Valuation Lecture: Small Closely Held Firms

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Valuation Lecture Small Closely Held Firms

• MBA 533, Fall 07
• Craig S. Galbraith

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Historical Attitudes

• Ancient Greeks True Value based upon the
  usefulness to mankind
• Water versus diamonds argument
• Cover the input cost (labor and material costs)
• No entrepreneurial profit
• Led to medieval restrictions on interest and
  speculation
• Predates Marxian economics
• Market determines true value
• Based on utility, demand and supply
• Moral issue (if any) is to influence the utility
  of something
• Utopia discussion

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Definitions of Value

• Intrinsic Value 2 definitions
• One analyst - the value something ought to have
• Stock analysis and forecast
• Personal attachment to a particular asset
• Heirloom or personal item
• Investment Value
• Value to one individual considering the unique
  financial (tax, synergy, ability) situation of
  that individual or the individual investment
  requirements

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Definitions of Value

• Fair Market Value
• Arms-length transaction
• No compulsion to buy or sell (willing buyers and
  sellers)
• Reasonable information
• Reasonable time on open market
• Fair Value
• Legal definition
• Excludes minority discounts or freeze-out
  activities
• Uniform Business Corporation Act Definition

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Adjusting Financial Statements

• Fair market salary for owner/operator
• paid for work performed, usually not deducted
• Fair market salaries for family members
• paid for work performed, usually overpaid
• Fair market expenses
• non-arms length transaction (lease from father,
  loan from mother, etc.)
• Eliminate personal expenses written off as
  business expenses

• Adjust to GAAP
• Non-accelerated/expensed depr. accrual
  accounting
• Eliminate extraordinary revenues/expenses
• lawsuits, sales of assets, one-off contracts,
  etc.
• Adjust for non-declared cash revenues
• particularly cash businesses
• Check assumptions for any forecast
• Dramatic Revenue increase

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How to buy a Business Case example

• Bookkeeping Firm in East San Diego
• Stock v. Asset Purchase
• Ethnic client base (Chaldeans) loss of goodwill
• Used business broker any good deals left?
• Due diligence was weak
• Rule of thumb valuation
• Down plus carried note (85,000)
• No earnout (work-out)
• Note was demand note upon sale 30 days didnt
  read

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DISCOUNTED CASHFLOWS

• Theoretical basis for all valuation
• Requires forecast of cashflows
• Select appropriate discount rate
• function of risk and transferability
• Build-up methods
• CAPM
• Appropriate for start-up (pro-formas)

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General Dividend Valuation Model-Under Zero Growth
D1 D2 PV0
-------------- --------------------- .
.etc 1 Dr1 (1 Dr1)(1 Dr2)
Dn dividends in year N, Drn discount rate in
year N Under assumptions of a) zero growth, b)
same discount rate, and c) N is long, the present
value can be approximated by
D1 PV0 --------------
Dr
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General Dividend Valuation Model-Under Zero
Growth (example)
D 4.20 per year, Dr 14.0 (required rate
of return by Investors)
D1 PV0 --------------
Dr
4.20 PV0 --------------
30.00 0.14
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General Dividend Valuation Model-Under Constant
Growth
D1 PV0 --------------
Dr - g
Where g is constant growth
D0(1 g) PV0 --------------
Dr - g
OR
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General Dividend Valuation Model-Under Constant
Growth (example)
D 4.20 per year, Dr 14.0 (required rate
of return by Investors), g 4
4.20 PV0 --------------
42.0 0.14 - .04
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General Earnings Valuation Model-Under Constant
Growth

• When a company retains earnings for reinvestment,
  
• what does this mean?
• In theory, the equity owner owns the rights to
  all the earnings
• The retaining of some of these earnings are
  essentially the
• same as if the equity owner received all
  earnings as dividends
• and then reinvested some back into the
  company
• What are the managerial and ethical
  implications of this?
• What are the valuation implications
  of this?

