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BUSINESS VALUATION METHODS FROM A BANKER’S PERSPECTIVE
By
Gregory M. Knue
Bank of Hawaii 27 S. Puunene Ave. Kahului, HI 96732
Submitted in partial fulfillment of the requirements of the Pacific Coast Banking School conducted at the University of Washington.
Seattle, Washington, April 2009
i
Executive Summary
Business Valuation Methods from a Banker’s Perspective
By: Gregory M. Knue
There is a large array of reference books and texts dedicated to the topic of business
valuations. These books may cover valuation methods from a business owner, a business
investor or from a professional appraiser’s point of view. Business valuations may be done for a
variety of purposes which include: determining a market price for a business to be sold; deriving
the fair value of a business to resolve shareholder disputes or divorce settlements; or appraising a
company to minimize taxes. There are many more reasons why a business appraisal is needed
and there are several approaches to determine value.
This report will touch on the concept of ‘value’ and define this term in a relevant manner
to help understand the process of determining the worth of a business. The main methods of
business valuation approaches will be introduced with an emphasis on the two income
approaches to value which are the most relevant to a business banking or lending officer,
namely, the Discounted Cash Flow Method and the Capitalization of Earnings Method.
In order to understand these approaches to value, the theories of the time value of money
and discounting future cash flows to a present value are introduced. These theories help the
reader to understand the concepts behind the two income approaches of business valuations.
The primary sources of information used for this report included three prominent texts, an
interview with a respected professional experienced in mergers and acquisitions and some
pertinent Internet articles found on the subject matter.
This report will show that it is very difficult to determine an accurate value for a business
due to the variety of variables that can affect the valuation outcome. Choosing an appropriate
ii
discount rate or capitalization rate can be challenging and you will see that the valuation process
depends upon subjective assumptions based on some predictive analyses.
Business banking officers or lending officers, who deal with small closely-held
businesses, may find the valuation methods described in this paper useful in deriving an
estimated value of a business. This estimated value can be used as a reference point of
comparison to the sales price of a business and/or as a basis to determine an appropriate
maximum loan amount the bank is willing to lend.
The original intent of this report was to establish a method of valuing a business that is
being purchased. However, you will see that a bank officer’s valuation analysis is beneficial in
underwriting most commercial loans, excluding those transactions that include real estate.
It is recommended that Bank of Hawaii adopt the business valuation processes discussed
in this report. Not only will the analytical skills of a bank lender/officer be improved, the bank
will make stronger loans and experience minimal commercial loan losses.
iii
TABLE OF CONTENTS
Page Executive Summary i Chapter
I. Introduction 1 II. Approaches to Business Valuations 3 III. Standards of Value – Terminology 6
a. Fair Market Value 6 b. Investment Value 7 c. Intrinsic Value 8 d. Going-Concern Value 9 e. Liquidation Value 10 f. Book Value 10
IV. Time Value of Money – Establishing the Discount Rate 12 V. Discounting Future Cash Flows 18 VI. Discounted Cash Flow Method of Valuation - Example 23
VII. Capitalization of Earnings Method 25
VIII. Conclusion 28
Endnotes 31 Table I - Valuation Terms 33 Appendix A - Annual Cash Flow Projections Spreadsheet 35 Bibliography 36 Biographical Summary 37 Certificate of Originality 37
1
I. INTRODUCTION
As a lending officer, have you ever been faced with a potential business loan for a
prospect looking to purchase a business? After reviewing the sales contract and the past
financial statements, you may wonder how the purchase price was developed.
Typical deals are normally asset purchases, where a prospective buyer purchases the
depreciated assets of the business, the trade name and goodwill. Most often, goodwill is greatly
exaggerated where the value is typically based on the business’ existing market share, a strong
client base, a desirable lease or exceptional location, an exclusive permit to operate or a strong
barrier to competitor entry into the market place.
The business purchase transaction can also be a stock purchase, where the business, from
the customer’s perspective, hasn’t changed. The business name remains the same, it continues to
offer the same product or service, and it has the same employees. Just the owners have changed.
The challenge comes when the buyers of a business want a bank to finance a significant
portion of the purchase price, which many times is ‘inflated’. As a lending officer, you have to
determine if the purchase transaction makes sense and if the sales price can be justified.
Commercial and private lenders want to know the value of the business so they can
assess whether their loans will be paid back. By their very nature, start-up businesses, businesses
that have been in existence for less than two years, are difficult to value because they do not have
an extensive financial history. Therefore, business valuations are more useful in the financing
decisions of ongoing companies.
A business valuation can help a banker assess the value of a business and the quality of
its cash flow from operations that could be used to repay the loan. Being able to calculate a
meaningful business value can be very beneficial to the banker. Not only are professional
2
business appraisals expensive, it is very difficult to find a qualified appraiser in smaller market
areas such as Hawaii. “Preliminary analyses and value studies may cost $3,000 to $10,000,
whereas, comprehensive business appraisals can run anywhere between $7,500 and $35,000.”1
Business bankers look for ways to protect their bank when making business loans and
would normally secure small business loans with as much collateral as possible, as well as taking
the personal guarantee of the owners and possibly their spouses. In addition, bankers will often
use the owner’s equity in their home as additional collateral. Business valuations may show that
the business is capable of generating the necessary future cash and/or has sufficient collateral so
that the business owner does not need to pledge personal assets to get a business loan. A
business banker, who has the skills to formulate a realistic business valuation, may have a
competitive edge over other lenders in the marketplace.
This paper will focus on developing a business valuation process to determine the
financial worth or value of a small closely-held company from a business banker or lending
officer’s perspective. Important value terminology will be discussed as well as the important
concepts of ‘discounted cash flows’ and ‘capitalization of earnings’. This report will attempt to
explain the two most important methods of deriving a business value in a simplified manner.
3
II. APPROACHES TO BUSINESS VALUATIONS
Traditionally, professional business appraisers have used the following approaches to
determine the value of a business:
- The Income Approach
- The Market Approach
- The Asset Approach
- The Excess Earnings Approach.
