Business Valuation using Financial

Statements (BVFS)
Prof. Vaidya Nathan
Term 6, November 2019
Price and Value are different
Do not confuse Price and Value. They are not the same.

Price
Value

Price is what you pay, Value is what you get.

If the Price paid is less than the Value derived, it’s a good investment.
Some of the many uses of valuation

Divestitures Fairness opinions

How much should we sell Is the price offered for the
our company or division company fair (from a
for? financial point of view)?

Hostile defense
Acquisitions Is our company
How much should we pay to undervalued and therefore
buy the company? vulnerable to a corporate
takeover?

Valuation
Research New business presentations
Should our clients buy, sell How much is the start-up
or hold positions in a given worth? (from Entrepreneur
security? or VC/PE perspective)

Debt offerings Public equity offerings

What is the asset value of For how much should we
firm against which debt is sell our company for in the
being issued? public market?
Misconceptions about Valuation

Myth: A valuation is an objective search for “true” value.

Truth: All valuations are biased. The only questions are how
much and in which direction.
Truth: The direction and magnitude of the bias in your
valuation is directly proportional to who pays you and how
much you are paid.
Misconceptions about Valuation

Myth: A good valuation provides a precise estimate of value.

Truth: There are no precise valuations.
Truth: The payoff to valuation is greatest when valuation is
least precise.
Misconceptions about Valuation

Myth: The more quantitative a model, the better the valuation.

Truth: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
Truth: Simpler valuation models do much better than complex
ones.
 The Roadmap Valuation for Start-ups & Conclude (Lecture 9)

Trading and Transaction Comps (Lecture 8)

Valuation for Buyouts LBO/MBO (Lecture 7)

Enterprise Value and FTE (Lecture 6)

Firm Value & WACC (Lecture 5)

Cost of Equity (Lecture 4)

Analytical ISBS for Valuation

(Lecture 3)

Cash Flow Method of

Balancing (Lecture 2)

Roadmap uses the natural steps in the Introduction to Valuation &

valuation process Integrated Financial
Statements (Lecture 1)
Modular approach in the Course
If the valuation process has a story, think of having the story told in
“chapters” i.e., in separate distinct modules.
In this modular approach, the blocks of the valuation process perform
interrelated but distinct operations within them.
More often that not, each block’s results are read by the next block, and
so on.
This makes it easy to put together a logical and structured process to
learn valuation.
It also makes the valuation process easier to implement, since we can
work within one module in each lecture.
We implement the modular approach in the course and learn hands-on
using in-class exercises so that the course is not mere theory.
In the valuation process the devil lies in the details, so the focus will be
on the details as much as on the big picture.
Business Valuation using Financial
Statements (BVFS)
Prof. Vaidya Nathan
Lecture 1, November 2019
Questions we answer in this lecture
How to forecast the financial statements of any corporation?
How to make sure that the balance sheet balances?
How to determine the future financing need of a corporation
next year or say, three years from now?
How much dividends or share buyback can a corporation
afford to do given its current cash position?
How much equity does a start-up needs to raise to be able to
survive for the next couple of years?
How much cash burn can a startup afford, say, next year or
the year after next?
Historical Balance Sheets are
balanced by definition

But Valuation is not done using historical cash flows:)

Projected Balance Sheet
Liabilities & Shareholder Equity Assets
Accounts Payable Excess Cash
Other Current Liabilities Operating Cash
Current Liabilities Short-term Investments
Revolver Accounts Receivables
Short-term Debt Inventory
Long-term Debt Other Current Assets
Other Long-term Liabilities such as DTL Current Assets
Total Liabilities
Preferred Stock Net PPE
Common Stock Intangibles
Retained Earnings Long-term Assets
Total Shareholders’ Equity Total Assets
Forecasted Balance Sheet need not
necessarily balance!

Surplus Funds Need To Finance

Liabilities
Liabilities

Assets Assets

Shareholders’ Shareholders’
Equity Equity
Surplus Funds (SF) and Necessary to
Finance (NTF)
First method of balancing called the Balance Sheet Method: Calculate the difference of Total
Liabilities and Equity and Total Assets.

Positive number is a Surplus Funds (SF) and negative number is a Necessary to Finance (NTF).

