UV6586

Rev. Nov. 21, 2013

BUSINESS VALUATION: STANDARD APPROACHES AND APPLICATIONS

Determining the value of a business is critical to many important managerial decisions.

Because the future of any enterprise is uncertain, business valuations are rarely identical across
analysts. Moreover, because of the complicated nature of assessing a business value, methods
vary. In this note we review standard approaches to valuing businesses from the perspective of
the investor and practical applications of each. Although we do not treat the specific
complexities associated with combining businesses, such as in M&A analysis, we provide tools
that are foundational to such analysis.

Basic Frameworks

To set an investor-based framework for our discussion of business valuation, Figure 1

presents what might be called an investors balance sheet. This balance sheet for a business is
somewhat different from the standard total asset format published in company financial
statements in that it focuses on the net assets or total capital invested in the business by debt and
equity investors. On the left side, net assets are divided into two categories. Net working capital
captures the net investment in liquid operating assetscurrent assets less non-interest-bearing
current liabilities. Net fixed assets captures the net investment in long-term assets such as
property, plant, and equipment. The sum of these two categories is termed net assets.

Figure 1. Investors balance sheet.

(Net assets) = (Total capital)

Net working capital

Debt

Net fixed assets

Equity

This technical note was prepared by Michael J. Schill, Associate Professor of Business Administration. Portions of
this note draw on an earlier note, Methods of Valuation for Mergers and Acquisitions (UVA-F-1274). Copyright
2013 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order
copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced,
stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic,
mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -2- UV6586

While the left side of the balance sheet captures business investment by type of
investment, the right side captures business investment by type of investor. Debt captures the
amount of investment in interest-bearing debt. Debt typically includes both long-term and short-
term debt. (The short-term debt is considered a permanent part of the capital structure because it
is expected to roll over each year). Equity captures all equity investment in the firm through both
the sale of equity claims and retained earningsthe cumulative amount equity holders have
invested in the firm. The sum of debt and equity investment is termed total capital.

In this note, the business value or enterprise value of a firm is the value of either its net
assets or total capitalwhich are, by definition, equaland throughout, we use the relationship
that the enterprise value (net assets or total capital) is equal to the value of the debt plus the value
of the equity (V = D + E). To value the equity once one has estimated the enterprise value, for
example, one subtracts the value of existing debt from the enterprise value. To obtain an implied
share price, one divides the equity value by the numbers of shares of stock outstanding.

Standard Approaches

There are several ways to determine the enterprise value of a firm, each with inherent
strengths and weaknesses. A thorough business valuation considers the merits and information
contained in each.

Book value

The book value captures the cumulative investment in the enterprise to date. The book
value of net assets is obtained straight from the business balance sheet (Enterprise value = Book
debt + Book equity). If the investments are value-creating, the amount invested to acquire them
is inherently less than what they are worth, so the enterprises true value will be understated. The
book-value method depends on accounting practices that vary across firms. Because it is
backward-looking, it also ignores the firms positive or negative operating prospects. As such,
book value may be most appropriate for firms with commodity-type assets, stable operations,
and no intangible assets.

Let us say that Humphrey and Harriet Honeycutt are considering the purchase of Funky
Nut Farm, a working nut farm. Funky Nuts balance sheet reports end-of-year net working
capital (cash, accounts receivable, and inventory less accounts and wages payable) to be
$400,000 and net fixed assets (property, trees, and equipment) of $1 million. Taken together, this
puts the book value of the farms net assets at $1.4 million. The total capital used to fund the net
assets of the farm is divided equally into $700,000 in debt and $700,000 in book equity. This
base book value of $1.4 million represents a base estimate of the value of the farm.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -3- UV6586

Market value of the firms traded securities

For many firms, claims on debt (e.g., bonds) and equity (e.g., shares) are traded in a
public market; the value observed for these securities in such a market provides another
important assessment of the firms value. The market value of the common equity of a given
company, for example, can be assessed as the recent share price multiplied by the number of
outstanding shares. This method is most helpful if the stock is actively traded and followed by
professional securities analysts and if the market efficiently impounds all public information
about the company and its industry.

In business valuations, analysts commonly consider the book values of debt to be

comparable to the market value of debt. This assumption is used for two reasons: first, the
market value of firm debt is typically difficult to estimate and second, the book value of debt is
commonly not that different from the market value.