The income approach establishes value by methods that capitalize future anticipated
benefits, such as cash flow, by a discount or capitalization rate that incorporates a market rate of
return as well as the risk of the investment. The capitalization of earnings or discounted cash
flow methods would be examples of this approach. “You can factor a discount for closely held
businesses for lack of marketability since they are not publicly traded. The theory is that since
you can’t just sell on the open market, you will have to incur some costs to sell the stock, or
equity of a business, and this reduces the value of the company. After applying an appropriate
discount for lack of marketability, the capitalization of earnings method can be discounted.”2
The market approach uses a method of comparisons with companies that are similar to
the company you are valuing. You can use comparisons to publicly traded guideline companies
or actual sales transactions of similar businesses. “Bizcomps, a database of actual business sales
transactions, is an option.”3 This method may work well in a large market area where a large
volume of company sales take place, however, in smaller markets such as Hawaii, it would be
difficult to find comparable sales to derive at meaningful valuations.
The asset approach, “also known as the adjusted asset approach or cost approach,
establishes value by netting the fair market value of assets with the liabilities to determine the net
4
asset value or net worth of the business.”4 The challenge with this method is that it does not take
into account the value of the future earnings of the business or any intangible value, such as
goodwill. Another challenge with this method is that you would need some professional advice
on determining the fair value of all of the company assets.
The excess earnings approach is a combination of the income and asset approach. “The
underlying theory behind the excess earnings method is that the total value of the business is the
sum of the adjusted net assets and the value of the intangibles determined by capitalizing the
excess earnings of the business.”5 The same challenge exists with this method, as in the adjusted
asset approach, in valuing the fair market value of the business assets. A valuator could use the
book value of assets disclosed on the company’s balance sheet, however, this is never a good
indicator of true value since the assets are either undervalued due to accelerated depreciation or
due to actual appreciation of the market value of the assets.
A small closely-held business is typically owned and managed by a single owner or a
relatively few amount of individuals or family members. For large, widely-held companies that
sell shares of their stock on an open market such as the National Association of Securities
Dealers Automated Quotation System (NASDAQ) or New York Stock Exchange (NYSE),
determining the value of a company is a relatively simple matter. “The economics of the free
market system and the laws of supply and demand determine the price of a stock. Once you
know the price per share, you simply multiply that price by the total outstanding shares of stock
to arrive at the value of the company.”6 Unfortunately, due to their lack of marketability, small
businesses are more difficult to appraise. Bank of Hawaii defines a typical ‘small’ closely-held
business as a company that has less than $8 million in annual revenues.
5
The business valuation process for a closely-held company takes some analytical skills
and subjective reasoning based on realistic assumptions and research. The process can be broken
down into the following basic steps:
• Determining the purpose of the business valuation
• Analyzing the company’s financial statements (historical and forecasted)
• Conducting a comparative and statistical analysis
• Analyzing internal and external qualitative factors
• Utilizing business valuation methods to calculate a value
There are numerous methods that can be used to value the worth of a business.
However, the two methods that have the most relevance to a banking officer are the discounted
cash flow method and the capitalization of earnings method.
6
III. STANDARDS OF VALUE - TERMINOLOGY
Before a discussion of business valuations can be done, it is important to understand
some of the pertinent terms used when looking at a company’s worth. The word value can mean
different things to different people. Even to the same person value means different things,
depending on the situation. In order to validate the appraised value of a business, the term value
would need to be defined.
For many situations the standard of value or the type of value being sought is legally
mandated, whether by law or by negotiated binding legal documents or contracts. In other cases,
it is a function of the wishes of the parties involved. The standard of value usually reflects an
assumption as to who will be the buyer and who will be the seller in the sales transaction
regarding the subject business assets or interests.
III. a. Fair Market Value
The most widely recognized and accepted standard of value related to business valuations
is fair market value. “With regard to business valuations, it is the standard that applies to
virtually all federal and state tax matters, such as estate taxes, gift taxes, inheritance taxes,
income taxes, and valorem taxes. It is also the legal standard of value in many others, though not
all, valuation situations.”7 Fair market value is defined by the American Society of Appraisers
(ASA) as “the amount at which property would change hands between a willing seller and a
willing buyer when neither is acting under compulsion and when both have reasonable
knowledge of the relevant facts.”8 This definition sounds very straightforward and reasonable,
however there are important assumptions built into it. It is important to understand that the
willing buyer and willing seller are hypothetical, not specific people or organizations with
particular motives or characteristics. Furthermore, the concept of fair market value assumes that
7
the economic and market conditions prevalent as of the date of the valuation will continue. Just
because similar companies sold at a certain multiple of earnings last year does not mean that the
value of your company will be the same this year during these recessionary times. The final
assumption is that the willing buyer and seller are able to buy or sell.
Fair market value serves as a basic starting point for various business valuation purposes
and, of course, as the final determinant when dictated by law. “But excluding statutory
valuation, fair market value is the only way to reckon the true value of a business. In practice,
the terms market value and cash value are used interchangeably with fair market value.”9
Depending on the purpose and the person doing the valuation several other standards of value
may be used.
III. b. Investment Value
Investors make purchase decisions based on their expected return of that investment such
as dividend returns, interest payments or capital gains from the appreciated assets. The worth of
an investment to a particular investor is called investment value and represents individual
investment requirements as opposed to a general, impersonal, and detached fair market value.
To clarify this point, market value reflects the worth or value of a business in the general
marketplace whereas, investment value reflects the worth of a business to a particular investor or
class of investors for their own reasons.
Expectations of the amounts of these future cash returns will vary with each investor,
depending on:
• “A business’ future earning power
• Investor tax status
• The degree of risk in the investment or in an anticipated action that might affect the investment
8
• Potential interaction with other businesses owned or controlled by the investor
• Future government regulations affecting the preservation of earning power
• Marketability of the investment at a future date.”10
Typically, investment value, or the estimated future earning power of the business, can be
calculated using discounted cash flow methods. Since investment value measures an investor’s
personal requirements, it is unlikely that investment value will coincide with market value,
which presumably reflects the consensus of unknown market participants. There is, however, a
relationship between the two.
For example, if a business seller determines that investment value, that is, the worth of
the business to the seller based on personal requirements, is greater than a calculated market
value, then the business should not be sold unless a buyer can be found whose investment
requirements are similar to the seller’s. On the other hand, a seller using investment value or a
buyer using market value should be able to arrive at a compromised price for the business after
effective negotiations.
