Valuation

Valuation

5 Valuation: Survey of Methods John Vinturella and Suzanne Erickson Introduction: Valuation Methodologies Valuation is a critical issue in all of fin...

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5 Valuation: Survey of Methods John Vinturella and Suzanne Erickson

Introduction: Valuation Methodologies Valuation is a critical issue in all of finance, including entrepreneurial finance. Sound company valuation is used for planning, for assessing the impact of different strategies on firm value, in estate planning for private firms, in litigation, in establishing the value of an ownership share, and in determining the value of a business for sale. We will discuss five approaches to firm valuation that are commonly used in practice: 1. 2. 3. 4. 5.

Asset-based valuation Market comparables Capitalization of earnings Valuation based on excess earnings Discounted cash flow (DCF) valuation or present value of the firm’s free cash flows

Finance theory would argue that only the DCF method is theoretically correct. It is true that the value of any asset is based on the amount of cash flows that the asset will generate over its useful life, adjusted for the risk of achieving those cash flows. The value of any asset is equal to the present value of its expected future cash flows, discounted at the appropriate risk-adjusted rate. The problem for new ventures is that the information acting as the basis for the free cash flow estimates is generally so speculative that the more sophisticated DCF method may not be perceived as worth the effort it takes to generate a value. There is nothing wrong with the DCF methodology itself; rather, the problem lies with the cash flow estimates. How useful can a number with a plus or minus 50 2 100% standard deviation be? Given the uncertainty surrounding the cash flow estimates, investors often question the resulting valuation even if it is performed. We recommend that the entrepreneur use a variety of methods as a reality check in establishing a business valuation. Keep in mind that the best anyone can hope for is a range of values; there is no true point estimate of firm value. Truth can be revealed only with the passage of time. Although, with any method, the valuation is only as good as the data used to derive it, an honest attempt at estimating future cash flows can provide one estimate that can be compared to other valuations to see whether the methods seem reasonable and the values are in the same ballpark. If a DCF valuation deviates greatly Raising Entrepreneurial Capital. DOI: http://dx.doi.org/10.1016/B978-0-12-401666-8.00005-4 © 2013 Elsevier Inc. All rights reserved.

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from a market multiple approach, it should cause the analyst to reexamine the assumptions used in the DCF model. If the assumptions seem reasonable, the DCF analysis may provide the basis for a higher market multiple and thus a higher price. Our experience is that investors tend to paint all companies at a similar stage with the same broad brush, saying, for example, “Early-stage companies are valued at five times EBITDA.” Entrepreneurs must make the argument why their company is different from the average one, if it indeed is. We would recommend that the entrepreneur always perform a thoughtful DCF analysis, no matter what potential investors are doing. The process of estimating cash flows causes the entrepreneur to focus on what creates value in the business, to better understand the risks, and to thus better understand the value drivers in the business.

Asset-Based Valuation The asset-based approaches to valuation assume that the value of a firm can be determined by examining the value of the underlying assets of the business (the left-hand side of the balance sheet). Three variations of this approach are: 1. Liquidation value of the assets 2. Replacement value of the assets 3. Modified book value of the assets

Liquidation Value Liquidation value entails estimating the amount of money that would be received if the firm ended its operations and liquidated or sold off its assets. Liquidation values tend to be the lowest of all the asset valuations because they assume that at least some of the assets will be valued at fire sale prices. This is not always the case, however. If a firm is a conglomerate operating several businesses with no real synergies, the sum of the business parts may actually be greater than the whole due to negative synergies within the conglomerate. In this case, breaking the business up and selling the assets to the highest valuing users can actually release value. This may have been exactly the dynamic that was at work in the leveraged buyout of RJR Nabisco. In the analysis that led to the Kohlberg, Kravis and Roberts (KKR) takeover of RJR Nabisco, the liquidation value of RJR’s assets was reported to be $95 per share at a time when the market value of the stock was just $57 per share.1 In a brand-by-brand analysis of the many consumer brands owned by RJR Nabisco, KKR identified potential buyers for each brand and added together the likely sales prices. Breaking the company up was forecast to nearly double its value! In general, liquidation value is not considered to be an appropriate valuation method for a going concern because part of firm value would be contingent on the business’s continuing in operation. It does provide a lower bound estimate for a valuation, however. Even in the RJR case, the continuing value of the business under new management was forecast to be $110 per share. 1

Michel and Shaked (1991).

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Replacement Value The replacement value approach to valuation involves estimating the cost to replace each of the firm’s assets. The value of the business is the sum of the replacement costs of the individual assets. This method is based not on what a willing buyer would pay for the assets (a market value test), but rather on what it would cost to replicate the company by buying the assets in the open market. In the majority of cases, there are likely to be large discrepancies between book value and replacement cost for assets such as land, plant, and equipment. The problem with this method is that it ignores assets that add great value to the business but that are not recorded as assets at all under generally accepted accounting principles. Value-adding assets such as human capital and intellectual property would be left out, potentially seriously understating the value of the business, as is the extent to which the firm adds value through superior asset management. Obviously, the degree to which this is a problem depends on the business. For asset-intensive businesses, it presents less of a problem and is therefore a more viable method than it is for businesses that derive most of their revenue from human capital and other intangible assets.

Modified Book Value In the modified book value approach, all assets and liabilities are restated to their current fair market values. Items not found on the balance sheet but that add to firm value are included. For example, the value of intangible real property such as easements, property rights, and leases would be added, as would intangible personal property such as trade names, relationships, and intellectual property. On the liability side, the value of any pending lawsuits or tax disputes would be disclosed. Because the values of many of these items are difficult to estimate, appraisers are usually hired to provide the necessary expertise. The value of the business in this method equals the value of the restated assets minus the value of the restated liabilities. The advantage of the modified book value approach to valuation is that it requires the most rigorous understanding of the business of all of the asset-based methods. The individual asset valuations highlight where value comes from in a business, and they ease the negotiating process by attributing value to specific assets. The major disadvantage of this method is the high cost associated with retaining a host of specialized appraisers. This method is also more time-consuming than the other methods. All of the asset-based methods ignore the firm’s value as a going concern. For this reason, none of the asset-based methodologies tend to be used as much by investors as the following methods.

Market Multiples The most common method of valuation used in practice is the market multiple, or guideline company, approach. In this method, the value of a company is typically

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Table 5.1 Sample P/E Ratios Apple Facebook Google Microsoft LinkedIn

13.68 78.60 18.61 10.90 663.29

General Motors Caterpillar Boeing General Electric Ford

6.48 11.60 12.43 15.81 2.16

Citigroup JP Morgan Goldman Sachs AIG Morgan Stanley

7.31 7.22 14.27 2.81 19.28

Source: May 22, 2012, http:finance.yahoo.com.

based on the observed market value of a comparable company relative to its earnings or some other metric. The observation of the market value of a comparable firm can be the market price of a publicly traded security or an actual transaction involving the sale of a comparable private company. Table 5.1 gives the diversity in price/earnings (P/E) ratios across firms and across industries for a sample of publically traded companies. The difference in ratios is explained by the market’s consensus estimate of future growth opportunities (to be discussed below). LinkedIn’s seemingly ridiculous P/E is a function of very low earnings per share ($0.15). The market does, however, seem very bullish on LinkedIn and Facebook, given the P/E ratios in Table 5.1.

