EFFECTIVENESS OF THE MANAGEMENT CONTROL SYSTEM
The aim of analysing and appraising the management control system (MCS) is to valuate
to which degree the organization is capable to achieve its intended goals and objectives
and to identify the major factors behind the organization failure or success. This requires
the valuator to identify which elements are in existence, which elements are missing,
which elements have problems and how all the elements are interlinked together. The
analysis will be based on appraising the three major elements of the MCS: planning,
control structure and the control process, and how they are interlinked with people as the
main unifying thread to achieve the organization goals and objectives.
1) Planning
The planning process is important to move the whole people of the organization
in the right direction. To give the organization the required bearing, the
following elements have to be in place:
Vision
Vision is the management and the whole people of the organization view on
how they see the organization in the future. It creates meaning and purpose,
which motivates people to high levels of achievement. Management and the
people of the organization have to articulate and share the vision. A shared
vision engages and empowers individuals in order to bring out the best in
people. A shared vision provides the focus that is required to "make it
happen". Without vision, people do not have the ability to focus on what's
important. No Vision, no Focus.
Mission
Mission is the organization reason for existence. It should be able to tell
people where the organization is exactly heading. A narrow mission may
limit the organization activities while aboard one may fail to tell where the
organization is heading.
Goals, objectives and critical success factors
Goals and objectives provide the people of the organizations with guidelines
of what results the organization would like to achieve. They help in
identifying any deviation from the required track. Goals are open-end
statements without specific time frame, while objectives specify what result
the organization would like to achieve by when. The critical success factors
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help the organization to gain competitive advantage and distinguish its
performance from its competitors by leveraging its key success factors.
Scanning the organization internal strengths can identify the key success
factors and identifying what can be considered as core competency. Core
competencies have to be sustainable, durable (the rate at which they
depreciate and become obsolete) and difficult to be imitated (the rate at
which they can be copied by competitors).
Strategies
Strategies are the long range planning that helps the organization to achieve
its intended goals and objectives in light of its vision and mission. Strategies
have to be formulated and implemented at the whole level of the
organization. The corporate management should formulate the corporate
strategies: directional and parenting. The directional strategy identifies how
the corporate management is going to achieve growth (internal or external),
while the parenting strategy identifies how the corporate management is
going to handle the transfer of resources and coordinate activities among the
different departments to create synergy and cultivate capabilities. The
strategic business units have to formulate and implement the business
strategy that identifies which products or services to offer and how they are
going to position the organization. The line and operational people should
have capabilities and skills to formulate and implement operational strategies
that are in line with the corporate and business strategies.
Policies
Policies provide management and employees with the broad guidelines for
taking decisions and implementing activities that are in line with the
organization vision, mission, goals, objectives and strategies. Policies have to
be flexible to enable taking decisions in real time.
2) Control structure
The control structure enables the organization to produce the required behaviour
from individuals, groups and teams of people and the organization as a whole
that is needed to move the whole organization to the required direction to achieve
its objectives and goals. It gives the organization its special identity. The control
structure is very important to ensure that the behaviour of the organization is
39
predictable and will remain the same. This may help to increase the level of
investor confidence and trust. The following elements have to be structured
properly in the control structure:
Responsibility centers
A responsibility center is a unit, division or subdivision within the
organization lead by a manager. There are three major types of responsibility
centers: profit centers, cost centers and revenue centers. The nature and type
of each responsibility center is determined by the type of activities
undertaken in each unit, division or subdivision of the organization and the
degree to which inputs or outputs can be controlled, measured and affected.
The ultimate objective behind defining the type of each responsibility center
is to get the desired behaviour from the people within each center to achieve
the required results for the whole organization.
Organizational setup
The organization structure has to be flat, lean and consistent with the
identified responsibility centers to provide the semi-autonomy where needed.
In a good organization structure, the organization leaders and managers get
their power from the respect they get from their people by demonstrating the
desirable behaviour not from their positions. The organizational structure
should empower people across all levels to increase their commitment and
participation. This will ensure the right decision making that will result in
faster response time to the customers’ needs and give the necessary support
for the responsibility centers to have better control over its input and outputs
to achieve the intended results.
Performance measures
It is very important to have the right performance measures for individuals,
groups, responsibility centers, customers and employees satisfaction and the
organization as a whole. These performance measures have to be aligned
carefully with the rewarding system, linking the division goals with the
organization goals, fair and create value for the whole organization. Any
failure in bringing and integrating the performance measures and the
rewarding system together, will result in producing undesirable behavior that
may undermine the achievement of the organization goals and objectives.
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Rewarding system
The rewarding system has to be organically linked with the performance
measures where desired behaviors are rewarded and undesired behaviors are
punished. A rewarding system linked with the performance measures is a
good reason for doing the work better. It produces the desirable influence on
people to generate the desired behavior and exploit their full potential to
achieve the organization goals and objective. The rewarding system has to be
based on adequate mix of performance indicators (individual, group,
organization, customer satisfaction, etc.). This will ensure the congruence
between the individual goals and the organization goals, creating value for
the whole organization and fairness for the employees.
Information system
The information system is an important part of the control structure that
enables taking the right decisions and keeping the whole organization moving
on the right track. A good information system is the one that enables each
person within the organization to access the level of information he needs to
analyze, compare and take the necessary decision and implement the required
actions in real time.