Funky Nut Farm does not have securities traded on a public market, so the Honeycutts
are not able to observe the markets assessment of the farms value, but they can observe the
markets assessment of the value of a comparable nut farm that maintains 4.19 million shares of
publicly traded equity. Shares are currently trading at $6.25, so the market value of equity is
$26.2 million [$6.25 4.19 million shares]. With its book value of debt equal to $12.3 million,
the total enterprise value for the comparable nut farm is estimated to be $38.5 million [$12.3
million + $26.2 million].

Market multiples

The market-multiple approach to valuation asserts that the value of any asset is equal to
the amount the market is paying for similar assets. To use a market multiple, one identifies some
observable characteristic of the firm that is commonly valued by the market or highly correlated
with market value. For firm valuation, current or expected firm profits are frequently used.

The Honeycutts can use a market-multiple approach to provide an additional assessment

of the farm value. They collect data on the value-to-EBIT ratio of comparable, publicly traded
nut growers and observe that they tend to trade for about 7.5 times operating profit (EBIT). Since
Funky Nut generated $200,000 in operating profit last year, the Honeycutts estimate the market-
multiple-based value of the farm to be 7.5 $200,000, or $1.5 million.

Discounted cash flow

Owners of a firm have claim on all future cash flows generated by its assets, so another
common approach is to estimate the present value of a firms future cash flows.1 Because

1
This note focuses on valuing the company as a whole (i.e., the enterprise). An estimate of equity value can be
derived under this approach by subtracting interest-bearing debt from enterprise value. An alternative method not
pursued here values the equity using residual cash flows, which are computed as net of interest payments and debt
repayments plus debt issuances. Residual cash flows must be discounted at the cost of equity.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -4- UV6586

businesses have the potential to generate cash flows over an infinite horizon, it is customary to
forecast cash flows over a specified horizon, then use a simplifying assumption to capture the
terminal value of the cash flow for the additional years. The forecast period should be as long as
one can expect abnormal profitability or growth to be maintained. Once any transitional effects
are implemented or any competitive advantage expires, the future business is assumed to move
to a competitive steady state, at which point simplifying terminal value assumptions can be
applied. A weighted average cost of capital (WACC) estimate is used as the discount rate in this
calculation. One of the merits of this discounted-cash-flow (DCF) approach is its flexibility in
modeling the inherent value of the business under any set of conditions.

The Honeycutts DCF valuation is presented later in the note. The valuation model
generates a base-case DCF valuation of $1.28 million.

Other approaches for special conditions

Liquidation value considers the current fire-sale value of the assets. This valuation
method may be appropriate for firms in financial distress or, more generally, for firms whose
operating prospects are highly uncertain. Liquidation value generally provides a lower bound to
the business valuation and depends on the recovery value of assets (e.g., collections from
receivables) and the extent of viable alternative uses for the assets.

Replacement value is based on the cost of replacing business assets in product markets.
During periods of high inflation, securities regulators often require public companies to estimate
replacement values in their financial statements.

Based on the expectation of operating this farm long term, the Honeycutts do not see
these alternative approaches as being relevant in this situation.

Variation as additional source of information

The three different valuation approaches used by the Honeycutts generate three different
values: $1.4 million for the book-value approach, $1.5 million for the market-multiple approach,
and $1.3 million for the DCF approach. The similarity of the values provides information for the
Honeycutts, suggesting a general range of $1.3 million to $1.5 million for the value of Funky
Nut. The variation in values also provides information for the Honeycutts: the market-multiple
figure may be too high because the comparable firms selected are less comparable than initially
thought, or the DCF figure may be too low because it is based on overly conservative
assumptions. By examining the variation in results, we can hone the inputs to each approach and
establish a more appropriate value.

Discounted-Cash-Flow Method in Depth

DCF valuation requires calculating the present value of a forecast of future cash flows
associated with the business. Like any DCF valuation, the valuation concept is to identify what

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -5- UV6586

amount of money could be invested today at the risk-adjusted required return to replicate the
cash flows associated with the business. To introduce the DCF basics, we detail in turn the
construction of the three components of a DCF valuation: the free-cash-flow forecast, the
terminal value, and the discount rate.

