VALUATIONS

Typical Reasons for Valuations

• Purchase or sale of business

• Shareholder arrangements/agreements

• Estate planning

• Litigation: assessment of damages

• Expropriations

• Divorce - distribution of assets

• Inheritance - distribution of estate

APPROACHES TO PERFORMING VALUATIONS

Asset Approaches

1. Liquidation value

2. Adjusted book value

3. Estimated cost of replacement

Going Concern/Transaction Based - Approaches

1. Capitalized earnings

2. Capitalized cash flows

3. Discounted cash flows

4. Discounted earnings

Market based Approach

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ASSET APPROACHES

1. Liquidation Value

Approach used when:

A. Business is not a going concern.

B. To back up going concern value.

Computation of Liquidation Value

Gross realizable value of assets

Less:

• Settlement value of liabilities

• Disposal costs , e.g., real estate commissions, legal, accounting or other fees discount for
time and risk associated with realization if relevant and

• Income taxes assumed on sale of assets

2. Adjusted Book Value

Based on net book value adjusted for market value increments/decrements

Example

Balance Sheet

Assets
Building $500K
Accounts Receivable 200K
Cash 100K
$800K
Liabilities
Accounts payable 400K

Equity $400K

Assume fair value of the building is $900K

$400 Increment
Adjusted book value - $400K + ($900K - $500K) = $800K

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If fair value of building was say below carrying value e.g. $300K then adjusted book value is:
$200 Decrement
$400K + ($300K - $500K) = $200K

3. Estimated Cost of Replacement

• Used primarily to test other approaches.

• Difficult to calculate reliably for large enterprises.

• Suitable for small businesses as primary valuation approach , e.g., grocery store, restaurant

• Also useful when deciding on maximum price that can be paid for a business.

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GOING CONCERN/TRANSACTION - BASED APPROACHES

1. Capitalized Earnings Approach

Calculation

Value = maintainable earnings x earnings multiple + redundant assets

Example

Maintainable earnings after tax = $150,000

Earning multiple = 10 times

Redundant assets (FMV) = $200,000

Value = ($150,000 x 10) + $200,000 = $1,700,000

Maintainable After Tax Earnings

Should represent firm’s ability to earn profits in the future - Historic results serve as guide to
future prospects.

Calculation

Pre-tax earnings * per financial statements are adjusted for:

1. Non recurring items

2. Adjustment to owners compensation and fringe benefits

3. Indirect owners/operator costs such as travel, entertainment, automotive etc.

4. Non arm’s length transactions

5. Income + expenses relating to redundant assets

6. Tax effects : e.g. low rate if purchaser is entitled to SBD

 Can be based upon prior year or average of a number of prior years

Examples of Non Recurring Income

1. Start up costs

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2. Moving expenses

3. Losses due to litigation

4. Gain/loss on disposal of fixed assets

5. Major write-off of receivables/inventory

6. Major foreign currency gain/loss

7. Historic research and development costs related to a completed project

8. Costs and revenues related to discontinued product lines

9. Costs related to isolated strikes and labour disputes

10. Significant changes in financing costs

Earnings Multiple

Multiple is a reciprocal of the capitalization rate

E.g. 20% capitalization rate equals multiple of 5

10% capitalization rate equals multiple of 10

Factors to consider in choosing a capitalization rate include:

 Risk of business - prime rate for business which not high risk
Add some percentage to reflect high risk

 Growth prospects

 Returns available on alternative investments (if information given)

Redundant Assets

Includes assets not necessary for the day-to-day operations of the business

Includes:

• Excess cash and marketable securities or other investments

• Excess land, buildings

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Limitations of Capitalized Earnings Approach

1. Cash is of primary interest to investors.

2. Assumes constant depreciation expense - ignores CCA.

3. Doesn’t anticipate future working capital needs.

4. Assumes infinite life and constant earnings level.

Most appropriate for stable, non capital intensive business.

2. Capitalization of After Tax Cash Flows

1. Similar to earnings approach but uses cash flow instead.

2. Considers tax shield.

3. Considers sustaining capital reinvestment.

Computation of Capitalized After Tax Cash Flows

1. Start with pre- tax maintainable earnings - add back non cash items (e.g. depreciation) and
subtract taxes, and sustaining capital reinvestment (net of the tax shield) to arrive at after tax
cash flows.