III. c. Intrinsic Value
Intrinsic value, sometimes called fundamental value, differs from investment value in
that it represents an analytical judgment of value based on the perceived characteristics of the
business, not the requirements of a particular investor. It can be 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 an equity security. The value that will become the market value when other
investors reach the same conclusions.”11
In the analysis of stock prices, intrinsic value is generally considered the appropriate
price for a stock according to security analysts who have completed a fundamental analysis of
9
the company’s balance sheet and income statements, discounted cash flow calculations based on
earnings projections, and other factors. If the market value is below what the analysts conclude
is the intrinsic value, the analysts considers the stock a ‘buy’. If the market value is above the
assumed intrinsic value, the analysts suggest selling the stock.
“It is important to note that the concept of intrinsic value cannot be entirely separated
from the concept of fair market value, since the actions of buyers and sellers based on their
specific perceptions of intrinsic value eventually lead to the general consensus market value and
to the constant dynamic changes in market value over time.”12
III. d. Going–Concern Value
The concept of going-concern value is not a measure of valuation at all. It is an
expression of the current status of a business. “Public accountants express their opinion on a
company’s financial statements based on their going-concern standard – that is, based on the
assumption that the business will continue in operation for an indefinite period of time.”13 In
contrast, the future longevity of a company may be in question if it has a negative net worth,
excessive debt, a weakening market, pending litigation, etc. Such a company would not be
considered a going-concern.
Although the going-concern concept is not a method of valuation, it does have influence
on the worth of a business. If future earnings and cash flow are jeopardized by negative
conditions, appraisal analysis such as discounted cash flows or comprehensive analysis of
current and historical financial statement ratios become meaningless.
In most cases, the going-concern concept relates to the total value of the business,
assuming it will continue to operate in its present form. It includes intangible assets that have no
10
liquidation value such as goodwill, client lists, trade names, skilled personnel, management
expertise, store location, etc.
III. e. Liquidation Value
Liquidation Value refers to the value of the tangible business assets, not the business as a
whole. When the focus is on the likely sale price of specific assets, future cash flow as a
measure of investor or market value has no meaning. The business is not viewed as an income
generator but merely as a group of assets, each of which has value to someone. The fundamental
assumption when arriving at a liquidation value is that the company will cease to do business and
as a result cannot be considered a going-concern.
Typically, liquidation value has little meaning for investors or business sellers, both of
whom look at future earnings and cash flow as justification for making the investment or
continuing to operate the business. However, bank lenders rely on liquidation value almost
exclusively to determine the adequacy of loan collateral. In most cases, this value could be as
low as ten cents on the dollar since liquidation of assets is typically one of the last resorts in
providing the means to pay off the outstanding debt. This is why most bankers will require
additional collateral and guarantors when making business loans.
All in all, from a lending officer’s perspective, liquidation value will have little or no
influence in lending decisions.
III. f. Book Value
Book value is an accounting term and reflects those assets and liabilities recorded on the
books and does not include contingent assets or liabilities, or intangible assets such as client lists
or brand value. For a business as a whole, the book value is simply the difference between total
assets and total liabilities. For individual assets or groups of assets, such as machinery and
11
equipment, the net book value is the difference of the original cost of the assets minus the
accumulated depreciation of those assets. When referring to the business as a whole, “book
value is used synonymously with net book value, owner’s equity, shareholders equity, and net
worth.”14
Since the concept of book value uses historical cost numbers, it would rarely have any
relationship to fair market value. Consequently, you would not use book value to determine the
worth of a company, but you can use book value as a tool for year-to-year comparisons. For
example, if the book value of a company is increasing from year to year, that is a positive
indicator.
**********
From a business banker’s point of view, his or her definition of business value is
basically the same as investment value, as defined above. An experienced lending officer would
need to assume the role of an ‘investor’ in determining the bank’s willingness to lend money to
the business in question. It is the officer’s assessment of cash flow that will provide the basis of
loan repayment, which equates to profitability to the bank. This concept is similar to an
investor’s thought process in purchasing a company, where the business cash flow provides the
basis for his or her ‘return on investment’.
The terms value, business value, investment value, present value, fair market value and
market value are commonly used interchangeably. When these terms are used, keep in mind that
‘value’ is assumed to be defined from an investor’s point of view.
12
IV. TIME VALUE OF MONEY - ESTABLISHING THE DISCOUNT RATE
There are a large variety of valuation methods that can be used to determine the worth of
a business, ranging from the adjusted net asset method to the excess earnings method. The
methods discussed in this paper focus only on those specific valuation methods that would be
beneficial to a bank lending officer.
In theory, the value of an asset is the present value of its expected returns. “Specifically,
you expect an asset to provide a stream of returns during the period of time that you own it. To
convert this estimated stream of returns to a value for the security you must discount this stream
at your required rate of return. This process of valuation requires estimates of (1) the stream of
expected returns, and (2) the required rate of return on the investment.”15
The business valuation process involves much more than plugging the numbers from a
company’s historical and projected financial statements into a formula that will automatically
produce a value of worth. Many other factors should be considered to determine a final value of
a business. Some of the following will have important influence:
The economic outlook for the business
The continuing financial condition of the business
The earnings capacity of the business
The type of business and its history
Whether the business has valuable goodwill, such as a strong name brand, patents,
propriety products or services, etc.
These other factors involve extensive research about the economy, the industry,
comparative sales and the history of the company. Understanding these factors will give you the
13
knowledge and background to make sound judgments regarding the financial analysis and
calculations done during the valuation process.
A major component of the business valuation process is assessing the risk of the
company. This risk is incorporated into the discount rate or capitalization rate used in technical
business valuation calculations. Some of the important terms utilized in this report are further
defined in Table 1 on page 34 of this report.
The theory behind discounting future cash flow to a present value is that a dollar received
today is worth more than a dollar to be received in the future. Everyone has heard of the saying,
“a bird in the hand is worth two in the bush”. Regardless of a business’ characteristics or the
analytical efforts that were undertaken to forecast future events, most investors would agree that
more risk is attached to the receipt of a dollar three to five years from now than to the receipt of a
dollar today or tomorrow.