Free-cash-flow forecast

Free cash flow (FCF) is the total incremental cash flow attributable to the business. Free
cash flow is all monetary flow to the owners of the business, including debt holders and equity
holders. Free cash flow can be calculated as the sum of net operating profits after taxes
(NOPAT), plus depreciation and noncash charges, less capital expenditure in fixed assets and
incremental investment in net working capital. This calculation is expressed in the following
equation (Equation 1):

FCF = NOPAT + Depreciation CAPEX NWC (1)

where NOPAT is equal to EBIT multiplied by (1 t) where t is the appropriate marginal (not
average) corporate income tax rate. This tax rate is inclusive of all federal, state, local, and
foreign jurisdictional income taxes. NOPAT captures the earnings after taxes that are available to
all providers of capital (debt and equity investors). As such, one does not deduct financing costs
such as interest expense when calculating NOPAT. Because the tax deductibility of interest
payments is accounted for in the WACC calculation, such financing tax effects are not captured
in NOPAT. Depreciation is composed of all noncash operating charges, such as depreciation,
depletion, and amortization, that are deductible for tax reporting purposes. These items are used
to reduce operating profit to calculate taxes but are naturally added back when calculating cash
flow because they are not cash expenses. CAPEX is capital expenditures for fixed assets. NWC
is the increase in net working capital defined as current assets less the non-interest-bearing
current liabilities.2

Since an increase in net fixed assets (NFA) is equal to CAPEX less depreciation,
Equation 1 can also be defined as (Equation 2)

FCF = NOPAT NFA NWC, (2)

where this equation emphasizes that free cash flow is simply the after-tax profit of the firm less
the amount reinvested in the firm in working capital and fixed assets.

Although the mechanics are straightforward, a proper estimation of business cash flows is
not an easy task. The cash-flow forecast should fairly reflect the expectations for business
growth, profits, and asset efficiency. Care should be taken to ensure that the cash-flow forecast is
2
Net working capital includes all cash, receivables, inventory, and payables levels required for the operation of
the business. If a firm has excess cash (more than is needed to sustain operations), for example, the cash forecast
should be reduced to the level of cash required for operations. Excess cash should be valued separately by adding it
to the enterprise value since it is not part of the business operations.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -6- UV6586

fully consistent with broader macroeconomic expectations as well as industry trends and
competitive impact. Good cash-flow forecasts are grounded in the economic reality facing the
firm.

The forecast period extends over the horizon in which the analyst estimates the business
to be able to sustain abnormal profits and growth. This horizon is called the forecast period or
planning period. A convenient way to think about abnormal profit for the firm is when the
expected return on capital (ROC) of the firm differs from the cost of capital.3 Positive abnormal
profitability attracts expansion and entry into the industry sufficient to put pressure on expected
returns until they drop to meet the cost of capital. Negative abnormal unprofitability attracts
contraction and exit from the industry until the returns rise to meet the cost of capital. By
definition, the opportunity cost of capital provides the guiding benchmark for all performance
evaluation.

ROC can be decomposed into an income statement component (operating margin) and a
balance sheet component (asset turnover):

ROC = NOPAT / Net Assets

= NOPAT / Sales Sales / Net Assets (3)

Equation 3 shows that firm ROC is decomposed into a margin component

(NOPAT/Sales) and an asset-turnover component (Sales/Net Assets). In equilibrium, one expects
both margin and turnover to reach steady state.

Terminal value

A terminal value in the final year of the forecast period is added to reflect the present
value of all cash flows occurring thereafter. Because it capitalizes all future cash flow beyond the
terminal year, the terminal value can be a large component of the value of a company and
therefore deserves careful attention. This can be of particular importance when cash flow over
the forecast period is close to zero (or even negative). Such negative cash flow can be the result
of aggressive investment for growth.

A common and convenient approach to terminal value is the use of the constant-growth
model. This model requires an expectation that the financial statements of the business grow at a
constant rate into perpetuity. Under this assumption, the cash-flow values beyond the terminal
year T are expected to grow forever at a constant rate. Specifically, this means that the value of
annual free-cash-flow values for periods T + 1 to infinite is expected to behave in the following
manner, where FCFTSS + 1 is the expected steady-state free cash flow for the year following the
terminal year T or final year of the cash-flow forecast.

3
ROC = NOPAT / (Debt + Equity). This is the same as return on net assets since net assets is equivalent to total
capital.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -7- UV6586

FCFT + 2 =FCFTSS + 1 1 + g
FCFT + 3 =FCFTSS + 1 1 + g 2

FCFT + 4 =FCFTSS + 1 1 + g 3

where g is the expected steady-state growth rate of the business revenue, costs, and assets in
perpetuity. To calculate the present value of such an infinite series of cash flows with a discount
rate of R, one applies the standard discounting procedure (Equation 4).