Tax Shield Formula relating to assets that will have to be purchased to sustain capital
reinvestment must take into account the half year rules as follows:

U.C.C. x Rate of Tax x CCA Rate x (1 + rate of return/2)

(CCA Rate + R.O.R) x (1 + rate of return)

2. Multiply after tax cash flows by multiplier (same concept as for capitalized earnings).

3. Add back redundant assets plus present value of tax shield relating to existing assets

Tax Shield Formula for existing assets:

U.C.C. x Rate of Tax x CCA Rate = Tax shield

CCA Rate + R.O.R

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Formula for Capitalized Cash flows:

(Pre- tax maintainable earnings plus non cash items less taxes, less sustaining capital investment
net of tax shield) X Multiplier + FMV of redundant Assets + Existing tax shield)

3. Discounted Cash Flows

1. Similar to capitalized cash flow except done over limited period of time on year to year basis.

2. Need to forecast free cash flow each year; would include terminal value at the end of the
forecast period.

3. Considers working capital requirements due to sales growth.

EXAMPLE OF DISCOUNTED CASH FLOWS

Free Cash Flows*:

Year 1: $150,000
Year 2: $200,000
Year 3: $800,000
Year 4: $1,000,000
Year 5: $500,000

Terminal Value (end of year 5): $4,000,000

*assume the cash flows occur at the end of each year

To calculate the valuation of the business using discounted cash flows:

(a) Discount back free cash flows for each of the 5 years of the forecast period.

(b) Discount back the terminal value of $4 million 5 years.

Add together the (a) the present value of the forecasted free cash flows and (b) the present value
of the terminal value to compute the value of the business.

A different discount rate may be used for the free cash flows for each of the 5 years of the
forecast period versus the terminal value.

4. Discounted Earnings

Discounted earnings is similar to discounted cash flows, except that earnings are used.

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MARKET BASED APPROACH

Business is valued by using comparable transactions in the market place to determine the factors
on which the valuation is to be based.

Assumes that similar businesses that have the same characteristics and evolve in the same
conditions have the same value. To use this approach there must be available comparative data.

Approach is often used when a large public company has to be valued or when publicly traded
companies in the same sector can be found (as large companies tend to have similar operational
structures and other similarities with other large public companies and easier to obtain
comparative data for public companies.)

This approach can be used as a “sanity Check” of the value obtained by other methods.

In looking for comparable data important to find companies in the same industry (by using
Standard Industrial Classification codes i.e. SIC codes).

In finding similar companies would consider factors such as: size, geographic and product
diversification, growth prospects, management depth, financial risk and operating risk.

After comparable companies are chosen need to find a multiple that uses the comparative
company’s stock price as the numerator and a measure of the comparative companies operating
results or financial position as the denominator.

Examples of ratios that can be used include: Price/Earnings ratio, Price/EBIT, Price/Gross cash
flows, Price/Book Value (based on tangible assets) etc.

Would need to consider consistency of accounting principles between the company being valued
and the comparative companies.

The company being valued would be appraised. based on using one (or more) of the above
multiples (i.e. valuation ratios) for similar companies. The multiple used can be a mean or
median of all of the comparatives.

It is also possible to adjust the value to reflect qualitative differences between the company being
valued and the comparatives. i.e. the stronger the company being valued the higher the ratio.

The multiple is applied to the results of the company being valued to estimate the value of the
company.

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Example of Market Based Approach

Company A has an earnings per share (EPS) of $10 and 1 million shares outstanding

Company B has a price earnings ratio of 16 to 1 and is very similar to Company A

Therefore Company A should also trade at a 16 to 1 price earnings ratio

Company A’s EPS of $10 X 16/1 price earnings ratio = a share price of $160

Consequently Company A is worth $160 X 1 million shares = $160 million

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FIVE PRINCIPLES OF VALUATION

1. Value relates to specific point in time.

2. Value relates to future expectations.

3. Assets are worth what they can earn - business is worth more as a going concern than it
would be based upon liquidation value.

4. Higher asset backing supports higher going concern value.

5. Hindsight is not permitted in establishing value at previous point in time.

OTHER VALUATION ISSUES

Control

Control position may be worth more than a minority position.

Minority interest

Minority interest is generally discounted in a closely held companies due to:

• Inability to influence direction of company

• Inability to dictate dividend policy and

• lack of market for shares

In considering discount consider:

• Size of shareholding and relative importance.

• Existing S/H agreements, articles of incorporation and by-laws.

• Family relationship.

• Existence of organized market for shares.

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Special Purchaser

Special Purchaser may pay a higher price than a regular purchaser.

Examples of reasons for paying a higher price:

-elimination of competition

-retention of market

-retention or acquisition of key personnel

-opportunity for economies of scale

-Good synergy with existing operations