Many uncertain events such as recessions, war conflicts, labor strikes, earthquakes, and
loss of key personnel can and usually do prevent the timely receipt of expected future benefits.
The longer the time period over which the benefits are to be received, the greater the likelihood
that uncontrollable events will either delay the receipt of those benefits or alter the expected
amount. By valuing future benefits, such as future cash flow, in today’s dollars, you can
establish a present value of those benefits. Investors then can at least partially quantify this
future uncertainty.
The present value concept can be further explained in terms of investor opportunity.
With $10,000 to invest today, you could lock in a risk-free return of 2.87% (as of 3/6/09) for the
next ten years by buying 10-year U.S. Treasury bonds. Earnings of $287 a year for ten years, or
$2870, plus a return of your original $10,000 investment would be guaranteed.
14
Contrast this choice with investing the $10,000 in the common stock of a privately owned
company that promises to pay dividends of 2.87% per year. The probability of actually receiving
the 2.87% dividends every year for 10 years and also getting your principal back would be
substantially less than with the Treasury bond option. To compensate for the greater risk, an
investor in this company may want more than a 2.87% return, perhaps three to five times as
much. The return required to make the investment as valuable as 10-year Treasury bond can be
calculated by discounting the future cash flow or dividend stream to its present value.
“When we speak of return and rate of return, we are referring to the total yield to the
investor, reflecting all dividends, interest, or other cash or cash equivalent received, plus or
minus any realized or unrealized appreciation or depreciation in the investment’s value.”16 The
rate of return or yield rate on an investment for a given time period is determined by using the
following formula:
“Return = Ending Prince – Beginning Price + Cash Distributions Beginning Price” 17 This formula simply says that the investment yield, or rate of return, is equal to the
ending price of an investment, minus the beginning price, plus any cash flows received from
holding that investment, divided by the initial price.
Suppose an investor buyer purchased the company Island Distributors, LLC, a going-
concern business, for $50,000 and held it for five years. The company had paid the current
owner a consistent cash distribution of $5,000 per year for the past three years, so the new buyer
assumes that he will receive that same annual payout of $5,000 a year or a total of $25,000 over
the five year period. In the sixth year, the investor sells the business for $100,000. The
investor’s rate of return would be calculated as follows:
15
Return = $100,000 - $50,000 + $25,000 = 150% = 30% per year $50,000
This 30% annual return is the expected return to the buyer based on the amount of risk he is
willing to take when purchasing the business.
This ‘expected’ total yield rate or rate of return is the discount rate that investors require
for the particular class of investment. In theory, it should represent the expected return on
alternative investments with comparable risk. However, the likelihood that two closely held
businesses, even in the same industry, will be faced with the same market, personnel,
management style, and economic risks over a three, five or ten year period would be very
remote.
The most difficult step in quantifying risk is establishing an appropriate discount rate.
Although several theoretical models have been developed, most are too complex for small
businesses and business bankers to use efficiently. These models make various assumptions that
may or may not be applicable to a given situation and the results that are derived contain
personal judgments and non-quantifiable factors.
To derive at a specific discount rate based on the specific purpose and the company you
are valuing, you would need to understand some very sophisticated economic concepts such as
the Capital Asset Pricing Model (CAPM) and beta, which is used by analysts to predict the
behavior of capital investments. This type of analysis would need to be done by a professional
business appraiser and can be quite expensive. If you are valuing a company for tax purposes,
equitable distribution, or for litigation purposes, you should pay someone to do a formal
valuation and make these sophisticated calculations and judgments. From a banker and small
business owner’s perspective, a more general process can be done.
16
A more subjective method can be used such as the Schilt’s risk premium model. “James
H. Schilt developed a guide to risk premiums based on the general characteristics of the business
rather than the analysis of the almost overwhelming amount of historical information inherent in
other models.”18 Schilt categorizes companies into one of the following five categories as seen in
table below, and assigns a risk premium accordingly.
Schilt Risk Premium Model 19 Category Risk Premium
1. Established businesses with a strong trade 6-10 percent position that are well financed, have depth and management, whose past earnings have been stable, and whose future is highly predictable.
2. Established businesses in a more competitive 11-15 percent industry that are well financed, have depth and management, have stable past earnings, and whose future is fairly predictable.
3. Businesses in a highly competitive industry that 16-20 percent require little capital to enter, no management depth, and have a high element of risk, although the past record may be good.
4. Small businesses that depend upon the special skills 21-25 percent of one or two people, or larger established businesses that are highly cyclical in nature. In both cases, future earnings may be expected to deviate widely from projections.
5. Small “one-man” businesses of a personal service 26-30 percent nature, where transferability of the income stream is in question.
Suppose you have a business that fits in Category 4 above. By using Schilt’s ‘build-up
method’, you can derive at a subjective discount rate as follows:
Risk-Free Long-Term Government Bond Rate 2.87%*
Risk Premium for a Category 4 Company 25%
Discount Rate 27.87%
* 10-Year Treasury Bond (as of 3/5/09)
17
Given the current economic environment, a prudent banker may want to use the higher end of the
ranges for the different categories and add an additional risk premium of 5-10% to reflect the
higher risks associated with the challenges many business owners are having today.
18
V. DISCOUNTING FUTURE CASH FLOWS
The theory behind the discounted cash flow method is that someone will only purchase an
investment today at a price that represents the earnings they expect or anticipate in the future.
The investor discounts the future earnings using the rate of return they could receive on other
investments of comparable risk.
Whether you use an asset, income, or market approach to valuation, the process of
determining fair market value is the process of estimating what you are ultimately going to get
out of the investment. “Consequently, you should always make an attempt to perform a
discounted cash flow analysis to corroborate the reasonableness of any other valuation methods
you use.”20 The difficulty lies in the estimation of the projected future cash flows.
The cash flow forecast is an important component of the valuation process. By using a
detailed cash flow forecast that recognizes all the variables of the business enterprise, your
chances of deriving at a realistic business value are improved.
A cash flow forecast begins with the analysis of historical financial data of the company,
which may include the current and past year’s income statements, balance sheets and tax returns.
Historical financial statements may or may not be a true reflection of the future, but they
represent the only verifiable summary data.