Organization culture
Culture is one of the most important factors that gives the organization its
unique identity, stability, increases employees commitment, distinguishes the
organization from its competitors, provides guidelines and reference for
behavioral conduct and helps the organization to achieve its goals and
objectives. Organizations culture consists of a set of values, beliefs,
expectations, guidelines and symbols. Culture has to extend across the whole
organization to achieve cultural intensity (the degree to which the whole
people belief in the organization culture) and cultural integration (the degree
to which the people of the whole organization share the same culture).
Standard operating procedures
Standard operating procedures help employees to understand what they are
supposed to do and how to get things done. It should help to complete the
task fast and in real time and provide quick response to customer and
increase his satisfaction. The valuator has to make sure that the standard
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operating procedures are not limiting the creativity of employees and slowing
down their response time.
3) Control process
The control process is very important element in the management control system.
It ensures that the system is effective and efficient and implementing the
organization strategies. In this process a continuous feedback, analyses and
comparison between the actual and projected results is made to ensure that the
whole organization is moving in the right direction. The control process should
incorporate the following elements:
Programming
The programming is determining the market offering by identifying the range
of products and/or services to be provided by the organization over time to
achieve its objectives and goals (financial and non-financial). The
programming has to start by analyzing the ongoing programs and assess to
what degree they are still contributing to achieve the intended organization
goals and objectives and identify the need to redesign them or introduce new
programs. The process starts by scanning the driving forces of the external
environment to identify opportunities and threats. The identified needs are
translated into real programs across time and supported by the required
budgets.
Budgeting
An effective budgeting comes after the programming process to allocate the
required resources (requires top management commitment) and project the
implications of the approved programs into financial and non-financial terms.
Each responsibility center has to prepare its budget according to its
responsibility (expenses budget, revenues budget, profit budget, etc.). The
budgeting system has to be integrated with the information system to allow
the comparison between the actual and the projected results where variances
and causes of variances are reported. The system should be effective to
produce the desirable pressure on sub-ordinates to take the necessary actions.
Evaluation, feedback and reporting
The evaluation has to be based on an appropriate information system in place
containing all the actual and the projected results. This will enable the
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continuous feedback, reporting of variances and reasons of variances and
what actions are being taken or should be taken. The evaluation has to
measure to what degree the performance indicators have been achieved both
financial and non financial. The reporting system and the layers of details
provided should correspond to the responsibility given.
The main advantages of analyzing the management control system include but are not
limited to the following:
(i). It enables the valuation of the organization planning system and to what
degree it is giving the organization the required direction and bearing.
(ii). Evaluates the ability of the management control structure to produce the
required behavior from people to move them in the right direction.
(iii). Evaluates the effectiveness of the management control process to achieve the
organization goals and objectives and the reasons behind this success or
failure
The main disadvantages and limitations of analyzing the management control system
include but are not limited to the following:
(i). It may fail to valuate companies that don’t have a management control
system in place because the model is based on the assessment of the
management control system elements.
(ii). The model is detailed and may be costly and time consuming and may not be
feasible in the case of small companies.
3.2.2 ORGANIZATION DIAGNOSIS MODEL: MATRIX MODEL
The organization diagnosis using the matrix model developed by Noel Tichy is based on
the system theory. This model is very powerful because it looks at the organization as a
living and dynamic system with different factors affecting each other. It helps the
valuator to study and analyse the organization at three levels: the technical level, the
power and influence level and cultural level. At the same time, the model allows the
valuator to look at the organization from major three angles: policy, internal
organization and people.
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This mix between the level of analysis and some of the organization elements results in
forming the following matrix shown in figure 3:
Level Policy Internal Organization People
Technical
Goals and Methods
Core activities
Strategic planning
Marketing
Finance
Tasks and Authorities
Organization structure
Task description
Need for information
Procedure
Knowledge and Skills
Function needs
Recruitment
Know-How
Rewarding system
Power and
Influence
Stakeholders
CEO and Board of
directors.
Pressure groups
Customers
Employees
Financiers
Decision Taking
Informal
structure
Participation in
decision making
Review of
results
Consultation
Negotiation
Autonomy
Room for action
Personal perspective
Status Individual
interest
Culture
Organizational climate
Values
Believes
House style
Co-operation
Problem
solving
Team playing
Coordination
of idea
Meeting style
Attitudes
Creativity
Fellowship
Trust
Dedication
Figure 3: Organization diagnosis model: matrix model, Noel Tichy.
The valuator task is to study and analyse the nine elements of the matrix, explain the
relationship between the different elements and develop a big picture for the whole
organization. In studying each of the nine elements, the valuator has to translate the
different factors under each element into a questionnaire to develop the knowledge and
understanding of the organization.
The major nine elements that will be studied are:
44
1) Goals and methods
Analysing this element enables the valuator to identify the organization goals,
and the methods being used to achieve these goals. This requires the valuator to
study the core activities of the organization, strategic planning and marketing and
financing strategies.
2) Task and authorities
This element enables the valuator to identify who is doing what and under what
authorities. This requires studying the organization structure, procedures, task
description and information flow.
3) Knowledge and skills
Under this element, the valuator will be able to valuate the match between the
quality of the human capital and the organization need. This requires the valuator
to study the job and function needs, the recruitment system, people knowledge
and how they are rewarded.