Surplus Funds Need to Finance

Liabilities
Liabilities

Assets Assets

Shareholders’ Shareholders’
Equity Equity
Project a Balance Sheet
(₹ crores) Actual Projected--> Actual Projected-->
Income Statement 31-Mar-19 31-Mar-20 31-Mar-21 31-Mar-22 31-Mar-19 31-Mar-20 31-Mar-21 31-Mar-22
Revenues ₹ 100.00 10% 10% 10% ₹ 100.00
COGS % of Revenues 60% 60% 60% 60% ₹ 60.00
EBITDA ₹ 40.00
Depreciation % of last year's Net Fixed Assets ₹ 6.50 10% 10% 10% ₹ 6.50
EBIT ₹ 33.50
Interest Income on Surplus Funds ₹ 0.00 5% 5% 5% ₹ 0.00
Interest Expense on Debt & NTF ₹ 5.00 10% 10% 10% ₹ 5.00
Profit Before Tax ₹ 28.50
Effective Tax Rate 25% 25% 25% 25% ₹ 7.17
Net Income ₹ 21.33
Dividend payout ratio (% of Net Income) 10% 10% 10% 10%
Addition to Retained Earnings

Capex (% of last year's Revenues) 20% 25% 30%

Balance Sheet 31-Mar-19 31-Mar-20 31-Mar-21 31-Mar-22 31-Mar-19 31-Mar-20 31-Mar-21 31-Mar-22
Surplus Funds (SF) ₹ 0.00 ₹ 0.00
Operating Cash ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00 ₹ 5.00
Accounts Receivable ₹ 18.00 60 60 60 ₹ 18.00
Inventory ₹ 7.00 40 40 40 ₹ 7.00
Net Fixed Assets ₹ 70.00 ₹ 70.00
Total Assets ₹ 100.00 ₹ 100.00

Accounts Payable ₹ 5.00 30 30 30 ₹ 5.00

Necessary to Finance (NTF)
Long Term Debt ₹ 45.00 ₹ 40.00 ₹ 35.00 ₹ 30.00 ₹ 45.00
Equity ₹ 50.00 ₹ 50.00
Total Liabilities ₹ 100.00 ₹ 100.00
Schematic of balancing method

Income Statement

Net Income

Liabilities

Net Income flows into the

Retained Earnings account Assets
in SH Equity

Shareholders’
Equity
Integrated Model: Iteration 0
Balance Sheet Income Statement

Revolver₹10
Revolver ₹0

Liabilities
₹60 Interest Expense
+₹0
Assets
₹100

Shareholders’ Net Income

Equity −₹0
₹30
Integrated Model: Iteration 1
Start Here Balance Sheet Income Statement
Revolver Begin ₹10
Revolver End ₹11

Liabilities
₹60
Interest Expense
+₹1
Assets
₹100

Shareholders’ Net Income

Equity −₹1
₹29

Beginning Equity Assuming 10% interest cost

₹30 No Income Tax
Integrated Model: Iteration 2
Start Here Balance Sheet Income Statement
Revolver Begin ₹11
Revolver End ₹11.1

Liabilities
₹60
Interest Expense
+₹1.1
Assets
₹100

Shareholders’ Net Income

Equity −₹1.1
₹28.9

Beginning Equity Assuming 10% interest cost

₹30 No Income Tax
Integrated Model: Iteration 3
Start Here Balance Sheet Income Statement
Revolver Begin ₹11.1
Revolver End ₹11.11

Liabilities
₹60
Interest Expense
+₹1.11
Assets
₹100

Shareholders’ Net Income

Equity −₹1.11
₹28.89

Beginning Equity Assuming 10% interest cost

₹30 No Income Tax
Results of Iterations (without taxes)
Iteration Beginning Interest at 10% (B) = Ending Revolver (C) Incremental change
Revolver (A) 10% x (A) = ₹10 + (B) in Revolver

0 ₹0 ₹0 ₹0 ₹0

1 ₹10 ₹1 ₹11 ₹1

2 ₹11 ₹1.1 ₹11.1 ₹0.1

3 ₹11.1 ₹1.11 ₹11.11 ₹0.11

4 ₹11.11 ₹1.111 ₹11.111 ₹0.111

5 ₹11.111 ₹1.1111 ₹11.1111 ₹0.1111

You need Circularity for more
accurate Financial Forecasting
What is a Circular Error?
A formula that includes itself in its formula

Surplus Circular Error, See CIRC Necessary to

Funds CIRC, See Circular Error Finance

The two warning signs

▪ 0 in a formula when you know the answer
should be some other number
▪ The Circular message on the status bar
Why do you need circularity?
Schematic of balancing method
involving Circularity

2. Which creates interest income 3. Interest income adds to net income

1. SF plug appears 4. Net income adds to retained earnings

Surplus Funds

Liabilities 5. Which adds to Shareholder Equity

Assets

Shareholders’
6. Which makes SF increase even more
Equity
Schematic of balancing method
involving Circularity