Comparables What is a comparable company? Industry is a good place to start, but industry does not always provide the best comparables. A case in point is the valuation of a company involved in the manufacture of electronic control equipment for the forest products industry. The consultants that were hired to do the valuation determined that the forest products industry provided better comparables than manufacturers of electronic control equipment due to the cyclical nature of the forest products industry, which was the ultimate driver of cash flows for the target company.2 The U.S. Tax Court has identified the following factors to be used as a basis of comparison:3 G

G

G

G

G

G

Capital structure Credit status Depth of management Personnel experience Nature of the competition Maturity of the business.

Comparable companies should be chosen based on the nature of the products, the industry, the buying pattern of the customers (repeat consumer, one-time, etc.), 2 3

Pratt (1993). Pratt (1989).

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Table 5.2 Valuation Example ($, 000s) Sales Operating expenses (including depreciation and interest expense) Income before income tax Add-back interest expense EBIT Plus depreciation EBITDA

5000 4000 1000 50 1050 100 1150

and the nature of the raw material input, as well as factors such as dividend payments, role of the owner/manager, and ownership structure.

Valuation: Example Investors will often look at next year’s projected earnings before interest, taxes, depreciation, and amortization (EBITDA) as a basis for valuing today’s investment. The ratio of price to EBITDA for similar companies is often used as the multiple for valuing a company, basically establishing how much the market is willing to pay for each dollar of EBITDA. EBITDA is used rather than net income because it is a proxy for cash flow in the valuation. Depreciation and amortization are added back to earnings before interest and taxes (EBIT) because they are noncash deductions that were subtracted in the calculation of EBIT. Taxes and interest are excluded because tax brackets differ across firms, and interest expense depends on the level of debt, which is discretionary. Table 5.2 presents information on a hypothetical company. Valuing the company in Table 5.2 based on projected EBITDA of $1,150,000 and a multiple of 12, the company value would be: 12 3 $1;150;000 5 $13;800;000 Note that this is the total firm value. The value of the equity interest in the business is calculated by subtracting all interest-bearing debt from the total firm value. Firm value is obviously sensitive to the multiple used, as well as to the earnings. Familiarity with market multiples at the time of valuation is imperative to establishing a strong negotiating position.

Valuing Service Businesses Often in valuing service businesses, multiples are applied to sales rather than to earnings. This is because sales are the driving force behind profits and cash flows in a service business, and expenses are more controllable than they are in an assetintensive business. The implicit assumption in this method is that a certain level of revenue will result in a certain level of profit. Similarly, if a new buyer will be

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more efficient in running the company, the company’s current expenses and earnings are less relevant than sales in determining value. A method related to the multiple of revenues is the multiple of some measure of output; e.g., beds in a hotel or hospital, subscribers in a cable company, or volume of production. The logic in these cases is that the output measure is the driving force behind revenue. The assumption is that costs and capital intensity are similar among firms within the industry, so the fundamental driver of value is units of output. When earnings serve as the basis of the valuation, they may be measured by net income, operating income, or EBITDA, as in the example given in Table 5.2. With each of these methods, various calculations are used to determine a company’s earnings. Earnings may be based on the latest period, the next forecast period, an average of recent years, or a normalized forecast of earnings. In a normalized forecast—the preferred approach—nonrecurring items are removed from the income statement, a fair and reasonable salary is assumed for the entrepreneur, and the effect of any forecast changes in operations is included. If the buyer is expected to create value for the firm based on synergies that the buyer can supply, this should be built into the earnings forecast. Whichever definition of earnings is used, those earnings are multiplied by a market-determined factor (the multiple) derived from data on the sale of comparable companies. This is the main reason the market multiple approach is so widely used in practice. The multiple is empirically determined from actual transactions, given current market conditions. Multiples can be based on public company data or on transaction data from sales of private companies. When public company data is are used, it is usually necessary to deduct an amount equal to 1020% of the resulting value due to a private company’s lack of marketability. In applying a multiple to earnings, implicit assumptions are made about the firm’s risk and its expected future growth in earnings. The greater the firm’s risk, the lower the multiple should be; the greater the expected growth in earnings, the higher the multiple should be. The multiples will also vary based on competitive market conditions. At the height of the dot-com boom of the late 1990s, companies raising their second round of financing were often valued at 1420 times earnings. When the bubble burst in 2000, that multiple fell overnight to around four to five times earnings.

Valuation Basics The relationship between risk, growth, and the multiple can be seen in Eq. (5.1). The value of an asset is expressed as the present value of a growing stream of cash flows discounted at the appropriate risk-adjusted discount rate: Vt 5

CFt ð1 1 gÞ r2g

ð5:1Þ

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where Vt 5 the value of the asset at time t. CFt 5 the cash flow at time t expected to continue in perpetuity. g 5 the constant growth rate of cash flows in perpetuity. r 5 the appropriate risk-adjusted discount rate. Rearranging Eq. (5.1) provides the multiple of value to cash flow:

Vt ð1 1 gÞ 5 ðr 2 gÞ CFt

ð5:2Þ

Expressing the multiple in this way makes it clear that the multiple increases with growth and decreases with risk. Risk and growth in cash flows are the value drivers of the multiple.

Case 5.1 (A) Woodridge Corporation This case illustrates the use of the market multiple approach. William Hunt is the former owner of the Woodridge Corporation. He shared the details of an offer he received for his firm that was based on a multiple of EBITDA. Assume that the appropriate multiple is four to six times EBITDA. The offer presented to him is summarized in Table 5.3. In establishing the sales price, long-term debt is subtracted to establish the value of the equity in the company. The logic is that total firm value is divided between equity holders and long-term lenders. Both have provided capital to the firm that was used to generate the earnings reported in Table 5.3. The lenders have a prior claim on the firm’s cash flows, and thus their claim must be subtracted to establish the value of the equity. Mr Hunt rejected the offer and indicated he would accept no less than $170 million for the firm’s equity, which translated to a multiple of just over six times EBITDA. Mr Hunt’s position was justified by a free cash flow valuation, shown later in this chapter. Having some idea of the current range of multiples, as well as the valuation derived from a free cash flow analysis, will greatly enhance the entrepreneur’s leverage in a negotiation. When the multiple of EBITDA is stated to be within some range, the prospective buyer needs a basis for determining where in that range the multiple should be for a specific company. We indicated earlier that risk and growth are the value drivers of the multiple, but what drives risk and growth? Insight might be provided by how the company has performed against averages for the industry in meaningful financial measures. Other factors that would move a company up the range would be the depth of management, maturity, position within the industry, and the presence of little or no debt.

