Business Valuation Boot Camp

Curtis A. Farrow, CPA, MBASenior Financial Analyst, Valuation Services(720) 839-6130cfarrow@gbq.com

Agenda 2

• Introduction & Reasons for a Valuation

•What is Value?

• Valuation Principles & Methodologies

Business Valuation Boot Camp

Introduction & Reasons for a Valuation

What is Business Valuation?

• Business Valuation involves estimating/appraising the value of a business or business interest

• Business valuation analysis is a surrogate for public market

• Business valuation is most prevalent in hard-to-value assets such as stock in privately held businesses

• BV is analogous to real estate appraisal

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When are Valuations Needed? 5

“Magnificent Seven” Questions to Ask when Selecting a Valuation Advisor

1. What % of your career is dedicated to BV (100% is the correct answer) and how many BV professionals are on your staff?

2. How many BVs have you/your firm completed?

3. How many BVs for this purpose have you/your firm completed?

4. Professional certifications related to BV (e.g., CFA, ASA, ABV)?

5. Have you given presentations/written articles on BV?

6. Can I have references from former clients, advisors, etc.?

7. Fee structure and expected turnaround time

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Typical Valuation Process

1. Scoping Out the Engagement• Confirm Purpose/Standard of Value/Valuation Date• Fee Quote/Timing• Complexity/Intended Audience

2. Review & Analyze Requested Information• Business and Industry• Historical/Projected Financial Performance

3. Due Diligence Meetings/Management Interviews

4. Select & Apply Appropriate Valuation Methodologies

5. Present Conclusions

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Business Valuation Boot Camp

What is Value?

What Standard of Value?

Liquidation Value• “Fire sale” of assets; lowest type of value

Fair Market Value• The price at which an asset would change hands between a willing

buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties being able, as well as willing, to trade and well-informed about the asset and the market for the asset.

• Assumes a financial buyer…no acquirer synergies are considered• This is the typical definition for regulatory purposes (e.g., IRS, DOL,

etc.)

Strategic Value• Value to strategic buyer, considering add-backs, synergies, etc.• Value is buyer-specific (i.e., different buyers will have different

perceived values)

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Enterprise Value vs. Equity Value

Enterprise Value the value of the business as a whole; may be viewed as:• Total invested capital (equity + debt – cash)

Equity Value = Enterprise Value – Debt + Cash• Represents shareholder value (i.e., stock value)• Zero-sum game: $1 more of debt = $1 less of equity• Analogous to home value less mortgage

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Business Valuation Boot Camp

Valuation Principles & Methodologies

Valuation Methodologies

Asset Approach• Going Concern• Liquidation

Income Approach• Multiple-Period Discounting Method (e.g., discounted cash

flow)• Single-Period Capitalization Method (e.g., capitalized cash

flow)

Market Approach• Guideline Public Company Method• Guideline Transaction (M&A) Method

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Overview of Valuation Principles

Valuation Must be Forward-Looking•Must consider anticipated future performance•Historical performance may help predict the future

Future Cash Flow is Key Driver of Value•Future cash flow is king•Must consider risk in realizing projected cash flow

Factors Considered in Valuations•Historical and expected future performance & trends•Market multiples of comparable companies and transactions•Economic, industry, and company-specific factors

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Asset Approach Overview

Premise: The value of a business can be estimated based on the value of its underlying assets and liabilities

Adjust ALL assets and liabilities to FMV• Must include booked and un-booked assets and liabilities• Must include tangible and intangible assets and liabilities

When is the Asset Approach Most Appropriate?• Generally appropriate for holding companies or asset-

intensive companies with modest profitability• Generally less appropriate for profitable operating entities

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Income Approach Overview

Premise: The value of a business can be estimated based on the present value of the future economic benefits it generates

Steps in performing the income approach:• Select & Determine Earnings Stream

• Develop Appropriate Required Rate of Return

• Select & Apply Multi-Period or Single-Period Model

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Preferred Earnings Stream: Distributable Cash Flow

Normalized After-Tax Net Income+ Depreciation and Amortization- Capital Expenditures+/- Additional Net Working Capital Requirements= Distributable (Debt-Free) Cash Flow

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Required Rate of Return

An investor’s required ROR is a function of the perceived risk & potential of the investment

Cost of Equity (ke) = Rf + (ERP x β) +/- Company-specific risk factors

WACC = ke*%e + kd*%d

Match Cash Flow with Rate of Return: • Cash Flow Available to Debt & Equity – Use WACC• Cash Flow Available to Equity Only – Use Cost of Equity

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Selecting a Model: Discounted Cash Flow vs. Capitalized Cash Flow

Multiple-Period Models (e.g., discounted future cash flow) are often far more appropriate because: • Can account for anticipated changes in the business such as

growth rates, margins, upcoming investments, business strategies, etc.