2. Which creates interest expense 3. Interest expense reduces net income

1. NTF plug appears 4. Less net income flows to retained earnings

NTF

Liabilities 5. Which reduces Shareholder Equity

Assets

Shareholders’
6. Which makes NTF increase even more
Equity
Circularity in financial forecasting

PROS
Elegant solution to NTF and Cash Balances
Allows accumulative formulas in NTF and SF
Interest Rate ‘rd’<=> Interest Coverage Ratio
Gets the Balance Sheet to balance accurately

CONS
Hides accidental CIRC’s
Doesn’t always resolve CIRC’s
Destabilizes the financial model
If you incorporate circularity, be wary of
‘The #REF! problem’
#REF!
“I need a reference”
Occurs when you:
▪ Delete cells, rows, columns, worksheets
▪ Move/Cut formulas
A #REF! that occurs when iteration is ON can’t be fixed with UNDO (Ctrl Z)
To correct the #REF! problem:
▪ Find the circular reference (typically in Surplus Funds and NTF)
▪ Break it (Link interest earned on Cash to previous years’ Cash Balance)
▪ Resolve the #REF! cells
 Solving ‘The #REF! problem’
#DIV/0! is carried in loop

#DIV/0! ISERROR = TRUE, so formula becomes a 0 and

message breaks the loop

No error message in loop

Source of
ISERROR = FALSE
error is
formula reverts to original reference
cleared
and reconnects the loop
Error corrected
Avoiding Circular Reference
Balance Sheet Year 0 Income Statement

Revolver ₹5

Balance Sheet Year 1

Revolver Begin ₹10
Liabilities
Revolver End ₹10.5
₹55
Interest Expense
+₹0.5
Assets
₹100 Liabilities
₹60

Shareholders’ Assets Net Income

Equity ₹100 −₹0.5
₹35

Shareholders’
Assuming 10% interest cost
Equity
No Income Tax
₹29.5

Beginning Equity ₹30

Variations on Balancing Plugs
The plug is typically viewed as debt because in the real world, when a company needs funding,
the easiest thing to do is to borrow money, rather than issue stock. Likewise, debt is readily
repayable when the company has cash on hand.

Revolver lines of credit allow for this: the company can draw down if it needs financing, and then
repay when it has excess cash. In this way, the revolver is best viewed as a short-term debt of the
revolving kind.

If we want to use the plug as an equity plug, the main difference is that the equity plug can
increase when there is a need for additional financing in the long-term.

This is because, companies (mostly start-ups and young companies) issue equity to meet
financing needs, although not for short-term needs. In general, companies use equity when the
sources of debt financing are limited.

Mature companies use excess cash to buy back their equity as a short-term response to low stock
price and also as a way to payback shareholders.

Another way to balance projected balance sheet is to reduce the liabilities and equity, by
dividending out the excess cash out of the retained earnings account.

We can also do a partial dividending out, where a percentage of the excess cash remains on the
balance sheet.
Variations on Balancing Plugs
We usually consider the plug on the liabilities side as debt, but a more useful way of thinking
about this plug is that it is a shortfall in financing.

From the business point of view, the plug does not have to be debt, as long as it provides the
necessary financing for the company. The plug can as well be equity.

Need to Finance

Liabilities
Liabilities

Assets Assets
Equity Plug

Shareholders’ Shareholders’
Equity Equity
Variations on Balancing Plugs
Another way to balance a projected balance sheet is to reduce the liabilities and equity side, by
dividending out the excess cash plug out of the retained earnings account.

We can also do a partial dividending out, where a percentage of the excess cash plug remains on
the balance sheet.

Surplus Funds

Liabilities
Liabilities
Assets
Assets

Shareholders’
Equity Shareholders’
Equity

Dividend Payout
Analytical Workhorse
You can use the analytical workhorse taught in the course in your workplace.
These standardized analytical tools enable team members in an organization to
be placed in different valuation projects quickly, with little or no time needed to
have them be “valuation ready.”
The tools ensure that valuations can proceed quickly, with no lead time
required to build an analytical framework from scratch.
Result: valuations done in less time and with greater clarity.
It conveys to colleagues in the corporation, the analytical methodologies that
others in the team are using, because those are embedded in the approach.
It ensures a consistency in the analytical approach to valuation.
Analytical Workhorse
It becomes in its own right an analysis tool, letting new team members
understand how the standard analysis should be conducted.
As colleagues agree to use the same approach, it becomes a common
yardstick of analysis, a way to foster cooperation and partnership across
groups doing valuation.
You can extend the approach to Credit and Investment Review Committees
beyond just valuation.
The team members who are familiar with the approach can proceed to the
qualitative analysis much more quickly and reach their decisions with
greater facility.
The economic returns can be significant: good (or better) decisions are
made; bad decisions avoided.