FCFSS
T +1 FCFTSS +1 1 + g FCFTSS +1 1 + g 2 FCFSS
T + 1 1 + g
3
PVT = 1 + + + + (4)
1 + R 1 + R 2 1 + R 3 1 + R 4

Since the present value equation in Equation 4 is an infinite sum, it is problematic to evaluate.
Conveniently, under the assumption of constant growth, Equation 4 can be simplified
algebraically to Equation 5, which is known as the constant-growth model:

FCFSS
T+1
PVT = , (5)
R-g

where the free-cash-flow value used in the numerator of constant-growth valuation formula
reflects the steady-state cash flow for the year after the forecast period.

The simplicity of Equation 5 makes its use highly attractive, but it is important that the
formula not be used navely. The business must be expected to be in steady state in the terminal
year. This means that all transitional effects in the business are expected to be over, as all line
items in the financial statements of the business are expected to grow at the same steady-state
growth rate. In perpetuity, this assumption makes logical sense because, by definition, if a firm is
truly in steady state, its financial statements should be growing at the same rate. In the event they
were not, the implied financial ratios (e.g., operating margins or ROC) would eventually deviate
widely from reasonable industry norms. It is important, therefore, that the firms forecast period
be extended to a point in time where such a steady state is truly expected.4 It is also important to
acknowledge that the terminal value estimate embeds assumptions about the long-term
profitability of the business. Because the profits and assets grow at a stable rate, the terminal
ROC is estimated to remain in perpetuity. The cost of capital provides a benchmark for the
steady-state ROC. Because of competitive pressure, it is difficult to justify a firm valuation
4
The steady state may only be accurate in terms of expectations. The model recognizes that the expected
terminal value has risk. Businesses may never actually achieve steady state due to technology innovations, business
cycles, and changing corporate strategy. The understanding that the firm may not actually achieve a steady state
does not preclude the analyst from anticipating a steady-state point as the best guess of the state of the business at
some point in the future.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -8- UV6586

where the steady-state ROC is substantially higher than the cost of capital. Alternatively, if the
steady-state ROC is substantially lower than the cost of capital, one questions the justification for
maintaining the business in steady state if the assets are not earning the cost of capital.

It is also important that the steady-state free cash flow properly incorporates the
investment required to sustain the steady-state growth expectation. The steady-state cash flow
can be constructed by growing all relevant line items at the steady-state growth rate. To estimate
free cash flow we need to estimate the steady-state values for NOPAT, net working capital, and
net property, plant and equipment assuming that all line items are growing at the steady-state
growth rate. This can be done in the following manner (Equation 6):

FCFTSS + 1 =NOPATT + 1 g NWCT + PPET , (6)

as this forces NWC and PPE reinvestment to hold at the steady-state growth rate. The net assets
are multiplied by g because the cash-flow formula subtracts the difference in net assets not the
total value. This approach is superior to using difference values such as CAPEX or NWC in the
steady-state cash flow as these may not ensure the proper reinvestment to maintain a balance
sheet growing at the steady-state rate.

It is also important to be thoughtful about the magnitude of the steady-state growth rate.
Because the financial statements are effectively being forecast into perpetuity, one might assume
that the expected growth rate of the overall economy provides an upper bound for the magnitude
of the steady-state growth rate. If this were not the case, it does not take that many years of
extrapolation for the magnitude of the business operations to exceed the size of the world
economy. One way to estimate the long-term nominal growth rate for the world economy is to
use prevailing long-maturity, risk-free interest rates (i.e., long-term government bond yields). For
example, the government bond yield can be decomposed into a real rate of return (typically
between 2% and 3%) and expected long-term inflation.5 If the long-term risk-free rate was 6%,
the implied inflation is 3% to 4%.

Over the long term, companies should experience the same inflationary growth as the
economy on average, which justifies using the expected inflation from the risk-free rate as a
reasonable proxy for the expected long-term inflation rate for the cash flows. The real economic
growth in developed economies has historically been about 2% to 3%, so one can add this real
growth to the inflation expectation to generate a nominal growth rate. Thus, using the risk-free
rate to proxy for the steady-state growth rate is equivalent to assuming that the expected long-
term cash flows of the business grow with the overall economy (i.e., nominal expected growth
rate of GDP) and that the nominal rate of interest is a good proxy for the nominal rate of growth.

One might assume that the steady-state growth rate is less than the nominal growth rate
for the world economy. For example, a business may be constrained from building new capacity

5
The 2% to 3% real rate of interest is observed empirically from the yields on inflation-protected government
securities, such as TIPS in the United States.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -9- UV6586

such that the cash flows grow only with expected inflation. Under this scenario, the steady-state
growth rate is the long-term expected inflation rate. It is worth noting that, even if capacity is not
expanded, investment must keep up with growth in profits to maintain a constant expected rate of
operating returns.