Many business bankers utilize some sort of cash flow projection work sheet to help with
the business forecasts. A sample of this tool, developed as an Excel spreadsheet, is included in
Appendix A on page 36. To properly utilize this tool the following elements should be
considered and included in the cash flow forecast:
1) Economic Assumptions: The forecast should be based on the preparer’s estimate of
economic factors such as inflation rate and interest rates. The effects of anticipated
19
market conditions such as demographic changes, market growth, introduction of new
competitive products, changes in market share and future expansion plans should be
stated in the forecast and included in the projected cash flow calculations.
2) Sales Forecast: A sales forecast should recognize both volume and price changes
from historical levels. The anticipated growth rate should include potential changes
in product mix, new product introductions and market trends.
3) Purchase Forecast: The purchase forecast should reflect the same variations in
product mix as the sales forecast. It should also reflect inflationary changes in the
pricing of all purchases, if possible.
4) Payroll Forecast: Payroll projections should include anticipated wage rate and salary
increases. The projected number of employees should be used as the basis so that all
fringe benefits can be projected as a percentage of the base wage forecasts. It is
important to use realistic management pay, based on comparable market salaries,
especially if the business owner also has a management role in the company. If you
use inflated incomes that many owners of small businesses pay themselves, your cash
flow forecasts may not be accurate.
5) Operating Expenses Forecast: The operating expenses forecast, which excludes
payroll, should include the inflationary changes to utility payments, leases, supplies,
professional fees, insurance, maintenance, etc. If facilities such as leased space
and/or equipment are added due to future expansions, this data should be adjusted
accordingly.
6) Capital Expenditures Forecast: If additional facilities or equipment/machinery
purchases are needed to meet the sales forecast, the costs of these facilities should be
20
forecasted in the appropriate years. Where relevant, the capital expenditures forecast
should include an analysis of lease versus buy decisions.
7) Taxes Forecast: Income taxes may or may not be forecasted depending on the
structure of the company. Partnerships, limited partnerships, sole proprietorships and
S-Corporations do not pay taxes since they pass income and losses directly to
partners, shareholders or owners for inclusion in their personal tax returns. C-
Corporations, however, do pay taxes and should include a taxes forecast based on
expected tax rates.
8) Financing Forecast: The forecast of payments against current financing should be
treated separately from other expenditures. Financing expenses should be adjusted to
reflect the pay-down or pay-off of existing debt as well as forecasted future capital
needs that cannot be paid through projected cash flow.
It’s important to note the differences between forecasting cash flow and forecasting net
income or earnings. If a company operates on the accrual basis, sales revenues are recognized
immediately, whether they are a cash sale or via credit. To properly forecast cash flow, cash
inflows should be recognized properly. For example, if a company allows payment terms, such
as 30 days, to allow customers to pay for it products or services, the cash flow projections should
reflect when the cash is received, not when it is recognized (according to accounting principals).
When properly constructed in sufficient detail, cash flow and net income forecasts will reconcile.
The discounted future income approach deals with uncertainty in two ways. First, as
mentioned earlier, the greater the uncertainty the higher the discount rate used, resulting in a
lower present value for the forecasted future results. Second, “since it is difficult to reliably
predict beyond five or seven years in a forecast, many valuators will only forecast year-by-year
21
results for that time period. Then, for the final year, a simplifying assumption is made that the
final year’s earnings or cash flow will continue to grow in the future at some assumed constant
long-term, annual sustainable rate of growth. This continuing income stream can itself be
capitalized into an estimate of value.”21
Therefore, the discounted projected future income method involves projecting a
company’s anticipated future income streams (e.g. earnings or cash flow) on a year-by-year basis
into the future, usually for five or seven years. Each of these future annual income streams are
then discounted back to their present worth today at an appropriate discount rate (expected rate
of return on investment for risk) required by a buyer. At the final projection year a ‘terminal
value’ is determined that represents the estimated value of the sale of the company at that time.
This sale value or terminal value is based on the capitalized value of the company’s future
income stream from that point onward. In other words, “if the business were sold in the final
forecast year based on its earnings or cash flow, this terminal value is what would be received at
that point in time.”22 Terminal value is discussed further in Table 1 on page 34.
The terminal value, which is to be received at the end of the valuation period of five or
seven years, is then discounted back (at the discount rate) to its present value today. The
summation of the present value of each of the forecasted annual income streams, along with the
present worth today of a future sale value of the company at the final forecast year, results in a
fair market estimate of the company.
The discounted cash flow method of valuation would be appropriate for determining the
value of companies that are growing rapidly. Suppose the company you are valuing had after-tax
earnings of $50,000 in its last fiscal year. Over the next three years, management expects annual
earnings to grow at a 25% annual rate of increase because of the market acceptance of a new
22
product line. The expected growth rates for the next two years are expected to slow to 8%
annually, followed by a long-term growth rate of 5% thereafter as the demand for the new
products reaches maturity.
In this example, the anticipated earnings in the next few years have a large impact on the
overall company value from the standpoint of the time value of money. As mentioned earlier in
this paper, the earlier in time an income stream is received, the greater its present worth today.
By using the discounted cash flow method, each individual year of the rapid growth phase can be
separately forecasted and discounted back to a present worth. Then, the long-term growth would
be captured by capitalizing the final year earnings, which represents the point at which this
stabilized growth rate is reached. Reaching the final value is then simply a matter of adding the
present values of the annual earnings streams together with the present value of the continuing
value at the terminal year.
The discounted cash flow method is also appropriate when valuing companies that are
highly cyclical with earnings tied to an overall industry or economic cycle. Such companies may
have two or three years of rapid growth on the rebound from an economic slump, followed by a
slowing growth in earnings as the market demand diminishes, followed by a downturn and then
losses as the economy enters a recession. We see this happening today with general contractors,
manufacturers and specialty retailers. As the economy recovers you will see the earnings of
these types of companies rebound and the cycle repeated.
Other examples of business valuations where the discounted method can be employed
include the valuing of companies with erratic earnings, companies that conduct business on a
contractual basis, and companies that have multiple outlets, subsidiaries or divisions.
