A Crash Course in Valuations

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A Crash Course in Valuations
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How do you value a business?

• 2 fundamental approaches
• Earnings approach
• Asset approach

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Earnings Approach

• Valuing future earnings is particularly
  speculative.
• Capitalize future anticipated earnings based on a
  rate of return that reflects the nature and
  relative risk of the particular business.
• For example Profits 100,000 annually, with a
  25 return normal for the industry would mean a
  value of 100,000/.25 or 400,000.

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Asset approach

• Separate valuation of the individual assets
• Adjusted book value method- adjusts book value
  on the Balance Sheet to a Fair market value
  balance sheet.
• This has limited application -usually used to
  value businesses being sold that are investment
  businesses or businesses being sold that are not
  currently operational.

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Capitalization of earnings

• Consider
• Capitalization rate
• Determination of earnings

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Capitalization rate

• You need to know
• Potential profits that may be achieved.
• Rate of return required to compensate for risk
  etc.
• The higher the risk, the higher the required rate
  of return.
• E.g.. 80,000 / .4 200,000 vs.
  80,000/.25 320,000.

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• It may also be reflected as an earnings multiple
• e.g.. 40 return is 2.5 times. 200,000/80,000
  2.5
• Should use a range of capitalization rates
• The range of rates should be determined taking
  into account general factors relating to the
  business.

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• These include
• The short long rum market potential for the
  primary products sold or services provided.
• The production capacity of plant or eqt the
  potential impact of technological changes which
  may affect production efficiency.
• The availability security of suppliers of raw
  materials and or specially trained skilled
  employees

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• The state of competition potential of
  competition on pricing
• Strength depth of mgt personnel
• Quality of labour relations in the province.
• Domestic economic trends possible impact on
  co
• Life cycle of primary products manufactured
• Quality quantity of tangible assets owned by
  the business.

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• Remember that different people may attach a
  different degree of risk to a business.
• Choosing a capitalization rate is very subjective
  complex.

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Determination of expected profits

• This again requires the decision maker to make
  certain assumptions.
• Profit projections are generally made under 3
  general scenarios
• optimistic
• most likely
• worst case
• The greater the history the better able to
  predict future growth.

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• Past earnings are important.
• Typically, the last 5 years are averaged to
  arrive at average profit, however greater
  consideration is given to current years
  earnings.
• You must use normal profits which adjust past
  earnings for items that are not considered
  normal

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• Some adjustments will include
• Owners compensation
• Excessive reserves
• Depreciation and Amortization policies
• Lease terms
• Debt service
• Non-recurring expense and gains/losses
• Investment income
• Income tax

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• Example of a valuation