Discount rate

The discount rate used to value the cash flows should compensate the investor for the risk
of the cash flows. An appropriate discount rate reflects the opportunity cost of making alternative
investments of similar risk. This opportunity cost of capital is commonly estimated using the
WACC for the various forms of financing of the assets such as debt and equity. The appropriate
rate is estimated by taking a weighted average of the required rates of return on debt and equity,
weighted by their proportion of the firms market value in the following way (Equation 7):

WACC = Wd kd (1 t) + We ke, (7)

where

Wd, We are the appropriate proportions of debt and equity in the capital structure6
kd is the cost of debt capital
t is the marginal tax rate
ke is the cost of equity capital.

To reflect the opportunity cost of the investors positions in the business, the capital-
structure weights that reflect market values are most informative. In order to avoid penalizing an
investment opportunity with a sub-optimal capital structure, the WACC incorporates the
appropriate target weights of financing going forward. The costs of debt and equity are forward-
looking market rates of return. The costs of debt and equity are denominated in the same
currency as the respective cash flow and reflect the same expected inflation. For debt securities,
this forward-looking rate can be approximated with the yield to maturity on the respective bonds.
One common approach for estimating the cost of equity is with the capital asset pricing model
(CAPM) in Equation 8:

ke = Rf + (MRP) (8)

where Rf is the expected return on risk-free securities over a time horizon consistent with the
investment horizon. Most firm valuations are best served by using a long-maturity government
bond yield as it reflects long-term inflation expectations. Beta () is a measure of the systematic
risk of a firms common stock. The beta of common stock includes compensation for business

6
Debt for purposes of the WACC should include all permanent, interest-bearing debt. If the market value of
debt is not available, the book value of debt is often assumed as a reasonable proxy. The shorter the maturity of the
debt and the closer the correspondence between the coupon rate and required return on the debt, the more accurate
the approximation.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -10- UV6586

and financial risk. MRP is the expected market risk premium. The expected market risk premium
measures the additional return required by investors to hold a portfolio with beta risk equal to 1.
As it is not readily observable, this value is difficult to estimate. One common assumption is to
rely on the historical realized market return premium to approximate a forward-looking expected
premium. To obtain a historical return premium it is common to use a portfolio of stocks to
proxy for the market portfolio and long-maturity government bonds to proxy for the risk-free
rate. For example, Ibbotson Associates reports that the arithmetic mean return for large
capitalization U.S. equities over the 1926 to 2011 period is 11.8%. They report the arithmetic
mean return for long-term government bonds is 6.1%. The difference between the two implies a
historical market-risk premium of 5.7%. Such a figure provides a reasonable estimate of the
market risk premium.7

As the cost of capital is commonly estimated with imprecision, additional precision can
be obtained by computing WACC estimates for comparable firms. By using the betas and
financial structures of firms engaged in this line of business, a reliable estimate of the business
risk and optimal financing can be established going forward. The average or median estimate
from such a sample provides a valuable estimate of the cost of capital.

Sometimes a firm may intend to increase or decrease the debt level of the firm
significantly in the future, perhaps because it believes the current financing mix is not optimal.
To adjust the financial risk embedded in the beta, one can lever or unlever the estimate of the
firm beta, or the beta of a comparable firm using the following relation (Equation 9):

L = u [1 + (1 t) D/E] (9)

where L is the levered-beta estimate, u is the unlevered-beta estimate, and D/E is the debt-to-
equity ratio.

7
For a less U.S.-centric estimate of the market risk premium, the difference in arithmetic means for portfolios
of worldwide stocks and government bonds over the 1900 to 2010 period was 5.0%. See Elroy Dimson, Paul Marsh,
and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns (Princeton, NJ: Princeton
University Press, 2002) and subsequent research.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -11- UV6586

Example of the DCF method

We now examine a DCF valuation of Funky Nut Farm. The Honeycutts begin with a
forecast of farm cash flows over the next five years (Table 1).

Table 1. Valuation of Funky Nut Farm (figures in thousands).