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Table 5.3 Woodridge Corporation, 000s Net income plus (add back to establish EBITDA): Income taxes (30%) Interest expense Depreciation and amortization EBITDA Multiple of EBITDA used by prospective buyer 5 4 Firm value less long-term debt Equity value (proposed sale price)

$9,800 4,200 1,000 12,720 $27,720 $110,880 210,000 $100,880

Case 5.2 (B) Superior Plumbing Supply Let us take another look at Superior Plumbing Supply (Chapter 2). The American Supply Association (ASA), the trade association for plumbing supply wholesalers and related firms, surveys financial statements for member companies. Annually, ASA reports averages, or industry norms, by supply specialties and, within these categories, norms for firms in specific sales volume ranges. Table 5.44 presents industry averages for similarly sized firms and information for SPS. Note that in measure 1, SPS achieves 73% more than the norm (ratio of 1.73) in net profit after taxes to net worth; i.e., its return on equity (ROE) is 73% higher than the average of similar companies. Before taxes (measure 2) SPS’s advantage is 36%, indicating that a lower than average effective tax rate is helping to boost returns to its owners. The company requires only 69% as much in total assets as a percentage of net worth as the norm (measure 3) to accomplish these results. The remaining measures also show high performance by SPS compared with similar companies. These may be considered indicators of greater value as a going concern, thereby earning SPS a higher multiple in the range indicated by comparables.

Appropriateness of Methods The appropriateness of using earnings to value a firm is the subject of ongoing debate. Some analysts contend that the markets value a firm based on future cash flows, not its reported earnings. Moreover, they argue that there are simply too many ways to influence the firm’s reported earnings within generally accepted accounting principles that lead to material differences in the valuation estimate but no difference in the intrinsic value of the firm.5 4 5

A review of ratio analysis can be found in Appendix 5.1. The normalization process just discussed is an attempt to remove distortions in accounting from reported earnings.

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Table 5.4 Superior Plumbing Comparative Ratios Performance Measures

Industry Average (%)

SPS (%)

SPS/Average

Net profit after tax/net worth Before tax profit/net worth Total assets/net worth Net profit after tax/total assets Net profit after tax/net sales Net profit before tax/total assets Net sales/total assets

7.1 11.7 2.4 3.1 1.2 4.9 2.6

12.3 15.9 1.7 7.4 2.2 9.6 3.3

1.73 1.36 0.69 2.38 1.86 1.95 1.27

Proponents of the market multiple method argue that companies are more similar than they are different at various stages of fund-raising, and therefore standard multiples can be applied to companies at each stage of their financing. They would argue that cash flow estimates are so speculative in the early years of a start-up, and the probability of failure is so high that a generic multiple is preferable to a more sophisticated analysis based on poor data. Although multiples can be calculated based on public firm data, it is very much an art that should be attempted carefully by the uninitiated. Data on current multiples from private transactions is are maintained in proprietary databases, making it necessary to hire an expert such as an investment banker or certified business appraiser for guidance on current market multiples. Multiples track the market for initial public offerings (IPOs). When the IPO market is hot, multiples are higher, and vice versa.

Capitalization Rates In some industries, it is more common to value a company using a capitalization rate rather than a market multiple. In fact, the methods are merely the inverse of each other. A multiple of five would correspond to a cap rate of one-fifth, or 20%. Most commonly used in the valuation of real estate companies, cap rates are typically applied to the next year’s earnings forecast. The cap rate is chosen to reflect the risk of the investment. Assume that a real estate company forecasts earnings of $10 million for next year. If the going cap rate for real estate companies of similar risk is 20%, the current market value of the company would be $10; 000; 000=0:20 5 $50; 000; 000 This formula should be recognizable as the present value of a perpetuity formula from basic finance or statistics. If the appropriate risk-adjusted discount rate is 20%, the implied growth rate of the earnings is zero. If growth in earnings is forecast to be positive, it should be modeled into the formula as follows for

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transparency. Assume in the real estate example that earnings are forecast to grow at 5% annually. The present value of a growing perpetuity is calculated as E0 ð1 1 gÞ r2g

ð5:3Þ

where E0 5 the current period earnings: E0(1 1 g) 5 E1. r 5 the required rate of return on the investment. g 5 the constant annual growth in earnings expected in perpetuity.

The addition of the 5% growth assumption would change the value of the company as follows: $10; 000; 000ð1 1 0:05Þ=ð0:20  0:05Þ 5 $70; 000; 000 A 5% growth in perpetuity increases today’s value of the business by 40%! As the example illustrates, it can be costly to assume zero growth or not to deal with the anticipated growth of earnings in the future.

Excess Earnings Approach The excess earnings approach is a method developed by the U.S. Treasury Department as a tool to value goodwill. Goodwill is the value created by intangible assets, such as brand name or reputation. These intangible assets cause cash flows and earnings to be higher than they otherwise would be and therefore increase firm value. Because internally developed goodwill, such as that of the Coca-Cola or Nike brands, is not reflected in financial statements prepared according to the generally accepted accounting principles, a method was needed to attach a value to the undeniable benefit of these intangible assets. Although originally developed as a tool for the valuation of goodwill, the method has been extended to the valuation of the whole company. Total firm value can be calculated by adding the value of goodwill to the value of the company’s tangible assets.6 In this method, adjustments are made to both the company’s balance sheet and its income statement. The company’s assets on the balance sheet are restated to their fair market values. The income statement is normalized to reflect normal, ongoing levels of revenue and expenses, while removing nonrecurring items and adjusting above- or below-market expenses (e.g., wages) to fair market values. An interest rate reflective of current returns on tangible assets (plant, equipment, land) is used to determine a fair return on the business’ tangible assets. This rate is 6

It should be noted that the IRS does not condone the use of this method for firm valuation, even though it is widely done.

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a relatively low rate reflective of the relatively low risk of investing in tangible assets. The risk is based on the projected change in the value of the assets, which is usually easier to predict than the expected level of earnings. The dollar return on tangible assets is calculated by multiplying the fair market value of the assets by this risk-adjusted rate. This imputed return is then subtracted from the forecasted normalized earnings for the next year to calculate excess earnings. The idea here is that the tangible assets are forecast to return the risk-adjusted rate for tangible assets. If the business actually produces more than this return, given its investment in assets, the excess return is due to some intangible factor, such as superior management or brand recognition, which is left off the balance sheet. The excess earnings are then capitalized at a higher rate than the rate on tangible assets to determine the present value of the company’s goodwill. The sum of the present value of goodwill and the firm’s tangible assets equals the total firm value. The problem in implementing this method should be apparent. The excess earnings, cap rate, and DCF methods all require the use of a risk-adjusted discount rate. The calculation of this rate is difficult and fraught with the potential for error. The excess earnings method requires the use of two risk-adjusted rates, which doubles the opportunity for error in the valuation. Remember that discount rates are reflective of both the risk of the investment and the general level of interest rates at the time of the valuation and are thus subject to change.

