UNIVERSITY of SAN CARLOS TECHNOLOGICAL CENTER

Nasipit, Talamban, Cebu City, 6000 Cebu, Philippines

A Written Report on
Chapter 14 The Valuation Challenge in Entrepreneurship

Submitted to:
Engr. Bernabe Ponla
Subject Instructor
IE ELEC 3 Entrepreneurship
Department of Industrial Engineering

Submitted by:
Chua, Felixter Leone
Pacio, Lance Brandon
Vasnani, Neelesh
BSIE 5

Submitted on:
October 8, 2016

Business Valuation calculating a business exact value

Useful when:

Buying or selling a business/department or major assets

Offering stock or profit sharing plans to employees
Raising capital through loans and stocks
Determining various tax liabilities
Giving out stocks
Structuring buy/sell agreements
Buying out a partner
Going public

Underlying Issues when acquiring a venture (and why valuation is important)

Goals of the Buyer and Seller players might value the property

differently due to their goals.

Emotional Bias often on the sellers side, sentimental attachment
Reason(s) for acquisition the buyers side, there are many reasons to
buy a property, but the buyer must stay follow his objectives and
assimilate his assets and efforts

Because of this, it is important to evaluate an acquisition

ROI
Difficulties during the transition period
Risks involved during the transaction; change of interest rates
Number of potential buyers
Effect on firm value if a turnaround in required
Key personnels intention to stay
Tax

Due Diligence a thorough analysis of every facet of a business. There is a

due diligence format. Each major segment or section has question needed to
be objectively answered. Potential is a very important aspect to look into, but
future trends of the business and its industry is vital. Furthermore, looking at
how much capital is necessary to keep the business is also important (e.g.
repairs, inventory, working capital, etc.)

Chapter 14 The Valuation Challenge in Entrepreneurship

Major questions in Due Diligence

Why is the business being sold?

Physical condition of the business?
How many key personnel will remain?
Degree of Competition in the industry?
Conditions for the lease? (if any)
Do any liens against the business exist?
Will the owner/seller sign a covenant to not compete?
Are any special licenses required?
Future trends of the business and its industry?
How much?

Analyzing the Business

In analyzing small businesses, we should not compare these to large
corporations since there are factors like valuation methods that are useless
to large corporations but of high importance to small businesses. These are
due to their (small businesses) common shortcomings including: (1) Lack of
Management

Depth,

(2)

Undercapitalization,

(3)

Insufficient

Controls, and (4) Divergent Goals between Owners.

With these shortcomings, careful analysis is required. Thus, small
business owners or entrepreneurs who are about to purchase a small
business shall look into particular information which are key in objectively
evaluating a probable business venture. From the information required in
composing an effective business plan, some of these key things to evaluate a
business venture is as follows: Business History, Market Competition,
Sales

and

Distribution,

Manufacturing,

Facilities,

Employees,

Ownership, Management, and Financial Aspect.

Valuation Methods
In this chapter, we will be focusing on three methods which are
considered principal measures for business valuations, namely: (1) Adjusted
Tangible Book Value, (2) Price/Earnings Ratio Method, and (3) Discounted
Earnings Method. However, before we focus our attention into these principal

Chapter 14 The Valuation Challenge in Entrepreneurship

methods, let us first get familiar with these various valuation methods
presented below.
1. Fixed Price Two or more owners set the business initial value based
what they think it is worth using figures from any one or a combination
of methods. However, this may cause inaccuracies due to personal
estimates.
2. Book Value Also known as Balance Sheet Method.
2a. Tangible Book Value Net worth of the firm which is total
assets less total liabilities
2b. Adjusted Tangible Book Value Similar to Tangible Book
Value; however, adjustments are considered making it more
accurate.
3. Price/Earnings Ratio (Multiple Earnings) More common with
public corporations. Capitalization rates vary depending on the firms
growth (High-growth: lower rate while Stable: higher rate) 15%
capitalization rate is often used.
4. Discounted Future Earnings Projects the future earnings of the
business

then

calculates

the

present

value

using

the

discounted/interest rate.
5. Return on Investment (ROI) Shows the percent of the investment
returned from the net profit of a specific period. Net profit divided by
the investment.
6. Replacement Value This is useful when selling the company. This is
the firms worth as if it is built from scratch where in inflation and
depreciation of assets are considered.
7. Liquidation Value Assume business ceases operation where it
reflects the net amount of the firm after payment of all liabilities. The
net amount is then distributed to shareholders.
8. Excess Earnings Very seldom used and method of last resort when
no better method is available. Although used to determine a firms
intangible assets, this method does not include intangibles with
estimated useful lives (e.g. patents).

Chapter 14 The Valuation Challenge in Entrepreneurship

9. Market Value Valuable only as a reference point to another similar

firm. However, it is difficult to find similar firms, which has recently
been sold, as a comparison.
Out of the several methods discussed above, there are three major
methods that are considered the principle measures in current business
valuations: (1) Adjusted Tangible Book Value (2) Price/Earnings and (3)
Discounted Future Earnings.
1. Adjusted Tangible Book Value Method
- Computes the net worth as the difference between the total assets
-

and total liabilities.

It is important to adjust for certain assets in order to test the true
economic worth, because inflation and depreciation affect the value
of some assets. These adjustments reflect in the balance sheet or

income statements. Some examples of these adjustments are:

o Bad debts
o Low interest, long term debt securities
o Investments in affiliates
o Loans and advances to employees or other parties
In computing the adjusted tangible book value, goodwill, patents,
deferred financing costs, and other intangible assets are considered
as upward or downward adjustments. These adjustments reflect the
fair market value of the assets, which eliminate some inaccuracies
in the value of the assets.