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

1 Revenue Growth 5.0% 0.0% 2.0% 5.0% 4.0% 3.0%
2 Gross Margin 36.2% 34.0% 35.0% 36.0% 36.5% 36.5%
3 SG&A 23.0% 27.0% 26.0% 25.0% 24.0% 23.0%
4 Depreciation/PPE 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
5 NWC Turnover 5.3 4.8 4.9 5.0 5.1 5.2
6 PPE Turnover 2.1 1.8 1.9 2.0 2.0 2.0
7 Tax Rate 35%
8 Discount Rate 8.0%
9 Terminal Growth Rate 2.0%

Calculation Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

10 Revenue 2,100 2,100 2,142 2,249 2,339 2,409
11 COGS 12 - 10 1,340 1,386 1,392 1,439 1,485 1,530
12 Gross Profit 10 x 2 760 714 750 810 854 879
13 SG&A Expense 10 x 3 483 567 557 562 561 554
14 Depreciation 18 x 4 100 117 113 112 117 120
15 Operating Profit 12 - 13 - 14 177 30 80 135 175 205
16 NOPAT 15 (1 - 7) 115 20 52 88 114 133

17 Net Working Capital 10 / 5 400 438 437 450 459 463

18 Net PP&E 10 / 6 1,000 1,167 1,127 1,125 1,170 1,205
19 Return on Capital 16 / (17 + 18) 8.2% 1.2% 3.3% 5.6% 7.0% 8.0%

20 NOPAT 16 20 52 88 114 133

21 Add: Depreciation 14 117 113 112 117 120
22 Less: Capital Expenditures Change in 18 + 14 283 73 110 162 156
23 Less: Increase in NWC Change in 17 38 0 13 9 5
24 Free Cash Flow 20 + 21 - 22 - 23 -184 92 78 60 93
25 Year 6 Steady-State FCF 20 (1 + 9) - (17 + 18) 9 102
26 Terminal Value 25 / (8 - 9) 1,702
Discounted Cash Flow -171 79 62 44 1,221

Enterprise Value 1,235

The transition effects of farm operations are built into the forecast. The Honeycutts
estimate that the current revenue of $2.1 million will remain flat over the coming year and then
grow at 2% in Year 2, 5% in Year 3, 4% in Year 4, and 3% in Year 5. They estimate that the
gross margin will drop to 34% in Year 1 and then improve each year through Year 4. They
forecast SG&A expense to increase to 27% of revenue in Year 1 and then drop by a percentage

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -12- UV6586

point each year. Depreciation is modeled as 10% of net PP&E. The asset balances are estimated
to increase from 4.8 times net working capital turnover and from 1.8 times PPE turnover.8 The
tax rate for farm income is 35%. Based on these assumptions, the farm financial forecast shows
NOPAT growing to $133,000 in Year 5 and net assets growing from the current $1.4 million to
$1.7 million in Year 5. The ROC value climbs from 1.2% in Year 1 to 8.0% in Year 5. The fact
that the ROC is expected to be approximately equal to the 8.0% cost of capital suggests that the
business is expected to be in a normal state of profitability, consistent with steady state.

Based on the financial forecast, the annual cash-flow forecast is computed with a free
cash flow of $184,000 in Year 1, $92,000 in Year 2, $78,000 in Year 3, $60,000 in Year 4, and
$93,000 in Year 5. The low cash flow in Year 1 comes from both the low operating profits and
the high asset investment in that year. The discount rate used to value the cash flows is 8.0%. As
detailed in Table 2, this rate is computed based on the average WACC of three publicly traded
companies with comparable risk characteristics.

Since the farm is expected to generate value beyond Year 5, the Honeycutts use the
constant-growth model to estimate the terminal value. To do so, they estimate a terminal Year 6
steady-state cash flow with the assumption that the financial statements will grow at a steady-
state growth rate of 2.0%. Since the farm is constrained by a fixed amount of property, they
assume that the cash flows will not grow in real terms but simply with inflation. Subtracting a
2% estimated real interest rate from the 10-year Treasury yield of 4% gives a 2% estimate of
long-term expected inflation. The 2% steady-state growth rate imbeds an assumption that the
farm cash flows will grow only with inflation. Using this assumption they calculate a steady-
state free cash flow for Year 6 of $102,000. This value is calculated as the Year 5 NOPAT of
$133,000 multiplied by 1 plus the steady-state growth rate, less the Year 5 net assets of $1.668
million multiplied by the steady-state growth rate as in Equation 6. Dividing the steady-state
cash flow by the discount rate less the growth rate generates a terminal value of $1.702 million.

Table 2. Calculation of WACC for publicly traded comparable companies.