Case 5.3 The Fairweather Company The Fairweather Company can be used to demonstrate the excess earnings approach to valuation. The Fairweather Company has the following book value and market value balance sheet:

Current assets Plant and equipment Land Total assets

Book Value ($)

Fair Market Value ($)

100,000 500,000 200,000 800,000

100,000 750,000 300,000 1,150,000

If the current market return on tangible assets is estimated to be 10%, a fair return on Fairweather’s tangible assets would be 10% 3 $1;150;000 5 $115;000 annually If normalized earnings for next year are forecast to be $200,000, excess earnings can be calculated as forecast earnings less fair return on assets (ROA):

Excess earnings

$200,000 115,000 $85,000

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Excess earnings would normally be capitalized at a rate 5 2 10% higher than the rate on tangible assets to reflect the increased risk of return on intangible assets. Assume that the appropriate risk-adjusted rate of return on intangibles is 18%. The present value of the excess earnings, assuming zero growth, would be $85;000=0:18 5 $472;222 The value of the business could then be calculated as the sum of the present value of excess earnings, that is the value of the goodwill, plus the value of the firm’s tangible assets. Tangible assets Goodwill Firm value

$1,150,000 472,222 $1,622,222

Free Cash Flow Valuation Defined Free cash flow valuation defines the value of the firm as the present value of the expected future cash flows in excess of those needed to operate the company. More specifically, a firm’s economic, or intrinsic, value is equal to the present value of its free cash flows, discounted at the company’s cost of capital, plus the value of the firm’s nonoperating assets. Examples of nonoperating assets might include such items as investments in marketable securities or the amount by which the firm’s pension fund is overfunded. Shareholder or equity value is calculated by subtracting the value of outstanding interest-bearing debt from the total firm value. There are actually two methods of calculating free cash flows: the direct and the indirect methods. In the direct method, debt service cash flows (interest and principal payments) are subtracted in calculating operating cash flows, and the resulting free cash flows are discounted at the company’s cost of equity to establish the value of the equity in the business. In the indirect method, the total firm value is estimated by discounting cash flows before interest at the firm’s weighted average cost of capital. In this method, the value of the equity can be found indirectly by subtracting the value of debt from total firm value. We will focus on the indirect method here because it allows for the estimation of the total firm value, whereas the direct method does not. In the indirect method, a firm’s free cash flow is calculated as follows: Operating income 1 Depreciation and amortization 2 Cash tax payments 5 NOPAT 2 Increase in current assets 1 Increase in noninterest-bearing current liabilities 2 Increase in fixed assets 5 Free cash flow

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Depreciation, amortization, and any other non-cash expenses deducted in the calculation of operating earnings must be added back to operating income to derive adjusted operating income, which is operating income adjusted to a cash basis. Note that operating income is income before interest expense is deducted. In effect, we are calculating the earnings available to all providers of capital, lenders, and equity holders alike. Adjusted operating income minus the cash tax payments equals after-tax cash flows from operations called net operating profit after tax (NOPAT). Cash tax payments equal the actual taxes paid, which will differ from the taxes reported on the income statement. This difference results from the differences in accounting methods used for financial statement reporting and reporting to the Internal Revenue Service (IRS) for tax purposes. From NOPAT, we subtract the investments (increase) in current assets and in fixed assets, net of any increase in noninterest-bearing current liabilities, to arrive at free cash flows. Noninterest-bearing current liabilities are subtracted from the increase in assets because they provide a spontaneous source of funding that helps to offset the cost of increase in the firm’s assets. Examples are the increase in accounts payable that arises when more inventory is purchased to support an increase in sales or the increase in taxes or wages payable that result from an expansion. Free cash flows are forecast over an explicit forecast period, most commonly 5 years. Because the business is expected to continue indefinitely, the cash flows beyond the explicit forecast period must also be estimated. A continuing value is calculated based on the cash flow forecast for the final year of the explicit forecast and a constant sustainable growth rate in perpetuity. FCFN ð1 1 gs Þ WACC 2 gs

ð5:4Þ

where FCFN 5 the free cash flow in the final year N of the explicit forecast. gs 5 the long-run sustainable growth rate. WACC 5 the weighted average cost of capital.

The value of the firm, then, is the sum of the present values of the cash flows during the explicit forecast period plus the present value of the continuing value. An example will illustrate the process.

Case 5.4 (B) Woodridge Corporation: Illustrating the Free Cash Flow Model Table 5.2 presented the valuation of the Woodridge Corporation based on a multiple of earnings. We are now ready to value the firm based on its free cash flows. Doing so requires the following information about Woodridge: G

G

Sales for the most recent period Estimated sales growth rate, both for the explicit forecast period and beyond

156 G

G

G

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Expected operating profit margins Tax rate Projected ratio of operating assets and noninterest-bearing liabilities to sales The firm’s cost of capital.

These variables are known as value drivers, in that they represent the primary factors that drive a firm’s economic or intrinsic value.

The Free Cash Flows In projecting the free cash flows for the Woodridge Corporation, we must estimate each of the firm’s value drivers. The assumptions in Table 5.5 are based on the company’s historical performance and management’s assessment of the situation at the time. Based on these assumptions, projected free cash flows can be generated for the Woodridge Corporation for the 6 years during the explicit forecast period. To generate these free cash flows, it is necessary to create pro forma income statements and balance sheets for Woodridge. Summary pro forma financial data are given in Table 5.6. Using the assumptions in Table 5.5, we forecast levels of assets and liabilities as well as profit estimates. Typically, free cash flows are estimated explicitly for 35 years or until the cash flows reach a steady state. In this case, free cash flows reach a steady state in the sixth year. Beginning with year 6, growth slows to 6% a year, and the present value of future cash flows beyond year 6 are captured in the continuing value calculated at the end of year 6. Table 5.6 includes the historical base year in the first column, followed by the summary balance sheet items in the rows calculated using the assumptions in Table 5.5. Increases in assets represent an outflow of cash, and increases in noninterest-bearing liabilities represent an inflow of cash.

Table 5.5 Woodridge Value Driver Assumptions (%)

Sales growth Operating profit margin Depreciation expense (percentage of fixed assets) Tax rate Net working capital/sales Fixed assets/sales Other assets/sales

Years 15

Year 6 1

15 13 20

6 7 20

30 25 30 5

30 25 30 5

Table 5.6 Woodbridge Forecasted Values ($)

Sales Working capital Change in working capital Fixed assets Change in fixed assets Depreciation

Actuals

1

2

3

4

5

6

150,000,000 37,500,000

172,500,000 43,125,000 5,625,000 51,750,000 (11,850,000) 10,350,000

198,375,000 49,593,750 6,468,750 59,512,500 7,762,500 11,902,500

228,131,250 57,032,813 7,439,062 68,439,375 8,926,875 13,687,875

262,350,938 65,587,734 8,554,922 78,705,281 10,265,906 15,741,056

301,703,578 75,425,895 9,838,160 90,511,073 11,805,792 18,102,215

319,805,793 79,951,448.20 4,525,553.67 95,941,737.84 5,430,664.41 19,188,348

63,600,000 12,720,000

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Table 5.6 gives the free cash flow calculations. Beginning in the sixth year, cash flows reach a steady growth rate in perpetuity of 6% per year. At that point, we can use the present value of a perpetuity model to calculate the continuing value of the cash flows. If we assume Woodridge’s cost of capital is 15%, the continuing value is calculated as CVT 5

FCFT ð1 1 gÞ WACC 2 g

ð5:5Þ

where CVT 5 the continuing value as of time T represents the present value of all the cash flows beyond time T, at time T. FCFT 5 the free cash flow in the final year of the explicit forecast period. g 5 the long-run sustainable growth rate in free cash flows. WACC 5 the overall weighted average cost of capital for the firm.