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General Earnings Valuation Model-Summary

• Under assumptions of ROE DR, the dividend model
  and the earnings models are essentially identical
• Under assumptions of constant growth and long
  time periods, present value can be approximated
  by simple formula of division
• When earnings is divided by a capitalization rate
  (computed from DR and g), valuation method is
  called capitalization of earnings

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DISCOUNT RATES

• Build-up
• Risk free
• Bond
• Equity
• Small firm (17 mutual fund)
• Failure (years in business failure rate)
• 0 (50) 1(30) 2(17) 3(8) 4(4) 5(2)
• Firm specific

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DISCOUNT RATES-Example

• Build-up
• Risk free 3.2 (Paper)
• Bond 5.6 Premium (Ibbotson)
• Equity 4.6 Premium (Ibbotson)
• Small firm (17 mutual fund) 2.3 Premium
  (Ibbotson)
• 16.7 (total)
• Failure (years in business failure rate)
• 0 (50) 1(30) 2(17) 3(8) 4(4) 5(2)
• Firm specific
• Check list evaluation based upon management
  skill, product strength, market position, etc

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Discount Rates Categories

• Add to the risk free rate the following premiums
• 1 (6 to 10) Established business with a good
  trade position, well financed, depth of
  management, and earnings that have, and will be,
  highly predictable
• 2 (11-15) Established business in a more
  competitive industry, well financed, depth of
  management, have stable past earnings, future
  earnings are fairly predictable
• 3 (16-20) Businesses in a highly competitive
  industry that requires capital to enter, less
  management depth, future risk may be high
  although past record may be good
• 4 (21-25) Small businesses that depend upon the
  special skill of one or two people. Larger
  businesses that are highly cyclical in nature.
  In both cases, future earnings may be expected to
  deviate widely from past earnings
• 5 (26-30) Small, one person businesses of a
  more personal services nature, where the
  transferability of the revenue stream is in
  question
• Adapted from Schilt, 1987.

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Valuations - Stage of Development (DR) Mid to
High Technology Firms

• Start-up (skeletal business plan) 135
• Development (RD taking place) 83
• Beta test Start (working prototype) 76
• Beta test successful 48
• Shipping (starting revenues) 44
• First profit 15
• Note 2001 data (for logistics software), varies
  by equity cycles and sector gives good sense of
  discount rate differentials, however. Data is
  highly protected by VC firms

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DISCOUNT RATES- CAPM

• Capital Asset Pricing Model (CAPM)
• drf rf ?im (rm - rf) ?where??im ?im/?m
• The excess return to an asset is derived from the
  ratio of asset specific risk (?im) to the risk of
  the market (?m). If the asset specific risk
  rises, the price of the asset must fall to
  maintain equilibrium pricing.

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DISCOUNT RATES- CAPM - Example

• Capital Asset Pricing Model (CAPM)
• drf rf ?im (rm - rf) ?where??im ?im/?m
• rf 3.0 rm 11.0 ??im 1.5
• drf 3.0 1.5(11.0-3.0)
• drf 3.0 1.5(8.0)
• drf 3.0 12.0
• drf 15.0
• This accounts for (variation) risk obtained from
  similar publicly traded firms
• Need to translate into closely held business

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Weighted Cost of Capital Enterprise versus
Equity Value

• Difference between equity value and enterprise
  value
• Value to equity holders (if you buy stock)
• Value to debt and equity holders (like the sale
  of a house)
• We have been discussing equity value
• New buyer assumes existing debt
• Since earnings/cash flow are net of debt
  payments
• To determine enterprise value can use
• New buyer pays/borrows to cover existing debt
• DR (cost of capital) Debt(Debt cost)
  Equity(Equity cost/DR)
• Note, the equations presented in this section are
  only estimates, the problems and theory can be
  much more complicated
• Diversified portfolio of investments
• More theoretical ways to determine CAPM, DR, and
  Cost of capital
• But sufficient for accuracy in actual valuation
  practice

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Comparable Firms

• Price/Earnings from Publicly Trade Firms
• Price/Earnings, Sellers Discretionary Earnings,
  and Revenue Multiples from Private Sale
  Comparisons
• How close is the comparison?
• Size
• Product
• Diversification
• Region
• PratStat and BizComp

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CAPITALIZED EXCESS EARNINGS

• Values goodwill
• Used in Professional Practice Valuation, etc.
• Utilizes balance sheet plus income statement
• 4-step process
• compute normal return on assets
• compute normal (expected earnings)
• compute excess earnings
• compute value of excess earnings (cap rate)
• compute value of company (value of excess
  earnings plus net tangible assets)

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GOODWILL

• Institutional Goodwill
• 15-25 risk
• Organizational Goodwill
• 25-35 risk
• Personal Goodwill
• 35-75 risk

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Rules of Thumb

• Ad hoc but commonly used formulas
• Non theoretical
• Specific to particular industries
• May be self fulfilling prophesies
• http//businessbookpress.com/catalog/b901.htm