4) Stakeholders
This element enables the valuator to identify the different stakeholders affecting
the organization. This requires the valuator to scan the major stakeholders (board
of directors, investors, bankers, trade unions, pressure groups, customers,
suppliers, etc.) and assess their influence on the organization.
5) Decision making
This element is of special importance. It enables the valuator to identify the real
decisions makers in the organization. This requires the valuator to identify the
informal organizational structure, real people participating in decision-making
and the impact of negotiation and consultation on decision-making.
6) Autonomy
Analysing this element helps the valuator to identify if people are empowered,
allowed to participate, how they are matching between their individual interest
and work interest and the impact of autonomy on their morale and quality of
work. This requires the valuator to see if people have freedom to act, check their
personal perspective and how they are using this autonomy.
7) Organization climate
This element enables the valuator to smell and sense the general atmosphere of
the organization. It helps to identify if people are unified together and sharing the
same culture. This requires the valuators to study and analyse the elements of the
organizational culture.
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8) Cooperation
This element enables the valuator to see if people are cooperating or competing
with each other. It requires the valuator to see how people handle problems,
share information, exchange ideas and how they handle meetings.
9) Attitude
Analysing this element is very important to identify people attitude toward
management and customers (+ve or –ve). This requires studying some of the
people characteristics including creativity, trust, commitment, dedication, etc.
The main advantages of the matrix model include but are not limited to the following:
(i). It looks at he whole organization as a living system with different factors
affecting each other.
(ii). It enables the valuator to assess the organization from different angles and at
three major levels: the technical level, the power and influence level and the
cultural level.
(iii). It enables the valuation of people, one of the organization most important
intangible resources. The valuation looks at the match between people
knowledge and skills and the organization needs, assess people commitment
and attitude and valuate to what degree people are participating and involved
to achieve the organization goals and objectives.
(iv). It enables the valuation of the organization culture, another important
intangible assets. The valuation assess to what degree culture is unifying the
whole people of the organization to achieve its goals and objectives and
giving it special identify that is difficult to be copied by competitors.
(v). Identifying who is really making decisions outside the organization formal
structure.
(vi). Assess the match between the organizational goals and the methods to
achieve them.
(vii). Identify the stakeholders affecting the organization.
46
The main disadvantages and limitations of the matrix model include but are not limited
to the following:
(i). The model requires the valuator to have knowledge and skills in organization
diagnosis tools and techniques.
(ii). The model is very detailed that may be costly and time consuming in certain
cases.
(iii). The model requires the valuator to have communication and social skills,
needed to establish relationship with the management team to develop trust to
get the required key information.
(iv). Then model is more applicable to valuing big companies.
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CHAPTER 4
PROPOSED FRAMEWORK FOR BUSINESS VALUATION
4.1 WHY DO WE NEED A FRAMEWORK FOR BUSINESS VALUATION
Part of what makes business valuation so difficult is the wide variety of tools and techniques
available for business valuation. From the review of the available literature on business
valuation, presented in Chapter 2, we can see, three main traditional methods in frequent use for
business valuation: the accounting based approach, the discounted cash flow based and the
market based approach. The accounting based approach is focused on the valuation of the
historical performance of the business, the discounted cash flow approach is concerned with the
assessment of the future earning capacity of the business and the market approach is concerned
with comparing the value of the company with similar companies in the market to estimate the
fair market value. Most of these traditional business valuation tools and techniques suffer
from the following main limitations and shortcomings:
(i). They are mainly designed to provide a quantitative valuation for the business.
(ii). Most of these tools and techniques are focused on the valuation of the tangible assets.
(iii). In most cases if you use different tools, each tool will produce different answer.
(iv). Most of the tools and techniques fail to provide valuation for the intangible assets.
(v). They fail to identify the drivers of value creation and assess the sustainability of value
generation.
(vi). No one single tool or technique can be used a lone by itself.
This is not to say that these tools and techniques can’t be used; they can be used provided that
their disadvantages and limitations are recognized and overcome.
The wide range of factors that influence business value further complicates the valuation task.
These factors include both internal and external factors that are always interacting with each
other shaping certain business landscape that will result in the creation of certain value. The
internal factors are company specific and under the control of the organization (company
acquires the factors it needs), while the external factors are imposed by the external
environment.
48
The major internal factors include but are not limited to the following:
(i). The organization including structure, systems, culture, policies, etc.
(ii). Tangible assets including machines, facilities, buildings, etc.
(iii). People including their skills, competencies, style, attitude, knowledge, etc.
(iv). Management including leadership, vision, integrity, strategies, etc.
(v). Other intangible assets including knowledge, brand name, reputation, technology, etc.
These internal factors are dynamic, when put together in the right organization structure, they
act as a process that may create business value through the transformation of the organization
inputs into products and services.
The major external factors include but are not limited to the following:
(i). Customers including their loyalty, taste, relationship, etc.
(ii). Stakeholders including board of directors, investors, bankers, pressure groups, etc.
(iii) External environment including industry outlook, economic situation, political situation,
social situation, technological situation, etc.
(iv). Competitors including their actions, strategies, substitutes, etc.
(v). Suppliers including their bargaining power, etc.