In Table 5.7, the continuing value is calculated as $24; 902; 613ð1 1 0:06Þ 5 $293; 297; 466 0:15 2 0:06 The continuing value represents the present value of all the future cash flows beginning in year 7 and continuing in perpetuity. The present value of those cash flows at time 6 is $293,297,466. All of the future cash flows—the flows during the explicit forecast period plus the continuing value in year 6—are then discounted to time 0 at 15% to calculate the value of the firm today. The present value of the future cash flows is $181,360,145 and represents the current value of the company given the assumptions in Table 5.5. If we wish to calculate the value of the equity in the firm, we must subtract the value of any interest-bearing debt. Woodridge’s interest-bearing debt totals $10 million, so subtracting debt of $10 million yields an equity value of $171,360,145 (Table 5.7). The free cash flow valuation of $171 million would tend to support Mr Hunt’s insistence that his firm was worth more than the $111 million indicated by the multiple approach. The free cash flow valuation is sensitive to assumptions made about the cash flows, especially the continuing value growth rate, which can account for as much as 50% of firm value. This is why it is important to think carefully about your assumptions but also to use another method to check the realism of both valuations.

Application Notes It is usually good practice to vary the assumptions underlying the DCF model to come up with worst-case, best-case, and most likely scenarios. Because even good faith estimates are likely to be erroneous, a range of values is more powerful than a single estimate of firm value. Perform this sensitivity analysis carefully, however. Do not just randomly vary the inputs to the model plus or minus x%. A sensitivity analysis requires

Table 5.7 Woodridge Free Cash Flows ($)

Sales Operating profit Taxes After-tax operating profit Depreciation NOPAT Increase in working capital Increase in fixed assets Free cash flow Continuing value Total FCF PV at 15% Debt value Equity value

1

2

3

4

5

6

172,500,000 22,425,000 6,727,500 15,697,500 (11,850,000) 3,847,500 5,625,000 (11,850,000) 10,072,500

198,375,000 25,788,750 7,736,625 18,052,125 7,762,500 25,814,625 6,468,750 7,762,500 11,583,375

228,131,250 29,657,063 8,897,119 20,759,944 8,926,875 29,686,819 7,439,062 8,926,875 13,320,881

262,350,938 34,105,622 10,231,687 23,873,935 10,265,906 34,139,842 8,554,922 10,265,906 15,319,013

301,703,578 39,221,465 11,766,440 27,455,026 11,805,792 39,260,818 9,838,160 11,805,792 17,616,865

10,072,500 181,360,145 10,000,000 171,360,145

11,583,375

13,320,881

15,319,013

17,616,865

319,805,793 22,386,405 6,715,922 15,670,484 19,188,348 34,858,831 4,525,554 11,805,792 24,902,613 293,297,446 318,200,059

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that you think about the relationships among the variables. Economists call this a general equilibrium analysis. In the worst-case scenario, for example, falling demand may cause you to lower prices at a time when costs are rising. Create scenarios in which the linkages between the variables in the model make sense. Discount rates are discussed in the next section, but it is important to note now that the 15% rate used in the preceding calculation is a nominal rate. This means the discount rate includes an inflation premium for the expected rate of inflation over the long run. To be consistent, the cash flows given in Tables 5.6 and 5.7 should be inflation-adjusted cash flows.

Determining the Discount Rate To this point, we have assumed that we know the right discount rate (cost of capital) to be used in the present value calculations, even though we really do not know it with any certainty. Measuring a company’s cost of capital, particularly for a privately held firm, is a difficult but necessary task. Because our estimates are likely to be inaccurate, we may even choose to compute a range of discount rates, rather than a single-point estimate of the cost of capital. Nevertheless, we are left with no other choice but to estimate the firm’s cost of capital as best we can. In doing so, some basic ideas should guide our computations. A firm’s cost of capital is an opportunity cost, not an out-of-pocket cost. The cost of capital is an economic concept, where the cost represents the return that could have been earned on a similar risk investment. As such, it is different from an accountant’s concept of cost, which exists only if it is explicitly incurred. Furthermore, as far as the accountant is concerned, there is no cost for equity capital when computing a firm’s income. In fact, the cost of equity is always higher than the cost of debt for a given firm due to the higher risk of equity. For the financial economist, the cost of equity is real and is equal to the foregone return that could have been earned somewhere else by the investor investing in an asset with similar risk. Therefore, to estimate the cost of equity, economists usually look to the capital markets to ascertain the opportunity cost as implied by the prevailing market price for a security of similar risk. Because we measure a firm’s free cash flows on an after-tax basis, the cost of capital should likewise be expressed after taxes. This applies only to the cost of debt because interest is tax deductible, thus reducing the effective cost of the firm’s debt. A firm’s weighted average cost of capital includes the costs from all sources of capital. The cost of each source of capital is weighted by its relative proportion in the firm’s capital structure. For a firm with only debt and common equity, the weighted average cost of capital is computed as follows:     debt value equity value WACC 5 ðCost of debtÞð1 2 TÞ 1 Cost of equity firm value firm value ð5:6Þ

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Firm value is equal to the total of the long-term debt and equity in the firm. A number of issues that have to be resolved in computing a company’s cost of capital lie beyond the scope of this book. For our purposes, we will limit our discussion to a relatively simple presentation to illustrate the basic framework. Let us look at how we computed the 15% cost of capital for the Woodridge Corporation. At the time of the valuation, Woodridge’s management assumed that the firm’s future financing would consist of 25% debt and 75% equity, with the equity coming from internally generated funds and new equity offerings. The weights in the cost of capital calculation should represent the firm’s target capital structure, or where the firm would like its capital structure to be. Currently, Woodridge is using less than 25% debt, but the cost of capital represents the average cost of raising capital through time at the target weights. Woodridge’s current low debt level would indicate considerable unused debt capacity for the near future. The firm’s before-tax cost of debt was estimated to be 8.5%. Thus, given a corporate tax rate of 30%, the firm’s after-tax cost of debt is After 2 tax cost of debt rd 5 8:5%ð1  0:3Þ 5 5:95% The firm’s cost of equity was estimated using the capital asset pricing model (CAPM), which holds that Cost of equityðr s Þ 5 Risk free rate 1 Beta ðmarket risk premiumÞ

ð5:7Þ

A risk-free rate of 6% was used based on the going interest rate for 10-year Treasury bonds at the time, along with a market risk premium of 8%. The market risk premium is usually calculated as the historical long-run premium of stocks over Treasury bonds. One good source for this data are the book Stocks, Bonds, Bills, and Inflation, updated annually by Ibbotson and Associates. Because Woodridge is not a publicly traded company, it has no observable beta. However, the beta for a comparable firm that is traded publicly was 1.50. It is best to identify several similar firms, if possible, and to use an average of the comparable firm’s betas. Given this information, management estimated the cost of equity for Woodridge to be 18%, computed as follows: Cost of equity 5 6% 1 ð1:50 3 8%Þ 5 18% Using this information, Woodridge’s weighted average cost of capital is estimated to be 15%: 0:25ð5:95%Þ 1 0:75ð18%Þ 5 15% Two issues arise when calculating the cost of equity for a private company using the CAPM. First, beta is a measure of the systematic or market risk of a security.