Single Period Models:• Only appropriate if growth in future cash flows is projected to be

constant• Difficult to rely on single-period models during times of turbulent

economic conditions and/or volatile company performance

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Year 1 Year 2 Year 3 Year 4 Year 5

Distributable Net Cash Flow 5,000,000$ 5,500,000$ 5,940,000$ 6,296,400$ 6,611,220$

Present Value Factor @ 18.0% 0.9206 0.7801 0.6611 0.5603 0.4748

Present Value of Distributable Cash Flow 4,602,873$ 4,290,814$ 3,927,186$ 3,527,811$ 3,139,154$

Present Value of Cash Flows (Years 1 to 5) 19,487,838$ Year 5 Cash Flow 6,611,220$ Present Value of Residual Cash Flow 25,354,703 Multiplied by: 1 + Growth Rate 1.05

Residual Cash Flow 6,941,781 Enterprise Value 44,842,541

Discount Rate 18.0%Rounded 44,800,000$ Less: Residual Growth Rate -5.0%

Capitalization Rate 13.0%

Residual Cash Flow Value 53,398,315Present Value Factor 0.4748

PV of Residual Cash Flow 25,354,703$

Discounted Cash Flow Example 19

Market Approach Overview

Premise: The value of a business can be estimated based on comparisons to similar businesses

Guideline Public Company Method• Stock market is the best and most accurate source of valuation

data; it is the source of rate of return data in income approach• Compare fundamentals of subject company and peer group of

publicly traded companies• Apply pricing multiples (e.g., price-to-earnings, enterprise value-

to-EBITDA, etc.) of publicly traded comparable companies

Guideline Transaction Method• Identical to public company approach, except use transaction

multiples from M&A deals as basis for valuation• Information about each transaction is typically limited since deals

often involve private companies

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Guideline Public Company Method Example 21

Closing Stock Price(12/31/07)

ABC 5.00$ x 45.52 = 227.6$ + 221.8$ - 108.4$ = 341.0$ 8.5 9.3 0.42DEF 25.50 x 22.18 = 565.6 + 305.8 - 78.4 = 793.0 7.4 8.6 0.34GHI 38.75 x 31.54 = 1,222.2 + 751.8 - 45.0 = 1,929.0 10.7 13.1 0.75JKL 8.00 x 18.95 = 151.6 + 0.0 - 3.6 = 148.0 6.2 7.8 0.33MNO 9.50 x 24.64 = 234.1 + 18.5 - 8.4 = 244.2 5.4 6.4 0.55PQR 18.25 x 41.84 = 763.6 + 106.9 - 24.7 = 845.8 6.8 8.5 0.68STU 14.00 x 35.72 = 500.1 + 247.9 - 7.4 = 740.6 5.7 7.4 0.42VWX 11.50 x 65.90 = 757.9 + 1,085.2 - 222.1 = 1,621.0 9.5 13.8 0.81YZ 22.75 x 45.52 = 1,035.6 + 333.6 - 26.9 = 1,342.3 7.1 8.9 0.59

Low 25% 6.2 7.8 0.42Median 7.1 8.6 0.55High 25% 8.5 9.3 0.68Variation 23.8% 26.9% 32.7%

Selected Multiple 6.5 8.1 0.45Subject Company Results 6.7 5.1 89.6Suggested Value 43.55 41.31 40.32

Concluded Enterprise Value: $42,000,000

EV / EBITDA

EV / EBIT

EV / Sales

Pricing Multiples

Debt & Preferred

StockCash and

EquivalentsEnterprise Value (EV)Co.

Derivation of Enterprise Value

Shares Outstanding

(millions)Market Value of Equity (mil)

• Valuations should consider all methodologies and utilize the appropriate ones; income and market approaches are most common with strong, profitable companies

• Valuation opinions supported by multiple valuation methods are preferable, more defensible, and often lead to more stable, accurate, and sustainable valuation levels

Valuation Methodologies

Guideline Public Company Method

Discounted Cash Flow Method Net Asset Value

Method

Guideline Transaction

MethodValuation

Conclusion

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Key Valuation Concept: Valuation is Forward-Looking

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“It’s tough to make predictions, especially about the future.”

-Yogi Berra