These external factors are on a continuous change, creating opportunities and threats for the
organization. The assessment of these internal and external factors can help to identify the main
drivers for value generation and its sustainability. If the organization can make a good match
between the internal and external factors at the right time, the right place, it can take advantage
of many opportunities creating extraordinary business value benefiting from synergy between
the different factors. The main drivers of business value can be summarized in figure 4 below:
People (skills, style, attitude,
motivation, etc.)
Business Value
Tangible assets
(machines, buildings,
facilities, etc.)
Other intangible assets (brand name,
knowledge, reputation, technology, etc.)
Stakeholders (board of directors,
pressure groups, etc.)
Management (leadership,
integrity, strategies, vision, etc.)
Surrounding environment
(economic, legal, technological,
social, etc.)
Competitors
(substitute, actions, etc.)
Suppliers (bargaining power, etc.)
Customers (loyalty,
relationship, taste, etc.)
Organization (structure, culture,
systems, policies, etc.)
49
Figure 4: Main drivers of business value.
The shortcomings and limitations of the traditional tools and techniques combined with the
lack of qualitative tools that can assess the variety of factors affecting business value,
complicates the task of the business valuator on which method or framework to use for
business valuation.
This complication creates the need to develop a comprehensive business valuation
framework that can overcome the limitations of the traditional tools and assess the impact of
the different factors affecting business value. The framework will help to mitigate the equity
financing risk and answer some of the investor’s questions and concerns.
4.2 Proposed FRAMEWORK FOR BUSINESS VALUATION
Business valuation is partly an art and partly a science. Given the shortcomings of the existing
business valuation tools and techniques, a good model has to build on the existing tools and
techniques, recognizing their limitations and overcoming their weaknesses. The framework for
business valuation will be developed benefiting from the knowledge gained from this study and
consolidating the skills and experience that I have built during this MBA programme. The
framework will use a mix of quantitative and qualitative tools and techniques for business valuation.
The quantitative tools and techniques will be drawn from the traditional business valuation tools and
techniques, presented in chapter 2, with the aim to:
(i). Estimate arrange for business value.
(ii). Valuate the historical business performance to examine to what degree the business
was taking advantage of opportunities and creating wealth for its shareholders.
(iii). Assess the business future outlook to identify its future earning capacity that may
contribute to create value for its shareholders.
(iv). Estimate the business value by comparing the company with similar companies in
the market.
The qualitative tools will be drawn from some management and organization diagnosis tools and
techniques, presented in chapter 3, with the aim to:
(i). Valuate the management effectiveness and behaviour in drawing the roadmap and
leading the whole organization to take advantage of market opportunities to create
value for its shareholders.
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(ii). Assess how the organization is setup and how its resources are deployed and aligned
to implement management strategies to achieve the organization mission, goals and
objectives. The proposed framework will mainly consist of the following
elements as shown in figure 5 below:
Valuing Future Outlook
Using the Discounted
Cash flow Approach
Company’s present value Estimating shares price
Valuing Historical
Performance
Using the Accounting
Based Approach
Ratio
analysis
Activity
Leverage
Profitability
Liquidity
Shareholders’
wealth book value
(owners equity)
Company’s book
value
Market Comparison
Using the Price Earning
Model
Company’s market value
Management Valuation
Using Management
Effectiveness Analysis
Model
Valuing management
team behavior and style
Valuing management
team effectiveness
Organization Valuation
Using
Matrix Model
Management Control
System Elements
Process
Structure
Planning
People
Culture
Organizational setup
Decision taking
Stakeholders
Goals and methods match
Figure 5: Proposed framework for business valuation to decide on equity financing.
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4.2.1 VALUING THE BUSINESS HISTORICAL PERFORMANCE
The historical business valuation will be conducted using the accounting based
approach, while recognizing its limitations and shortcoming presented in chapter 2, page
9 and 11. Valuing the business historical performance is very important to assess to what
degree the business was taking advantage of market opportunities and creating wealth
for its shareholders. Historical analysis has to be combined with the identification of the
main factors behind the company’s success and whether they will continue to be in the
future. A part of the company’s past achievements can be found in its financial
statements. However an adjustment can be made on the financial statements before
conducting any valuation. The adjustments may be carried out with the objective to
provide a more realistic valuation of the company’s assets. This can be carried out to
check the physical conditions of the tangible assets (machines, buildings, facilities,
infrastructure, inventory, etc.). The accounts receivable can also be checked to make
sure that they will be collected and there is a provision for bad debts.
The financial statement will be used to:
(i). Provide a static picture and estimation of the company’s book value and its
shareholders’ wealth. As indicated in chapter 2 page 8, the book value of the
company can be estimated by adding the net value of its total assets while the
book value of its shareholders’ wealth can be estimated by deducting the
company’s total liabilities from its total assets. These figures are important to
be compared with other figures obtained from other methods to establish a
range for the business value.
(ii). Conduct ratio analysis to provide a picture on the company’s profitability,
liquidity, capital structure and financial leverage, and an assessment of the
management efficiency to utilize the company’s tangible resources. The
ratios pattern will be compared over the last two to three years and will be
compared with similar companies or the industry average. These figures are
very important to assess where the company excels and where it needs
improvement. The calculation of ratios is presented in appendixes I to IV,
page 54 to 58.
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(iii). Identify the dividend distribution pattern over the past years and the likely
hood if it will be the case in the future. This is very important to help
investors to have an initial assessment of what benefit (dividends stream or
capital gain) they are expected to receive in the future.