23
VI. DISCOUNTED CASH FLOW METHOD OF VALUATION – EXAMPLE
Maui Equipment Rental, Inc. is a small closely-held business owned by Harry and Myra
Wong, specializing in equipment and tool rentals useful in the construction industry. As with
many typical small family-owned companies, the Wong’s children had no interest in taking over
the business. After 20 years of running the business, the Wongs decided to retire and sell it. To
help them derive a value of their business, the Wongs decided to use the discounted cash flow
method. By using their historical financial information, future assumptions and the cash flow
calculation tools provided by their banker, they were able to forecast the following cash flows for
the next five years:
2010: $50,000 2013: $100,000
2011: $50,000 2014: $125,000
2012: $75,000
The Wongs used a discount rate that was derived using the methods described earlier and
then adjusted it to reflect today’s economic conditions. Their subjective analysis determined an
appropriate discount rate of 30%.
The capitalization rate used to calculate the terminal value was 25%, which is based on
an annual discount rate of 30% for risk, minus a long-term sustainable growth rate of 5%.
Capitalization rates will be discussed further in the next section.
Although the present value of the projected cash flows can be calculated using a financial
calculator, the following algebraic formula can be used to determine the present value for each
future cash flow:
“Discounted Cash Flow = Future Cash Flow (Present Value) (1 + Discount Rate)n
n = nth year (the number of years into the future)”23
The present values for each projected year can be calculated as follows:
24
2010: $50,000 = $ 38,462 (1 + .30)1
2011: $50,000 = ___$50,000___ = 29,586
(1 + .30)2 (1 + .30) (1 + .30) 2012: $75,000 = _______$75,000_______ = 34,091 (1 + .30)3 (1 + .30)(1 + .30)(1 + .30) 2013: $100,000 = _________$100,000_________ = 34,965 (1 + .30)4 (1 + .30)(1 + .30)(1 + .30)(1 +.30) 2014: $125,000 = ______________$125,000_____________ = 33,693 (1 + .30)5 (1 + .30)(1 + .30)(1 + .30)(1 + .30)(1 + .30) Total Present Values of the Projected Cash Flows = $170,797 The terminal value is calculated by capitalizing the last year’s projected cash flow: Terminal Value = Future Cash Flow (ending year) Capitalization Rate Terminal Value = $125,000 = $500,000 .25 The terminal value will need to be discounted to the present so that the value is expressed in today’s dollars: Present Value of Terminal Value = Terminal Value = $134,771 (1 + .30)5 By adding the present values of the cash flows and the terminal value, the Wongs are able to
derive a fair market value of their business of:
Fair Market Value = $170,797 + $134,771 = $305,568 Many professional appraisers may adjust this value depending on factors such as
marketability or issues related to company control, but this method will provide a lending officer
with a ‘ball-park’ figure of market value to support the underwriting for a loan request.
25
VII. CAPITALIZATION OF EARNINGS METHOD
The capitalization of earnings method looks at the actual past results of the company as
an indicator of its expected future results. It then converts these earnings into an estimate of
value using a capitalization rate. This capitalization rate “incorporates risk (the discount rate)
and a factor for the expected future annual growth of these earnings.”24 In other words, “a
capitalization rate is any divisor (usually expressed as a percentage) that is used to convert
income into value.”25
In contrast to the more comprehensive method of discounting all of the expected returns
forecasted into the future, as we saw in the discounted cash flow method, a capitalization rate
“converts only a single return flow number to a an indicated present value.”26 If a company’s
annual historic income is expected to grow in the future at a more or less stable annual rate of
increase, the capitalization of earnings method can be a simplistic alternative to determine a
business value. In other words, “if a company’s annual income grows at a constant rate into the
future, the valuator can obtain exactly the same value as with year-by-year forecasts simply by
dividing the company’s historic income stream by a capitalization rate.”27 The entire valuation
method can be reduced to one basic formula:
“Present Value = Expected Economic Income Capitalization Rate”28
The capitalization rate is determined by subtracting the estimated future long term annual
growth rate of income from the rate of return for risk required for that income:
Capitalization Rate = Discount Rate - Annual Future Growth Rate (Required Annual Rate of Return for Risk)
26
The capitalization method simply says that the value of a business is a function of the elements
of a company’s income, the risk associated with that income (which is reflected in the discount
rate), and the company’s expected rate of future annual growth.
Suppose that Maui Equipment Rental, Inc., as discussed in the previous chapter, was a
mature company with stable earnings with a consistent growth rate of 3%. If it was determined
that the company’s operation will remain consistent without any foreseeable changes in the near
future and assuming that the current and future economic environment will be stable, the
capitalization method could be used. If you presume that an appropriate discount rate of 28% is
used and that the last fiscal year’s cash flow was $50,000, you can determine the business value
by using the capitalization of earnings formula from the previous page:
Business Value = $50,000 = $50,000 28% - 3% 25%
= $200,000
What if the company’s earnings were flat with no growth over the past few years and it projects
no growth over the next few years? In this case, the capitalization rate and discount rate would
be the same, and the value would be as follows:
Business Value = $50,000 28% = $178,571
As the formula implies, a company that is not growing would have less value than a
comparable company that is experiencing stable growth. Also, if you foresee declining earnings
rather than growth, you should add the rate of decline to the capitalization rate to derive at a
more appropriate value based on this future earnings risk.
27
Business brokers typically use the capitalization of earnings method to determine an
appropriate sales price for a business they represent. In an interview with Tom Caltrider, the
Managing Director of the Maui Office of VR Mergers & Acquisitions Brokers, he stated that
“the business broker industry uses the seller’s discretionary earnings (SDE) method for small
businesses or single owner operators and EBITDA (Earning before interest, taxes, depreciation
and amortization) for larger companies. The cash flows determined from these methods are then
capitalized at 25-35% for smaller companies or 20-25% for larger companies to come up with an
appropriate business value.” The challenge with this method is that historical income streams are
used, which would not be realistic given today’s recessionary impacts. Caltrider does
acknowledge that they are making significant adjustments to business values to reflect today’s
market conditions.
The underlying assumption of capitalization is that earnings of the company will continue
to grow evenly forever. However, this is not realistic in real life circumstances - this method is
what you are left with when you do not have confidence in projecting more realistic year-by-year
earnings that you can use in the discounting process.