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This is appropriate for publicly traded stocks because company-specific risk can be diversified away and therefore is not priced. However, for entrepreneurs with all of their wealth invested in the company, no diversification is possible, and they must bear the total risk of the investment. This means that the CAPM will understate the necessary risk premium for entrepreneurs. Second, if no comparable firms can be identified, there is no beta to use as a proxy in the first place. For both of these reasons, it may sometimes be preferable to estimate a beta for the company itself rather than use a proxy beta. Accounting betas can be estimated by comparing the variability in a company’s earnings with the variability in the overall average earnings of the firms in the market index being used. If the company has a sufficient earning’s history, this is possible, and beta can be calculated as the ratio of the standard deviations of earnings for the company and the market as a whole. β5

σCompany earnings σMarket earnings

ð5:8Þ

If the company lacks sufficient history to calculate a historical beta, variability can be measured from the sensitivity analysis from the cash flow forecast, but this requires estimating the variability in market earnings over the future as well, which is problematic to say the least. Perhaps the best that can be done with the cost of equity is to use the CAPM as a guide and add a risk premium based on the entrepreneur’s opportunity cost of being in the business. This will be a subjective estimate, to be sure, but it is preferable to ignoring the added risk altogether.

Summary This chapter presented several methods used in the valuation of a business. Given that the quality of information for a start-up is so poor, it is wise to use two or more of these methods as a reality check on the resulting valuation. We looked at asset-based valuations of a business in which the company value is a function of the value of the tangible assets held by the company. This method is limited in its usefulness for most companies but may be applicable to a business that derives most of its value from tangible assets, such as a natural resource company. The most common method used in practice is the market multiple approach. In this method, value is determined by looking at the ratio of price to sales, earnings, or other value drivers, using similar publicly traded companies as a benchmark. Differences between the private start-up and the public companies must be factored into the analysis to adjust for lack of marketability, age, or other critical factors. Also, use several guideline companies as a basis for comparison to average out the effects of company-specific information on firm value.

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Earnings capitalization is a method similar to the market multiple approach, used primarily in the real estate industry. In this method, an income stream is discounted, in perpetuity, to establish firm value. When this method is used, it is important to understand the implicit assumptions being made about growth. The excess earnings approach was originally developed to value the goodwill in a business. In this method, an imputed return is calculated based on the tangible assets of the business. Earnings over this amount are attributed to goodwill, valued separately, and added to the value generated by the tangible assets. The sum of the two is the total firm value. Finally, DCF analysis was presented. In this method, the free cash flows of the business are discounted at the company’s cost of capital. Although this is theoretically the most sound and rigorous method, as with any model, garbage in equals garbage out. Forecasts of questionable quality diminish the usefulness of this method in establishing value. On the other hand, the exercise of generating the free cash flows causes the entrepreneur to think long and hard about how the business will progress. Calculation of the appropriate discount rate to be used in the DCF analysis was also discussed, with special emphasis on the weighted average cost of capital. It is best to think of the firm’s cost of capital in an opportunity cost sense: The weighted average cost of capital represents the returns demanded by all investors, based on the risk of their investment. Valuation is one of the most important and contentious aspects of entrepreneurial finance. The more ways you can attack the problem, the stronger the resulting valuation will be.

Discussion Questions 1. Use the following information to develop a spreadsheet model that will calculate the free cash flows and the value of the equity for the company. Cost of capital Most recent year’s sales Nonoperating assets Interest-bearing debt Operating profit margin Working capital/sales Fixed assets/sales Noninterest-bearing Current liabilities/sales Tax rate Forecasted sales growth Years 12 Years 35 6N

12% $1000 $100 $250 12% 35% 20% 10% 40% 12% 8% 4%

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Calculate the value of the firm and the value of the equity in the firm using DCF analysis. 2. Using the company of your choice, identify five comparable publicly traded companies and develop a multiple based on earnings from the public company data.

Case 5.5 New Tech (I): What Is the Company Worth? Grant explains to the management team that the company valuation is critical for both investors and the company. The goal is to produce a rough estimated value for New Tech’s common shares. He and Elizabeth have prepared documents that can be used to put a price tag on New Tech’s market data.

Valuation: The Company’s Perspective Grant points out the importance of having a solid understanding of New Tech’s value. If they do not know what the company is worth, they will not know how much ownership they have to give up in exchange for the investment they need. If the company is worth $2 million, then a $1 million investment represents a big piece of the business—and a large percentage of the equity. On the other hand, if the business is worth $10 million, then an investment of $1 million represents a much smaller proportion of the business’s equity. The other benefit of determining New Tech’s value is that it will provide management with a clearer understanding of how investors will evaluate New Tech as an investment opportunity.

DCF Methods Grant points out that they should use the discounted free cash flow technique for valuing New Tech, and, though he is aware of other methods, he feels that the discounted free cash flow approach is the most appropriate. Grant explains to the members of the management team the various steps involved in the process. 1. Determine the present value of the free cash flows New Tech expects over the next 5 years (FCF 5 NOPAT 2 investment in net operating working capital and fixed assets). 2. Determine the company’s terminal value at the end of the 5 years and what that amount is worth today. To calculate the terminal value, assume an 8% growth rate of the free cash flows in perpetuity. 3. Calculate New Tech’s estimated market value by adding these two amounts: the present value of the free cash flows over the 5 years and the terminal value of the company at the end of the 5-year period.

Grant has determined that the appropriate risk-adjusted discount rate is 20%. Grant subjectively determined (with input from New Tech’s management) the 20% discount rate based on estimated required rates of return, as well as economic-, industry-, and company-specific risk factors.

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Table 5.8 New Tech’s Financial Forecast ($, 000s) 2012 Actual 2013 Forecast 2014 Sales Cost of goods Sold1 Gross margin

2015

3,000 1,185 1,815

3,900 1,560 2,340

4,700 5,640 1,645 1,805 3,055 3,835

Selling expense 857 Administrative expenses 555 Total operating costs 1,412 Operating income 403 Taxes (34%) 109 Net income 294 Working capital Accounts receivable 450 Inventory 350 Accounts payable 550 Net working capital 250 Capital spending 1 COGS includes depreciation of the amounts to the right

1,326 702 2,028 312 106 206

1,316 752 2,068 987 336 651

546 429 585 390 1,100 325

$658 $470 $658 470 740 375

2016

2017

6,700 8,040 2,077 2,412 4,623 5,628

Operating expenses 1,410 1,474 846 1,005 2,256 2,479 1,579 2,144 537 $729 1,042 $1,415 733 564 620 677 500 400

1,528 1,206 2,734 2,894 984 1,910

871 1,045 670 804 737 884 804 965 500 500 430 490

To Do Calculate the value of New Tech today, using the data given in Table 5.8 and the preceding assumptions.