4.2.2 VALUING THE BUSINESS FUTURE OUTLOOK
The future business valuation will be based on the discounted cash flow approach
recognizing its limitations and shortcomings presented in chapter 2, page 15. Future
business valuation is very important to provide an assessment of the business future
outlook, assess its future earning capacity and the ability to create value for its
shareholders. A part of the business future outlook can be assessed by estimating its
expected future cash flows. The foresting of cash flows should be based on a sound
business plan and scanning of the external environment to identify any opportunities and
threats. This will require an assessment of the industry outlook, the economic, political
and social situation. The assumptions in the forecasting should be very clear and the
period should not be extended over a long time, because the longer the forecasting
period, the less the reliability of cash flows. The future business valuation will be used
to:
(i). Provide an estimation of the business present value. The present value will be
estimated by discounting the expected future cash flows at the appropriate
discount rate as shown in Chapter 2, page 13 and 14. The discount rate can be
the weighted average cost of capital or the opportunity cost of capital. The
business present value will help to provide an expectation of how much the
investors’ sacrifice of resources now is expected to generate to them in the
future. The estimated value will be compared with other values obtained from
other methods to estimate a range for the business value.
(ii). Estimating the value of the shares price now. This can be done using the
dividend valuation model by discounting the expected dividends stream and
capital gains at the appropriate discount rate as shown in chapter 2, page 19.
The estimation of the share price now using the dividend model is very
important to compare it with the current market price of shares. This will help
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investors to make decision on whether to acquire the shares of the company
or not.
4.2.3 BUSINESS MARKET VALUE
The estimation of the business market value will be based on the price earning multiple
method presented in chapter 2, page 20 and 21. The estimation of the market value is
very important to estimate the company’s value compared to similar companies in the
industry given the business current earning capacity. The estimated value will be
compared with the value obtained from other methods to establish a range for the
business value.
4.2.4 MANAGEMENT VALUATION
Management valuation will be carried out using the management effectiveness analysis
model presented in chapter 3, page 26. Valuing the management team is very important
to assess its capabilities to deploy the company’s resources and draw the road map to
lead the whole people of the organization to achieve its goals and objectives, add value
for its customers and create wealth for its shareholders. The management effectiveness
analysis model will be used with the main aim to:
(i). Valuate the effectiveness of the management team to perform its intended
functions. The model will measure six main management functions:
evaluation, decision-making, implementation, leadership, follow through and
public relation. This will help to assess to what degree the management team
is capable to mange the corporate resources to boost its value.
(ii). Develop a general profile for the management team behaviour and
characteristics. Beside the management effectiveness analysis model, the
valuator can use Walter Schuppe model presented in chapter 3, page 22 to
improve the ability to identify the management team characteristics.
Predicting the behaviour of the management team is very helpful to establish
trust and increase the investor confidence.
4.2.5 ORGANIZATION VALUATION
Organization valuation will be based on two models: assessing the effectiveness of the
management control system (presented in chapter 3, page 32) and the organization
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diagnosis model: matrix model (presented in chapter 3, page 37). Valuing the internal
organization is very helpful to assess how the organization is setup and how its different
resources are deployed and aligned to take advantage of market opportunities to convert
the organization knowledge into products and services that will add value to customers
and shareholders.
The organization diagnosis model: matrix model, is very powerful in linking several
elements affecting the organization in one model and looking at the organization as a
living and dynamic system. The model valuates two important items of the organization
intangible assets and resources: people and culture. People knowledge and skills are one
of the most important intangible resources. They can make or break the whole
organization. You need people with commitment, positive attitude, fire from inside and
the desire to win. You need organization leaders surrounded by real smart people not
dummies. Organization culture is another important intangible assets. It is the unifying
thread that brings people from different cultures across the organization together to share
the same identity, values, beliefs and expectations. This helps the organization to form
high performance teams who can achieve the organization intended goals and objectives.
The organization diagnosis model: matrix model, will be used with the main aim to:
(i). Valuate the match between people knowledge and skills and the
organization requirements.
(ii). Valuate to what degree are people empowered to make decisions on real
time and to what degree they are involved to achieve the organization
goals and objectives.
(iii). Valuate to what degree are people committed to take their part in the
organization.
(iv). Valuate to what degree the whole organization is benefiting from its
culture to create a special identity that is difficult to be copied by
competitors.
(v). Valuate the impact of culture on unifying the whole people of the
organization together and improving their attitude and commitment. This
requires the organization to have cultural intensity (the degree to which
the whole people belief in the organization culture) and cultural
integration (the degree to which the people of the whole organization
share the same culture).
(vi). Identify which of the stakeholders has major influence and impact on the
organization.
55
(vii). Valuate the match between the organization goals and the methods used
to achieve these goals.
(viii). Identify who is really taking decisions outside the organization formal
structure.
The assessment of the management control system elements is very helpful to valuate to
what degree the organization is capable to achieve its intended goals and objectives and
to identify the major factors behind the organization success or failure.
The assessment of the management control system will be used with the main aim to:
(i). Assess if the organization has the right direction and bearing to achieve
its intended goals and objectives. This will be based on the assessment of
the main planning elements (vision, mission, goals, objectives, critical
success factors, strategies and policies).