“The capitalization of earnings method is usually a good way to value
professional service firms or other companies with the following characteristics:
1. Income is generated by people, not assets. 2. Specialized education is usually required. 3. Loyalty and trust reside with the professional. 4. The industry is regulated, such as by certification, licensure, and ownership structure. 5. New business comes via referrals.”29 Companies that possess these types of characteristics generally have stable predictable
earnings and do not have rapid growth.
28
VIII. CONCLUSION The two income methods described in this report quantify value in two fundamentally
different ways. Both have important implications that determine which one is appropriate in a
given situation. This distinction arises from the different underlying assumptions used in each
method. The capitalization method, as mentioned above, assumes that company income or cash
flow grows at the same constant annual rate of increase each year into the future in perpetuity.
By contrast, the discounted future income method forecasts each specific year’s anticipated
results, thus capturing the impacts of changing growth rates, profit margins and other key factors.
Selecting the appropriate method to use, or, if both are used, determining which method warrants
the greater weight involves a number of different considerations.
As discussed, the type of company and/or industry plays an important role in determining
which valuation method is most appropriate. However, each method has its drawbacks. In a
rapidly growing company, the discounted cash flow valuation process includes the subjective
predictions of short-term and long-term growth rates. For cyclical companies, the discounted
method is only realistic if the business cycle is reasonably predictable, as to the timing and
length of each phase of the cycle. The associated projected earnings for each year must be
subject to estimations as well. In reality, no two cycles are exactly alike.
The capitalization of earnings method brings substantial simplicity to a valuation
situation, but not without its own dilemmas. Suppose you have a company that has had stable
earnings over the past five years. This company, like many others seen today, is now entering a
recessionary economic phase that could last for several years. Since the capitalization method
utilizes historical earnings or cash flows, the appraised value will be overstated from the time
value of money standpoint. Simply using the historical average earnings or cash flow patterns
29
does not mean this will be the pattern in the future, as the magnitude and duration of the current
cycle may differ from those in the past.
Both valuation methods highly depend on the use of an appropriate discount rate. There
is no way to determine an exact rate to use in each specialized situation, so subjective methods
are used to derive at a reasonable rate estimation. An appropriate discount rate can also vary
from year to year depending on the changing market risks or sudden changes to the operational
risks of the company being valued.
The two methods also incorporate subjective assumptions in determining the value. For
example, the assumed rate of annual growth, in the straight capitalization method and in
determining the terminal value of the discounted method, is assumed constant. In the discounted
cash flow method, the discount rate is also assumed to be constant in each of the forecasted
years, and several assumptions are made when constructing the forecasted cash flows. In the
capitalization method, it is assumed that historical earnings averages will continue into the
future.
From a business banker’s perspective, the discounted cash flow approach would be the
most appropriate method to determine a reasonable value, especially since the majority of small
businesses have inconsistent historical earnings. Also, since we are currently in a recession,
companies with stable historical earnings will most likely experience declining profits over the
next few years. Most small businesses are too unsophisticated to create accurate forecasted cash
flows and bank officers typically would not spend the hours of time needed to authenticate a
borrower’s cash flow projections. This is why many business brokers would normally employ
some form of the capitalization method, utilizing an adjusted average of historical earnings.
30
As you can see, it would be quite difficult for a typical business owner or a lending
officer to determine an accurate market value of a closely held business without utilizing the ‘art’
of assumptions. Nonetheless, the process of valuing a business by a lending officer is
worthwhile. By using conservative assumptions to formulate meaningful cash flow projections
and using a realistic discount rates based on the company being valued and the current economic
conditions, the banker can determine an appropriate loan amount to lend to a prospective
borrower. For example, if the borrower was purchasing a business for $200,000, yet the
valuation analysis provided a value of $150,000, the bank may require the borrower to inject a
greater amount of equity into the transaction.
It is recommended that the Bank of Hawaii adopt these forms of business valuations as it
would be beneficial to its commercial loan underwriting process, not just for purchase
transactions. It is also recommended that the bank adopt a version of the Schilt risk premium
model, adjusting it to reflect business sectors in Hawaii as well as the current economic
environment. A business banking officer will have a realistic discount rate to use in various
lending situations if the bank’s version of the Schilt model is amended on a consistent basis.
If the bank considers implementing this recommended process, two important results
could be achieved. First, lending officers will improve their analytical skills. Secondly, officers
will enhance their understanding of a company’s financial reports and projections as it relates to
the current and anticipated changes to the business operations and the markets in which it serves.
A business banker’s ability to proficiently conduct meaningful analysis during the business
valuation process will give him/her sufficient grounds to recommend sound loans with a minimal
default rate, ultimately improving the value of the bank’s loan asset pool.
31
ENDNOTES
1. Internet Article: Schroeder, Steven F., “How Much Should a Business Appraisal Cost?” Inc., July 2003, http://www.inc.com/articles/2003/07/25684.html
2. Book: Smith Linton, Heather. Business Valuation: Proven Methods to Easily Determine
the True Value of Your Business, Avon, MA: F and W Publications, Inc., 2004, p. 33. 3. Interview: Caltrider, Tom, Managing Director, VR Mergers & Acquisitions Brokers,
Maui Office, Kahului, HI, March 5, 2009. 4. Smith Linton, p. 33. 5. Ibid.
6. Ibid, p. 2.
7. Book: Pratt, Shannon P., Robert F. Reilly and Robert P. Schweihs. Valuing a Business, forth Edition, New York, N.Y.: McGraw-Hill Companies, 2000, p. 28.
8. Periodical: “ASA Business Valuation Standards” American Society of Appraisers,
revised, 2008. 9. Book: Tuller, Lawrence W. The Small Business Valuation Book, Avon, MA: F and W
Publications, Inc. 1994, p. 18. 10. Ibid. 11. Pratt, p. 31. 12. Ibid, p. 32. 13. Tuller, p. 19. 14. Ibid, p. 21. 15. Pratt, p. 152.