10-year government bond yield 4.7%
Market risk premium 5.0%
Earthy Nut Quirky Nut Normal Nut
Cost of d ebt 6.1% 5.9% 6.1%
Tax rate 35% 35% 35%
After-tax cost of debt 4.0% 3.8% 4.0%

Beta 1.1 0.9 1.2

CAPM cos t of equity 10.2% 9.2% 10.7%

Debt/v alue 0.32 0.25 0.40

WACC 8.2% 7.9% 8.0%

8
NWC turnover and PP&E turnover is defined as Revenue/NWC and Revenue/PP&E, respectively.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -13- UV6586

Discounting the cash-flow forecast and terminal value at 8% produces a DCF enterprise
value of $1.24 million. This $1.2 million value includes cash flows that go to both debt and
equity holders. If the Honeycutts are not buying out debt holders, they can estimate the equity
value by subtracting the value of debt from enterprise value (E = V D).

Advantages of DCF

The DCF method focuses on cash flow, not profits, so it is forward-looking rather than
tied to historical accounting values. It fairly recognizes the time value of money. It is highly
flexible in that it allows private information or particular scenarios to be incorporated explicitly
into the valuation. It allows the specific business operating strategy to be incorporated explicitly.
It embodies the operating costs and benefits of intangible assets.

That said, it is important to recognize that virtually every number used in a DCF
valuation is measured with error. Because of uncertainty about the future, no valuation is right
in any absolute sense. Consequently, one should use several scenarios about the future to get a
feel for the key bets that underlie the business valuation.

Market-Multiple Method in Depth

Market multiples are derived from relative valuation metrics based on comparable
publicly traded companies. The logic behind a market multiple is to use the markets relative
valuation metrics for an entity comparable in risk and growth prospects. The basis used for the
relative valuation metric should be something that is readily observable and highly correlated
with market value. For example, in the real estate market, dwellings are frequently priced based
on the prevailing price per square foot of comparable properties. The assumption made is that the
size of the house is correlated with its market value. Since square footage is readily observable,
the house square footage provides a good valuation basis. If comparable houses are selling at
$100 per sq. ft., the market value for a 2,000-sq.-ft. house is easily valued at $200,000. For firm
valuation, current or expected profits are frequently used as the basis for relative market-multiple
approaches.

Suppose the Honeycutts examine the three publicly traded comparable nut growers:
Earthy Nut, Quirky Nut, and Normal Nut. The respective financial and market data that apply to
these companies is shown in Table 3. The enterprise value for each comparable firm is estimated
as the current share price multiplied by the number of shares outstanding (equity value) plus the
book value of debt. Taking a ratio of the enterprise value divided by the operating profit (EBIT),
we obtain an EBIT multiple. In the case of Earthy Nut, the EBIT multiple is 7.7, meaning that
for every $1 in current operating profit generated by Earthy Nut, investors are willing to pay $7.7
of firm value. If Earthy Nut is similar today to Funky Nut, the 7.7 EBIT multiple can be used
to estimate the value of Funky Nut.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -14- UV6586

Table 3. Financial and market data for comparable growers.

Earthy Nut Quirky Nut Normal Nut

Recent g rowt h ra t e 5% 6% 12%

Revenue 50.0 77.0 60.0

Operating profit (EBIT) 5.0 6.6 4.7
Net profit 2.8 3.3 2.8

Debt value 12.3 17.9 11.1

Equity value 26.2 30.5 33.4
Enterprise value 38.5 48.3 44.6

Enterprise value / EBIT 7.7 7.3 9.4

Equity value / n et p rofit 9.5 9.2 11.8

To reduce the effect of outliers on the EBIT-multiple estimate, we use information

provided from a sample of comparable multiples. In sampling additional comparables, we are
best served by selecting multiples from among only those firms that are comparable to the
business of interest on the basis of business risk and profitability and growth expectations. The
Honeycutts note that Normal Nuts EBIT multiple of 9.4 is substantially higher than the others
in Table 3. Why should investors be willing to pay so much more for a dollar of Normal Nuts
operating profit than for a dollar of Earthy Nuts operating profit? They observe that Normal Nut
is in a higher growth stage than Earthy Nut and Quirky Nut. If Normal Nuts profits are expected
to grow at a higher rate, the valuation or capitalization of these profits will occur at a higher level
or multiple. Investors anticipate higher future profits for Normal Nut and consequently bid up the
value of the respective capital. (For an example of the relationship between market multiples and
the constant-cash-flow growth model, see Appendix.)

Because of Normal Nuts abnormally strong expected growth, the Honeycutts conclude
that Normal Nut is not a good comparable for Funky Nut. They choose, consequently, to not use
the 9.4 EBIT multiple in their value estimate. They conclude instead that investors are more
likely to value Funky Nuts operating profits at approximately 7.5 (the average of 7.7 and
7.3).