(ii). Assess the capability of the control structure to produce the required
behaviour from the whole people of the organization. This will be based
on the assessment of the main control structure elements (responsibility
centers, organizational setup, performance measures, rewarding system,
information system, organization culture and the standard operating
procedures).
(iii). Assess the effectiveness and efficiency of implementing the organization
strategies and achieving its goals. This will be based on the assessment of
the main control process elements (programming, budgeting, evaluation,
feedback and reporting).
4.2.6 ADVANTAGES, DISADVANTAGES AND LIMITATIONS OF THE FRAMEWORK
The presented framework for business valuation has some advantages but at the same
time it has some shortcomings and limitations. This is caused by the complexity of
business valuation task and the wide range of factors that affects business value. This
makes it very difficult to have one single framework that can cover all the gaps and
answer all the investor’s questions and concerns. The objective of this framework was to
minimize a part of the shortcomings of the traditional business valuation tools and
techniques and reduce the level of investment uncertainty.
56
The main advantages of the framework include but are not limited to the following:
(i). It provides the investor with both quantitative and qualitative valuation
for the prospectus company. The quantitative valuation is in line with the
investor desire to see how much benefit he is expected to realize in the
future by sacrificing his funds now. The qualitative valuation helps the
investor to assess the sustainability, stability and risk of the prospectus
company to preserve the invested capital and generate value for its
shareholders. This combination helps the investor to look at the company
from different angles.
(ii). It allows the investor and/or the valuator to work closely with the
management team of the potential company that helps to establish good
relationship and trust.
(iii). It enables the valuation of two organization intangible resources and
assets: people and culture. People valuation is very important because
they can make or break the organization while culture is the unifying
thread that brings the whole people across the organization together to
achieve its intended goals and objectives.
(iv). It identifies the real decision makers inside the organization and the
stakeholders influencing the organization.
(v). It helps to assess the match between the organization goals and objectives
and the methods to achieve these goals.
(vi). It helps to provide an assessment of the management team capability to
draw the road map and lead the whole people of the company to achieve
its goals and objectives.
(vii). It helps to valuate the capacity of the company to take advantage of
market opportunities and create value for its customers and shareholders.
(viii). It provides investors with some insight about the company’s future
prospects to generate revenues and add value to its shareholders.
(ix). It helps investor to establish a range for the business value obtained from
several methods that may facilitate the investment decision.
(x). It provides investor with some knowledge about the company’s history
on managing its resources to generate profits.
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(xi). The framework may help the investor to provide some feedback and
recommendations to the prospectus company that may help them to
generate more value for their shareholders.
The disadvantages and limitations of the model include but are not limited to the following:
(i). The framework requires the valuator to have skills and capabilities in
valuing the quantitative and qualitative business aspects. Besides the
financial analysis skills, a valuator should have skills and knowledge in
management and organization analysis tools and techniques
(ii). The framework as it is exactly designed, may fail to valuate new
businesses. However some elements can be adjusted to widen the
applicability of the model.
(iii). The model is more suitable for valuing big companies with clear
organization setup and management team. It may fail to valuate family
business where you don’t have a clear management team or
organizational setup.
(iv). The model requires the establishment of a good relationship with the
management team to develop trust and have access to key employees to
collect the required and relevant information. This raises the required
skills of the valuator to have some communication and social skills.
(v). The model requires certain level of detailed information collection,
screening and analysis. This may be time consuming and costly that may
not be feasible in certain cases.
For the model to achieve the best results and benefits in valuing a business, the following
conditions are required:
(i). The valuator and investor should have an appreciation of the business
intangible assets and resources in adding value to customers and
generating wealth for shareholders.
(ii). The valuator needs to have financial analysis skills, management and
organization analysis skills and communication and social skills.
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(iii). The valuator has to work with the potential management company as a
partner. This requires him to establish a good relationship with the
management team to establish certain level of trust and confidence.
(iv). The framework requires the valuator to look at the organization as a
dynamic model with different factors and resources affecting each other.
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CHAPTER 5
THEORETICAL FINDINGS AND RECOMMENDATIONS
5.1 MAIN FINDINGS
The main findings of this study can be summarized as follows:
(i). The main definitions of value come from three major streams: the accounting
theories, discounted cash flow theories and market theories. The accounting
definition of value is based on the historical cost, the discounted cash flow
definition of value is drawn form the future earning capacity of the business and
the market definition is derived from the market theories and comparison (for
more details, see appendix V page 59).
(ii). There are three main traditional methods in frequent use for business valuation:
the accounting based approach, the discounted cash flow based approach and the
market based approach (for more details, see appendix VI page 60).
(iii). Most of the traditional business valuation tools and techniques are quantitative
and focused on valuating the tangible assets of the business. They don’t attach
value to the intangible assets and resources of the business that are contributing
either in generating extraordinary business value or maintaining the sustainability
of business value.
(iv). Each of the traditional business valuation tools is focused on certain area and has
its own advantages, disadvantages and limitations.
(v). The accounting business valuation tools and techniques are focused on valuating
the past business performances and to what degree the business was taking
advantage of market opportunities to create wealth for its shareholders.
(vi). The discounted cash flow business valuation tools and techniques are focused on
assessing the business future outlook and its capacity to seize market
opportunities to generate cash flows and add value to its shareholders.