Example:
Book Value

Fair Market Value

Net Assets
Inventory

Php 1,000,000.00

Php

Php 4,000,000.00

Php

1,250,000.00
Plant and equipment
5,000,000.00
Net Liabilities

(Php 200,000.00)

Chapter 14 The Valuation Challenge in Entrepreneurship

(Php 200,000.00)

Business Value or Net Worth

Php 4,800,000.00

Php

6,050,000.00
Excess: Php 1,250,000.00
It can be seen in the example above that after the adjustments, the
business value is Php 6,050,000.00. Without the adjustments, the business
value would have been Php 4,800,000.00. Hence, the adjustments can make
a big difference in the net worth of a business. It is also important to note
that the liabilities are not adjusted anymore, because the adjustments are
only applicable to assets.
2. Price/Earnings Ratio (Multiple of Earnings) method
- Usually used for valuing public corporations
- Simplest of the three principle methods
- For public corporations, the valuation is determined by multiplying
the price/earnings ratio to the number of common shares, wherein
the price/earnings ratio is the market price of each common stock
divided by the earnings per share.
Example: A company has 100,000 shares of common stock that
cost Php 5.00 each. The companys net income is Php 100,000. Find
the valuation of the company using the price/earnings ratio method.
Solution:
B usiness Value=Price Earnings RatioNumber of Common Shares
Business Value=
Business Value=

Market Price per stock

Number of Common Shares
Earnings per share
Market Price per stock
Number of Common Shares
Net Income
Number of Shares

Business Value=

Php 5.00
100,000
Php100,000
= Php 500,000
100,000

Chapter 14 The Valuation Challenge in Entrepreneurship

Private companies do not have open stock prices in the market, so

they have to use a multiple derived from a similar public
corporation. This approach has 4 major drawbacks:
o The stock of a private company is not publicly traded.
o The stated net income of a private company may not truly
reflect its actual earning power.
o The sale of a large controlling block of stock of closely held
business can command a premium.
o It is very difficult to find a truly comparable publicly held

company, even in the same industry.

3. Discounted Earnings Method
- Relies on potential earning power of the company. Most analysts
agree that this accurately determines the true value of the firm and
-

is often useful during acquisitions.

Idea is that dollars earned in the future are worth less than the
present (due to loss of purchasing power), thus creating a need to

discount cash flows.

This method has 4 steps involved:
o Step 1: Expected cash flow is estimated
o Step 2: An appropriate discount rate is determined. The
buyer
o Step 3: A reasonable life expectancy of firm is determined
o Step 4: The firms value is determined by discounting the
estimated net cash flow by the appropriate discount rate over
the expected life of the business. It is simply getting the
present worth of the business using cash flows and a discount
rate.

Term Sheets in Venture Valuation

-

Investors look at this document before infusing capital in any

venture.
Outlines the material terms and conditions of a venture agreement
and guides legal counsel in the preparation of a proposed final
agreement.

Chapter 14 The Valuation Challenge in Entrepreneurship

Are very similar to letters of intent (LOI) in that they are both
preliminary, mostly nonbinding documents meant to record two or
more parties intentions to enter into a future agreement based on
specified (but incomplete or preliminary) terms. Term sheets are
direct and in bullet point format, while LOI is a written in letter form

and focuses on the intentions in greater detail.

Common terminologies found in a term sheet:
o Valuation Net worth declared by the company
o Fully Diluted Valuation is computed on a fully diluted basis,
meaning all securities (such as preferred stocks, warrants
etc.) are included in the total number of common shares.
o Type of Security Convertibility of the investors stocks
o Liquidation Preference fixed amount of money that all
stockholders receive prior to the selling or liquidation of the
company.
o Dividend Preference stock dividend percentages for each
stockholder
o Redemption The price any party (investor or company)
would have to pay should it want to retire a certain stock.
o Conversion Rights the rights to convert common stocks to
preferred stocks and vice versa.
o Antidilution Protection price of converting stock should
remain open to negotiation.
o Voting Rights The ratio of stocks a party holds in the
company is directly proportional to its voting rights.
o Right of First Refusal holders of stocks can still purchase
additional stocks
o Co-Sale Right Investors get protection that founder is not
simultaneously selling to a third party.
o Registration Rights Investors get the right to sell their
stocks as soon as they register for those stocks.
o Vesting on a Founders Stock When the founder leaves
the company, the company can purchase the stocks owned by
the founder.

Additional Factors in the Valuation Process

Chapter 14 The Valuation Challenge in Entrepreneurship

These factors also have a significant impact to the final valuation of the
business venture.

Avoiding start-up costs

Buyers are willing to pay more than the evaluated price for
an existing firm to avoid start-up costs.

Accuracy of projections
The sales and earnings of a venture are always projected
on the basis of historical financial and economic data.

Control factor
The degree of control an owner legally has over the firm
can affect its valuation; more control, more value.

In the end, the business valuation depends on so many factors. The

best that can be done is to use the accepted methods as a guide in order to
accurately estimate the valuation. In many situations, it also comes down to
the negotiation and agreement between buyer and seller during the
purchase or sale of a venture.
------------------------- Price is what you pay. Value is what you get. Warren Buffet
-----------------------

Chapter 14 The Valuation Challenge in Entrepreneurship