Other commonly used multiples that are appropriate for free-cash-flow valuation include
EBITDA (earnings before interest, tax, depreciation, and amortization), free cash flow, and total
capital multiples. In identifying an appropriate valuation multiple, one must be careful to choose
one consistent with the underlying earnings stream of the entity. For example, the price-earnings
or P/E multiple compares the value of the equity to the value of net income. In a valuation model
based on free cash flow, it is typically inappropriate to use multiples based on net income
because these value only the equity portion of the firm and assume a certain capital structure.9

9
Only in the case of a company not using debt would the P/E ratio be an appropriate multiple.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -15- UV6586

Although the market-multiple valuation approach provides a convenient, market-based

approach for valuing businesses, there are a number of cautions worth noting:

1. Multiples can be deceptively simple. Multiples should provide an alternative way to

triangulate toward an appropriate long-term growth rate and not a way to avoid thinking
about the long-term economics of a business.
2. Market multiples are subject to distortions due to market misvaluations and accounting
policy. Accounting numbers further down in the income statement (such as net earnings)
are typically subject to greater distortion than items high on the income statement.
Because market valuations tend to be affected by business cycles less than annual profit
figures, multiples can exhibit some business-cycle effects. Moreover, business profits are
negative, and the multiples constructed from negative earnings are not meaningful.
3. Identifying closely comparable firms is challenging. Firms within the same industry may
differ greatly in business risk, cost and revenue structure, and growth prospects.
4. Multiples can be computed with different timing conventions. Consider a firm with a
December 31 fiscal year (FY) end that is being valued in January 2012. A trailing EBIT
multiple for the firm would reflect the January 2012 firm value divided by the 2011 FY
EBIT. In contrast, a current-year EBIT multiple (leading or forward EBIT multiple) is
computed as the January 2012 firm value divided by the 2012 EBIT (expected end-of-
year 2013 EBIT).10 Because leading multiples are based on expected values, they tend to
be less volatile than trailing multiples. Moreover, leading and trailing multiples will be
systematically different for growing businesses.

An additional use of market multiples is in the estimation of terminal value. To estimate

Funky Nuts terminal value based on our average EBIT multiple, one can multiply the Year 5
stand-alone EBIT of $205,000 by the average comparable multiple of 7.5. This process
provides a multiple-based estimate of Funky Nuts terminal value of $1.54 million. This estimate
is somewhat below the constant-growth-based terminal value estimate of $1.70 million. The
variation in estimated values should prompt questions on the appropriateness of the underlying
assumptions of each approach.11 For example, the differences in terminal value estimates could
be due to one of the following:

1. The use of comparable multiples that fails to match the expected risk, expected growth,
or macroeconomic conditions of the target company in the terminal year
2. The use of a comparable multiple that does not reflect the conditions of terminal state of
the valuation business
10
Profit figures used in multiples can also be computed by cumulating profits from the expected or most recent
quarters.
11
We assume in this example that current multiples are the best proxies for future multiples. If there is some
reason to believe that the current multiple is a poor or biased estimate of the future, the market multiples must be
adjusted accordingly. For example, if the current profits are extraordinarily small or large, a multiple based on such
a distorted value will produce an artificial estimate of the expected future value. A more appropriate multiple will
use an undistorted or normalized profit measure.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -16- UV6586

3. A forecast period that is too short to have resulted in steady-state performance

4. An assumed constant-growth rate that is lower or higher than that expected by the market

The potential discrepancies motivate further investigation of the assumptions and

information contained in the various approaches so that the analyst can triangulate to the most
appropriate terminal-value estimate.

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.
 -17- UV6586

Appendix
BUSINESS VALUATION: STANDARD APPROACHES AND APPLICATIONS
Description of Relationship Between Multiples of Operating Profit and Constant-Growth Model

One can show that cash-flow multiples such as EBIT and EBITDA are economically
related to the constant-growth model. For example, the constant-growth model can be expressed
as follows:

FCF
V
WACC g

Rearranging this expression gives a free-cash-flow multiple expressed in a constant-

growth model:

V 1

FCF WACC g

This expression suggests that cash-flow multiples are increasing in the growth rate and
decreasing in the WACC. In the following table, one can vary the WACC and growth rate to
produce the implied multiple.

WACC
8% 10% 12%
0% 12.5 10.0 8.3
Growth

2% 16.7 12.5 10.0

4% 25.0 16.7 12.5
6% 50.0 25.0 16.7

This document is authorized for use only in Jorge Rojas's 201702 Valuation Challenge I course at Universidad Francisco Marroquin (UFM), from February 2017 to August 2017.