(vii). The market business valuation tools and techniques are concerned with
estimating the value of the company compared to similar companies in the
industry.
(viii). Business valuation is not an exact science. It is both an art and a science that
requires experience, insight and the combination of several skills: technical,
managerial and financial analytical skills, communication skills and social skills.
(ix). Qualitative analysis of the business is an important and integral part of the
business valuation process. It requires the valuator to look for some tools and
60
techniques that can be used to overcome the weaknesses of the traditional tools
and address this part of valuation.
(x). The power and quality of business valuation is enhanced by a deep understanding
of the business than by a general experience with valuation.
5.2 RECOMMENDATIONS
In the light of the knowledge gained from this research and the main findings presented in
section 5.1, the following recommendations can drawn out of this study:
(i). Business valuation should be carried out utilizing a framework consisting of a
mix of quantitative and qualitative business valuation tools and techniques. The
quantitative business valuation is important to be carried out to assess a part of
the value generated by the business and to establish arrange for business value,
while the qualitative business valuation is important to be carried out to assess
the sustainability of value generation and identify other sources adding
extraordinary value to the business.
(ii). Business valuation should enable investors to look at the business from different
angles and dimensions. The valuation framework should provide investors with
an evaluation of the business historical performance, assess the business future
outlook, compare the business with similar companies in the market, assess the
management capability and the organizational setup.
(iii). The traditional business valuation tools and techniques (accounting based,
discounted cash flow based and market based tools and techniques) can be used
for valuing a part of the business given that we understand their advantages,
acknowledge their disadvantages and limitations and overcome their weaknesses.
(iv). Business historical performance should be valuated to enable investors to assess
to what degree the company was capable to take advantage of market
opportunities to create wealth for its shareholders and identify the factors that
were behind the company’s success or failure and whether they will continue in
the future. This can be carried out, in part, using the accounting business
valuation tools and techniques.
(v). Business future outlook should be valuated to make it possible for investors to
assess the company’s ability to generate future cash flows enough to compensate
them for the risk they are willing to take and resources they are willing to
61
sacrifice now. This can be carried out, in part, by using the discounted cash flow
business valuation tools and techniques.
(vi). Company’s value compared to similar companies in the market should be
estimated to help investors see if the company is a head or behind its competitors
and to compare it with the value obtained from other methods. This can be
carried out, in part, by using the market business valuation tools and techniques.
(vii). Management team effectiveness and behaviour should be valuated to enable
investors to assess the management team capability to deploy the organization
resources, draw the road map and lead the whole people of the organization to
achieve its intended goals and objectives. This can be carried out, in part, by
using the management effectiveness analysis model.
(viii). The effectiveness of the management control system should be valuated to help
investors identify if the organization has the right planning that gives the
organization the required direction and bearing, the right organizational setup
that produces the desired behaviour from its people and the right control process
that helps the organization to achieve its intended goals and objectives. This can
be carried out, in part, by assessing the three elements of the management control
system: planning, structure and process.
(ix). Organization should be valuated from different angles and at different levels as a
living and dynamic system with different factors interacting with each other. This
can be carried out, in part, using the organization diagnosis model: matrix model,
to enable investors to:
Identify the match between people knowledge and skills and the
organization requirements. People valuation is important to assess their
knowledge, skills, commitment and attitude necessary to implement the
organization strategies and programs to add value to its customers and
create wealth for its shareholders.
Assess the effectiveness of the organization culture. Culture valuation is
important to assess how the whole people across the organization are
brought together, united, sharing the same values, having the same
identity that is giving the organization competitive advantage over
competitors.
Identify the stakeholders affecting the organization.
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Identify the decision making outside the formal organizational structure.
Assess the match between the organization goals and the methods used to
achieve these goals.
(x). Business valuation has to be transparent, based on mutual trust, cooperation and
sharing of reliable information between the valuator, the management team and
employees of the company being valuated to enable a sound and reliable business
valuation.
(xi). Business valuator should have capabilities and skills to valuate the business
tangible and intangible assets and resources. This requires him to have adequate
knowledge and understanding of the traditional business valuation tools and
techniques, their advantages, disadvantages, limitations and shortcomings and a
good knowledge of some management and organization analysis tools and
techniques. He needs to have financial analysis skills, management and
organization analysis skills, communication skills and social skills.
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BIBLIOGRAPHY
Anthony, Robert N., and Vijay Givindarajan. Management Control Systems, 10th
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Copeland, Tom, Tim Koller, and Jack Murrin. Valuation: Measuring and Managing the
Value of Companies, 2nd
ed. New York: John Wiley, 1996.
Coper, W.W., and Yuri Ijiri. Kohler’s Dictionary for Accountants, 6th
ed. New York:
Prentice Hall, 1983.
Damodaran, Aswash. Investment Valuation. New York: John Wiley, 1996.
Gitman, Lawrence. Principles of Managerial Finance, 9th
ed. New York: Addison Wesley,
2000.
Gregory, Alan. Valuing Companies. London: Woodhead-Faulkner, 1992.
Lorie, J. H., and M. T. Hamilton. The Stock Market: Theories and Evidence. New York:
Prentice Hall, 1998.
Luehrman, T. “What’s It Worth?.” Harvard Business Review, May - June 1997, 132.
Malburg, C. “The Path To Value.” Industry Week, 4 September 2000, 47.