Valuation: The Investor’s Perspective Once Grant has established a value for the company, he discusses the investor’s perspective. Of course, investors will be looking for an exceptional return on their investment. They will also want to determine how much of the firm’s shares they need to acquire to command that return. Grant expects that early-stage investors will want to earn a return of 30% to compensate for the risk. The rate of return reflects the investor’s perceptions of the economic, industry-, and company-specific risk factors. It also accounts for the alternative investments available. Grant thinks that 30% will be adequate compensation for the risks associated with investing in a new, untried venture like New Tech’s growth plan. Grant explains that investors will evaluate the percentage of shares they require by looking at the potential return at exit, i.e., at the end of the investment period. This exit might be achieved through an IPO, a sale of the whole company, a buyback or redemption of the investors’ shares, or other means. The investor will be getting a percentage of the value of New Tech’s shares at exit and will want to be sure that percentage is high enough for them to hit their rate of return target of 30%.

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Grant’s initial assessment is that New Tech will fall short of an expected 30% after-tax return on investment for its investors. If that is so, they will need to alter their offering somehow to accommodate investor demands, possibly the percentage of shares they will offer. But first he explains how the calculations are done.

Case Study Questions Grant starts with the assumption that potential investors would likely want to exit around 2017. 1. Assuming that the investors own 30% of New Tech’s shares at the time of exit and that the 2017 value would be three times the 2017 EBITDA, what would be the value of the firm in 2017? 2. What would be the investors’ share of the 2017 value? 3. What would be the return on a $1 million investment in the company today at that valuation? 4. Is your calculated return adequate? If not, how can it be made acceptable to investors?

Appendix 5.1 Review of Ratio Analysis In the context of this chapter, ratios can be helpful in assessing the risk and the expected profitability for a new venture. This information can be used to adjust the discount rate or the multiple used in a valuation. Ratios are typically divided into four categories: liquidity, asset management, debt, and profitability. To perform a meaningful analysis of the ratios, one must have at least a few years of historical data to examine the trends of the ratios over time, as well as industry averages for comparison. Trends are important because a below-average ratio that is improving is much different in interpretation than a below-average ratio on a downward trend. Likewise, ratios looked at in isolation are meaningless. Definitions of what is good and what is bad depend completely on the industry in which the firm is operating. Without industry averages, we cannot conclude anything about the health of a ratio. We will discuss each of the categories with the appropriate ratios. Sources for industry data will be discussed at the end of the appendix.

Liquidity Ratios Current Ratio Current assests Current liabilities The current ratio measures the firm’s short-term bill-paying ability. By comparing current assets to current liabilities, we are asking whether the firm has sufficient assets to pay off its short-term debt if the current assets were liquidated. What

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is considered a good ratio depends on the purpose of the evaluation. To a banker, a higher current ratio is better. Less debt relative to assets increases the chances that the assets are securely covered. To an entrepreneur or equity investor, current assets are nonearning assets and should be minimized. In this case, a low current ratio might indicate efficient utilization of current assets. In assessing the risk of a venture, a current ratio below 1 might indicate higher risk.

Quick Ratio Current assets 2 Inventory Current liabilities The quick ratio, sometimes called the acid test ratio, is a refinement of the current ratio. If we are truly interested in the ability of the firm to cover their liabilities with short-term assets, we may want to remove inventory from the numerator because inventory is the least liquid of the current assets. The quick ratio provides a better picture of short-term liquidity than the current ratio, but the interpretation caveats of the current ratio still apply.

Working Capital to Sales Current assets 2 Current liabilities Sales The working-capital-to-sales ratio is an efficiency measure. The goal is to do more with less—produce a given level of sales with the fewest assets possible. For this ratio, lower is better from an efficiency standpoint.

Asset Management Average Collection Period Accounts receivable Credit sales=365 The average collection period, also known as the days sales outstanding (DSO), indicates how long a company must wait, on average, to turn accounts receivable into cash. For an outside evaluator, this ratio is problematic. To be accurate, we must use only the credit sales in the denominator, but firms do not typically break sales into cash and credit in their financial statements. For an insider, this information should be readily available; however, to be able to analyze the ratio, we must calculate it in the same manner as the industry averages are calculated, and they are based on total sales, not on credit sales. Industry average is especially important in interpreting this ratio. In some industries, virtually 100% of sales are on credit, so credit sales equal total sales. In an industry like retail, on the other hand, perhaps

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half of the sales are for cash. In this case, the denominator would be greatly overstated (by using total sales in the calculation), and the average collection period would be severely understated. Knowing whether your sales breakdown approximates the breakdown between cash and credit for your industry increases the usefulness of this ratio. Trends in this ratio are particularly important because they are often a leading indicator of future cash flow problems. If your customers start taking longer to pay, that will cause a cash flow problem down the road.

Inventory Turnover Cost of goods Sold inventory Inventory turnover measures how many times you turn, or sell, your inventory in a year. Inventory turnover is highly industry dependent, but, in general, higher is better. One potential danger of a high turnover ratio is that it can be achieved by minimizing inventory. If your supply chain is absolutely reliable, this may not be a problem, but low levels of inventory could lead to stockouts and lost sales. On the other hand, too much inventory ties up cash and reduces the firm’s profitability.

Total Asset Turnover Sales Total assets This ratio measures how efficiently a firm uses its assets to generate sales. Ideally, higher is better, indicating a high sales volume for a given investment in assets. A low total asset turnover should be traceable to either the current assets or the fixed assets as the source of the problem.

Fixed Asset Turnover Sales Fixed assets This ratio measures how efficiently the firm uses its fixed assets in generating sales. In general, higher is better, but this ratio must be analyzed carefully. For a new company, or a company that is in expansion mode, assets on the balance sheet will be newer, with higher book values due to less accumulated depreciation than the average firm. Thus, a low fixed asset turnover may be an indication of a new company rather than an inefficient one.

Debt Ratios Debt ratios come in two varieties: income statement ratios and balance sheet ratios. The first looks at the impact of debt on earnings; the second examines the

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impact of debt on the firm’s capital structure. We will begin with the balance sheet ratios.

Total Debt to Assets Total debt Total assets The debt ratio is a measure of the financial risk of the firm. It indicates the percentage of the firm’s assets that were paid for by lenders. From a risk standpoint, lower is better. Debt increases risk due to the fixed nature of debt payments. If sales decline, the debt payments remain, increasing the volatility of the firm’s earnings. From an equity standpoint, however, debt use decreases the equity and increases the return to that equity by allocating a return over a smaller base.

Degree of Financial Leverage % Change in net income % Change in EBIT This ratio is not typically included with the ratios in a standard ratio analysis because it is not included in published industry averages. It does, however, serve as a useful measure of the risk imposed by debt issue. The degree of financial leverage (DFL) measures the volatility of net income caused by having fixed interest payments. The larger the interest payments, the larger the difference between EBIT and net income will be, and the higher the DFL. Interpreting the DFL is simple. A DFL of 2 would indicate that, for a given percentage change in EBIT, the change in net income would be two times as large. Debt causes volatility in earnings. The more debt a firm has, the more volatile the earnings will be, and the riskier the firm will be to investors.