16. Ibid, p. 160.
17. Ibid.
18. Smith Linton, p. 181. 19. Ibid, p. 182.
32
20. Ibid, p. 183.
21. Internet Article: Hawkins, George B., “The Income Valuation Approach” Fair Value, summer 2005. http://www.businessvalue.com/Income%20Approach%20(FV,%207-05).pdfhttp://www.themanager.org/knowledgebase/finance/Valuation.htm
22. Ibid. 23. Pratt, p. 156.
24. Hawkins article. 25. Pratt, p. 204.
26. Ibid. 27. Hawkins article. 28. Smith Linton, p. 148. 29. Ibid, p. 158.
33
TABLE 1
Valuation Terms Goodwill1 – An intangible asset that arises as a result of the name or reputation of the company, the owner/manager, or company products or services; the company’s location; customer loyalty; or similar conditions unique to a given business. Goodwill does not have a monetary value under generally accepted accounting principles (GAAP) and therefore is not recorded on company’s balance sheet (unless it is paid for as a premium over book value in the acquisition of a going concern). However, goodwill does add economic benefit to a company and therefore, in some cases, must be reckoned with as part of the valuation process. Discount Rate2 – A rate of return used to convert a monetary sum, payable or receivable in the future, into a present value. Discounted Cash Flow3 – A stream of monetary sums to be paid or generated in the future reduced to its present value by the application of a discount rate. The discount rate frequently, but not always, incorporates the current market rate of interest. A discount rate may also be tied to a common easily verifiable interest rate such as that paid on U.S. government securities. In theory, the degree of risk of the cash flow determines the discount rate – the more risk the higher the discount rate. Capitalization4 – A term describing three different things: (1) the capital structure of a business enterprise, comprising the sum of long term debt and equity, (2) the accounting recognition of an expenditure as a balance sheet asset rather than an expense, or (3) the conversion of income into value as part of the valuation process of the application of a capitalization factor (any multiplier or divisor used to convert income into value). …or… Capitalization5 – A method used to convert an estimate of a single year’s income expectancy into an indication of value in one direct step, either by dividing the income estimate by an appropriate rate or by multiplying the income estimate by an appropriate factor. Capitalization Rate6 – Any divisor (usually expressed as a percentage) that is used to convert income into value. Terminal Value7 – The terminal value in a discounted cash flow analysis is the number that represents the present value of all of the future cash flows that you are not going to individually forecast. For example, say you did project five years of unique cash flows and discounted them back to present value. You would probably have a difficult time projecting discrete cash flows beyond that point, so what do you do? You develop a number that represents the present value of all of these subsequent cash flows. This number is called the terminal value. You can calculate the terminal value either using a capitalized economic income method or using earnings multiples from comparable companies. ____________________ 1. Tuller, Lawrence W. The Small Business Valuation Book, Avon, MA: F and W
Publications, Inc. 1994, p. 22. 2. Pratt, Shannon P., Robert F. Reilly and Robert P. Schweihs. Valuing a Business, Fourth Edition, New York, N.Y.: McGraw-Hill Companies, 2000, p. 204. 3. Tuller, p. 22. 4. Ibid.
34
5. Pratt, p. 204. 6. Ibid. 7. Smith Linton, Heather. Business Valuation: Proven Methods to Easily Determine the
True Value of Your Business, Avon, MA: F and W Publications, Inc., 2004, p. 178.
35
APPENDIX A
ANNUAL CASH FLOW PROJECTIONS Name of Business:
Date:
Monthly Projections Year 1 1 2 3 4 5 6 7 8 9 10 11 12 Income Projections Revenue/Sales (Cash Inflows) Cost of Goods Sold Gross Margin $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - Expenses (Cash Outflows) Loan Payments Officer Salary Rent Depreciation General Expenses Accounting and Legal Advertising Car, delivery, and travel Insurance Other Outside Services Payroll Repairs and Maintenance Supplies Taxes (Real estate, etc.) Telephone Utilities
Total Expenses $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ -
Net Income (Cash Basis) $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ -
Cash Flow Projections Cash On Hand Start Up Costs
Capital Purchases
Net Cash Flow $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ -
36
BIBLIOGRAPHY
Books
Smith Linton, Heather. Business Valuation: Proven Methods to Easily Determine the
True Value of Your Business, Avon, MA: F and W Publications, Inc., 2004. Tuller, Lawrence W. The Small Business Valuation Book, Avon, MA: F and W
Publications, Inc. 1994. Pratt, Shannon P., Robert F. Reilly and Robert P. Schweihs. Valuing a Business, Fourth Edition, New York, N.Y.: McGraw-Hill Companies, 2000.
Periodicals
“ASA Business Valuation Standards” American Society of Appraisers, revised, 2008.
Interviews Caltrider, Tom, Managing Director, VR Mergers & Acquisitions Brokers, Maui Office,
Kahului, HI, March 5, 2009.
Internet Hawkins, George B., “The Income Valuation Approach” Fair Value, summer 2005.
http://www.businessvalue.com/Income%20Approach%20(FV,%207-05).pdf http://www.themanager.org/knowledgebase/finance/Valuation.htm
Schroeder, Steven F., “How Much Should a Business Appraisal Cost?” Inc., July 2003,
http://www.inc.com/articles/2003/07/25684.html
37
Biographical Summary – Gregory M. Knue
After graduating from Cornell University in 1982 with a Bachelor of Science degree in Consumer Economics, I received my first ‘taste’ of the world of finance with a management training position with Household Finance. A transfer with this company enabled my move from Cincinnati, Ohio, where I was born and raised, to Hawaii where I later acquired a position with a subsidiary of Bank of Hawaii. Since my employment in 1988, I have had numerous management and relationship officer positions with Bank of Hawaii, and currently hold the position of Vice President and Business Banking Manager, overseeing a team of business banking officers, who service small businesses throughout Maui County. Bank of Hawaii Corporation and Subsidiaries is a $10.8 billion company with the largest branch network throughout the State of Hawaii, American Samoa and the Western Pacific (Guam, Saipan and Palau).
Certificate of Originality “I certify that this paper represents and contains my own work. I have placed all quotations from other sources in a form to indicate that they did not originate with me and I have cited the work from which the material was taken. I have included footnotes for all information and ideas that I have taken from other sources. I have not shared and will not share my completed work with any other PCBS student nor have I read the completed work of any other student.” s/Gregory M. Knue Date 4-13-2009