Pike, Richard, and Bill Neale. Corporate Finance and Investment, 3rd
ed. Europe: Prentice
Hall, 1999.
Pratt, Shannon, Robert Reilly, and Robert Schweihs. Valuing A Business, 3rd
ed. New
York: McGraw Hill, 1996.
Schuppe, Walter. “Management: The Most Subjective Valuation.” Secured Lender, Jan -
Feb 1999, 44 - 48.
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September 2000, 35.
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APPENDIX I
PROFITABILITY RATIOS
Gross Profit Margin
This ratio measures the percentage of each sales dollar remaining after the firm has paid for
its goods. It is calculated as follows:
Gross Profit Margin = sales - cost of goods sold
sales
Operating Profit Margin
This ratio measures the percentage of each sales dollar remaining after all costs and
expenses other than interest and taxes are deducted; the pure profit earned on each sales
dollar. It is calculated as follows:
Operating Profit Margin = sales - cost of goods sold – operating expenses
sales
Net Profit Margin
This ratio measures the percentage of each sales dollar remaining after all costs and expenses
including interest and taxes, have been deducted. It is calculated as follows:
Net Profit Margin = net profit after taxes
sales
Return on Total Assets
The return on total assets (ROA) measures the firm’s overall effectiveness in generating
profits with its available asset. This ratio is also called the return on investment. It is
calculated as follows:
Return on Total Assets = net profit after taxes
total assets
Return on Equity
The return on equity (ROE) measures the return earned on the owners’ investment in the firm. It
is calculated as follows:
Return on Equity = net profit after taxes
stockholders’ equity
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Earning per Share
The earning per share (EPS) represents the dollar amount earned on behalf of each share and
not the amount of earnings actually distributed to shareholders’. It is calculated as follows:
Earning per Share = earning available for common stockholders
number of shares of common stock outstanding
Price Earning Ratio
The price-earning (P:E) ratio measures the amount investors are willing to pay for each dollar of
the firm’s earning. The higher the P:E ratio, the greater the investor’s confidence. It is calculated
as follows:
Price Earning Ratio = market price per share of common stock
earning per share
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APPENDIX II
ACTIVITY RATIOS
Inventory Turnover
The inventory turnover measures the activity, or liquidity, of a firm’s inventory. It is
calculated as follows:
Inventory Turnover = cost of goods sold
inventory
The inventory turnover can be converted into average age of inventory by dividing it into
360 (the number of days in a year).
Average Age of Inventory = 360
inventory turnover
Average Collection Period
The average collection period is the average amount of time needed to collect accounts
receivable. It is calculated as follows:
Average Collection Period = accounts receivable
average sales per day
where
Average Sales per Day = annual sales
360
Average Payment Period
The average payment period is the average amount of time needed to pay accounts payable. It is
calculated as follows:
Average Payment Period = accounts payable
average purchases per day
where
Average Sales per Day = annual purchases
360
Total Assets Turnover
This ratio indicates the efficiency with which the firm uses its assets to generate sales. It is
calculated as follows:
Total Assets Turnover = sales
total assets
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APPENDIX III
LIQUIDITY RATIOS
Net Working Capital
The networking capital is a common measure of the firm’s overall liquidity. This figure is
not useful for comparing the performance of different firms, but its quite useful for internal
control. It is calculated as follows:
Net Working Capital = current assets - current liabilities
Current Ratio
This ratio measures the firm’s ability to meet its short-term obligations from its current
assets. It is calculated as follows:
Current Ratio = current assets
current liabilities
Quick (Acid-Test) Ratio
This ratio measures the firm’s ability to meet its short-term obligations from its current
assets excluding inventory. It is calculated as follows:
Quick Ratio = current assets - inventory
current liabilities
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APPENDIX IV
DEBT RATIOS
Debt Ratio
The debt ratio measures the proportion of total assets financed by the firm’s creditors. It is
calculated as follows:
Debt Ratio = total liabilities
total assets
Times Interest Earned
The times interest earned ratio, sometimes called the interest coverage ratio measures the
firm’s ability to make contractual interest payments when they come due. It is calculated as
follows:
Time Interest Earned = earning before interest and taxes
interest
Fixed Payment Coverage Ratio
The fixed payment coverage ratio measure the firm’s ability to meet all fixed payment
obligations as they come due. It is calculated as follows:
Fixed Payment Coverage Ratio =
earning before interest and taxes + lease payments
interest + lease payments + {(principal payments +
preferred stock dividends) x [1/ (1- tax rate)]}
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Main Definitions of Value in Frequent Use
APPENDIX V
MAIN DEFINITIONS OF VALUE
Accounting based Market based Discounted cash flow based
Net Present value
Shareholders’ value
Company’s book value Fair market value
Corporate value
Investment value
Assets book value
Owners’ stake book value
Book value per share of
common stock
Intrinsic value
Liquidation value
Strategic value
Fair Value
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Traditional Business Valuation Tools and Techniques in Frequent Use
APPENDIX VI
SUMMARY OF THE TRADITIONAL BUSINESS VALUATION TOOLS AND TECHNIQUES
Accounting based Market based Discounted cash flow based
Present value
Net present value
Company’s book value Price earning multiple
Profitability index
Internal rate of return
Net assets value
Ratio analysis
Accounting rate of return
Payback period Dividend valuation model