Debt to Equity Long-term debt Stockholder’s equity This ratio examines the capitalization of the firm. Where does long-term capital come from? Although the ratio of total debt to total assets measures the total debt burden, most analysts are more concerned with the long-term debt than with the current liabilities. A debt-to-equity ratio of 1 would indicate that lenders and owners supply capital equally. Although industry averages will determine what is normal, from a risk standpoint, lower is better.

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Debt to Capital Long-term debt Long-term debt 1 Equity This ratio is merely a reconfiguration of the debt-to-equity ratio. It too looks at what percentage of the firm’s long-term financing is provided through debt. A debt-to-equity ratio of 1 would correspond to a debt-to-capital ratio of 50%. The use of the term capital is intended to focus on how the firm is capitalized. Capitalization is interpreted as long-term financing, so we are really looking at the firm’s capital structure in this ratio.

Fixed Assets to Equity Fixed assets Stockholder’s equity Sometimes called the fixed-to-worth ratio, this ratio indirectly examines the proportion of fixed assets that are financed by debt. The higher the firm’s debt, the lower the stockholder’s equity will be, and the higher the ratio. In assessing risk of the business, a higher fixed-asset-to-equity ratio would indicate relatively higher risk to investors.

Times Interest Earned EBIT Interest expense This ratio examines the impact of debt on the firm’s earnings. Debt is a problem only if the firm has insufficient earnings to service the debt. The balance sheetbased debt ratios must always be analyzed in conjunction with the timesinterest-earned ratio (TIE) before any conclusions can be drawn about the firm’s relative use of debt. The TIE tells us how many times a firm can cover its annual interest expense. Higher is better in general, but too high indicates unused debt capacity and a higher than optimal cost of capital. Interpreting this ratio, as with all ratios, requires an industry average to be meaningful. Nonetheless, assume for the moment that the TIE is 20. Most people would call that a very high TIE, indicating that debt is not a substantial risk for the firm. If the TIE of 20 corresponds to a debt-to-asset ratio of 0.60, which would normally be considered high, we would have to conclude that, for this firm, the debt level is not too high based on the TIE.

Fixed Charge Coverage EBIT1Lease payments1Other fixed charges Interest1Current portion of long-term debt1Lease payments1Other fixed charges

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Although TIE is the most commonly used coverage ratio, firms have fixed costs other than interest that could pose risks to potential investors. Principal repayments, lease payments, and any other contractually fixed payments the firm must make all increase the volatility of earnings in response to a change in sales. The fixedcharge-coverage ratio is a broader measure than the TIE and indicates whether the firm has sufficient income to cover all of its fixed financial charges.

Profitability As with the debt ratios, we can measure profitability in terms of the income statement alone or in conjunction with the balance sheet. We begin with the income statement.

Profit Margin Net income Sales Profitability is the main fuel for the firm’s growth engine. This makes profit margin an important variable in making the case for higher growth and a higher multiple in negotiating valuation. Simply, this ratio measures what percentage of every dollar in sales remains as profit after all the expenses have been paid. Industry averages are a must for interpreting this highly industry-dependent ratio.

Gross Profit Margin Gross profit Sales In analyzing the financial statements, a low profit margin is a cause for concern. The next reasonable step is to ask why the profit margin is low. Is it due to high manufacturing costs, high overhead, or high levels of debt? We should be able to answer the last question based on the TIE. To answer the first two, we need two additional ratios. The gross profit margin is the first. Gross profit is calculated as (sales 2 cost of goods sold). If the problem driving low profits is due to manufacturing, it will be spotted here as a low gross profit margin. Cost of goods sold includes only the costs of production and focuses attention on operations.

Operating Margin Operating income Sales Operating margin is sometimes measured as EBIT divided by sales. Operating income and EBIT are the same only if the firm has no nonoperating items on its

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income statement. In tracking down the cause of our low profit margin, a low operating margin in the presence of an acceptable gross margin would be an indication of high overhead costs. The difference between gross margin and operating margin are all the selling, administrative, and overhead costs in the firm.

Return on Assets Net income Total assets ROA ties together the income statement and the balance sheet. It indicates the percentage return on the investment in the firm’s assets. Technically, this ratio should be calculated as Net income 1 Interest expense Total assets The denominator of this ratio is total assets, which were paid for by both equity holders and lenders. The numerator, therefore, should include returns to both lenders and owners, which would include interest to the lenders. As with all ratios, we must calculate the ratio the way the published industry averages are calculated, and most publications use the first (albeit incorrect) definition. The real usefulness of the ROA is in breaking it down into its component parts: ROA 5 Profit margin 3 Turnover 5

Net income Sales 3 Sales Total assets

Knowing that the ROA is low is interesting but not very helpful. Why is it low? Is it because we are unprofitable in operations (low profit margin), or is it because we are inefficient in our use of assets (low total asset turnover)? From the answer to these questions, we can begin to work backward through the other ratios to find a fairly complete explanation of overall performance.

Return on Equity Net income Stockholder’s equity The most interesting measure of performance to an investor is the ROE. Theoretically, this ratio measures the investor’s return on investment in the company and is comparable to the returns available on other investment opportunities available in the market. Because actual investment returns can be calculated based only on the sale of shares in the company, this is a current-period proxy for the investor’s return on investment. Like the ROA, the ROE can be broken down into its component parts, which makes it more useful.

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ROE 1 Profit margin 3 Turnover 3 Leverage 5

173

Net income Sales 3 Sales Total assets Total assets 3 Equity

The insight that this last equation provides is that the ROE can be increased through the use of leverage. More use of debt will reduce the denominator in the last term and increase the multiplier effect on the ROE.

Industry Average Data The two most common sources of industry average data are the RMA Annual Statement Studies produced by the Risk Management Association and data published by Dun & Bradstreet. From either source, industry data are organized by NAICS code, and, within the industry, the code is categorized by size and measured either by assets or sales. The North American Industry Classification System (NAICS) replaced the U.S. Standard Industrial Classification (SIC) system. NAICS was developed jointly by the United States, Canada, and Mexico to provide new comparability in statistics about business activity across North America. Industry averages are also available from trade associations and on most financial web sites such as www.finance.yahoo.com or http://www.Reuters.com. All sources of industry data start with common size financial statements. Common size financial statements break out the various line items in the income statement as a percentage of sales and the balance sheet items as a percentage of total assets. The common size financial statements can provide the analyst with industry average information for the various profit margins, as well as the debt ratios. After the common size financial statements, industry average ratios are provided. For each ratio, three numbers are listed, corresponding to the lower quartile, the middle 50%, and the upper quartile for that ratio. The middle quartile would represent truly average performance, whereas the upper quartile should represent superior performance. In the front of the book of averages that you are using, check to verify that the publication is calculating the ratios in the same manner as you are. Obviously, you must use the method used by the publication for meaningful comparison.

Summary Ratio analysis can be used to attempt to measure the risk of the business (above average, below average, etc.) and to build a case for growth expectations. There is no magic formula that translates the ratios into a discount rate or a growth factor, but they do provide information that can help in the derivation of these numbers.

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