85
Valuation Approaches and
discounted cash flow procedure within the multiple-period dis- counting method within the income approach.
The income approach is described in Chapter 7, with Chap- ters 8 and 9 devoted to development of appropriate rates of return within that approach. Chapters 10 and 11 introduce the market approach and asset approach. Business valuation theory requires that the appraiser attempt to use each of the three approaches in every appraisal assignment, although doing so is not always practi- cal. For example, a company may lack a positive return to discount or capitalize, which may prevent use of the income approach. Use of the market approach may not be possible because of the lack of similar companies for comparison. The asset approach, in the ab- sence of the use of the excess earnings method (which is generally not employed for merger and acquisition appraisals), cannot ac- curately portray general intangible or goodwill value that is not shown at market value on a company’s balance sheet. Thus, each of the approaches bring constraints that may limit its use or effec- tiveness in a specific appraisal assignment. It is even more impor- tant, however, to recognize that each approach brings a unique focus on value and what drives it. While the income approach most often looks at future returns discounted to reflect their relative level of risk, the market approach establishes value based on the price paid for alternative investments, while the asset approach es- Exhibit 6-1 Business Valuation Approaches
Income Approach
Asset Approach
Single- Period Capitalization
Method
Multiple- Period Discounting
Method
Guideline Public Company
Method
M&A Transaction Data Method
Adjusted Book Value
Liquidation Value Method Market
Approach
tablishes value based on a hypothetical sale of the company’s un- derlying assets. The strengths and weaknesses of each methodol- ogy, the nature of the appraisal assignment, and the circumstances present in the company being appraised and the industry in which it operates determine which of the approaches can be used and the relative reliability of the results from application of that ap- proach. How to evaluate these results is discussed in Chapter 13, and Exhibit 13-1 provides a summary of the circumstances in which each approach is generally most applicable.
In providing this overview of the approaches to business val- uation for merger and acquisition, this discussion assumes, unless stated to the contrary, that the business being appraised is a viable, going concern. Those companies intending to liquidate or that are in long-term decline may require different assumptions and valuation procedures.
USING THE INVESTED CAPITAL MODEL TO DEFINE THE INVESTMENT BEING APPRAISED
For merger and acquisition, the investment in the company is gen- erally defined as the invested capital of the business, which is the sum of its interest-bearing debt and equity. This quantity is com- puted in Exhibit 6 -2.
Subtracting the payables from the current assets yields the company’s net working capital. Nonoperating assets are also re- moved, with a corresponding decrease in owner’s equity. This leaves the net operating assets that are used in the business and the interest-bearing debt and equity—the invested capital—that is used to finance them.
Keep in mind that all of the company’s general intangible characteristics, including employees, customers, and technology, will be included in the calculation of the value of invested capital.
Invested capital is also referred to as the enterprise value of the company on an operating basis because the whole business—
including the net operating tangible and intangible assets—is being appraised. A major reason why invested capital, rather than just equity, is valued for merger and acquisition is to prevent potential distortions that could be caused by variations in the company’s
capital structure. Invested capital is frequently referred to as a debt- free modelbecause it portrays the business before the relative levels of debt and equity are determined. The objective is to compute the value of the company before considering how operations are financed with debt or equity. Each buyer may choose to finance the company in a different way. This choice, however, should not affect the value of the business. Its operations should have the same value regardless of how they are financed. Also note that any debt related to the acquisition is excluded from invested capital because the value should not be distorted by financing choices.
Since the invested capital model portrays the company on a predebt basis, the company’s returns—income or cash flow—must be calculated before debt, and its cost of capital or operating mul- tiples must consider both debt and equity financing sources.
These points will be described in Chapters 9, 10, and 11 after fur- ther discussion on returns and rates of return.
WHY NET CASH FLOW MEASURES VALUE MOST ACCURATELY
As we discussed in the first two chapters, value creation in a business ultimately can be defined as the risk adjusted net cash flow that is made available to the providers of capital. Whether the company’s Exhibit 6-2 Computation of Invested Capital
Balance Sheet Assets
(Nonoperating assets excluded)
Total Operating Assets*
Less:Payables Net Operating Assets
* All operating assets and liabilities should be adjusted to market value.
Liabilities Payables
Interest-Bearing Debt Equity
Total Liabilities and Equity*
Less:Payables Invested Capital
stock price increases as a result of a new technology, an improved product line, more efficient operations, or a similar reason, all of these will produce increased cash to capital providers. Thus, value inevitably can be traced to cash flow, which is why in the context of valuation a commonly used phrase is “Cash is king.” Investors and managers are used to seeing a company’s performance expressed as some level of earnings—before or after interest or taxes. The first difficulty with earnings, of course, is that it does not represent the amount that can be spent. As such, earnings frequently fail to show the true amount that is available to capital providers. For example, a company may have an impressive earnings before interest and taxes (EBIT), but if most or all of this is consumed in interest, taxes, or reinvestments into the company for the working capital or capi- tal expenditures needed to fund anticipated operations, there may be no cash return available for capital providers.
For closely held companies, earnings often are presented as net income before or after taxes. Because this is a return to equity—after interest expense has been recognized—it reflects the present owner’s preferences for relative levels of debt versus equity financing. Buyers want an accurate picture of the true op- erating performance of the company prior to the influence of fi- nancing, so returns to invested capital rather than equity should be presented.
Computation of Net Cash Flow to Invested Capital
Because financial statements usually are prepared in compliance with generally accepted accounting principles (GAAP) for report- ing to external parties, net cash flow to invested capital (NCFIC) does not appear anywhere in the statements, including the state- ment of cash flows. It can, however, easily be computed, as Exhibit 6-3 illustrates.
In reviewing this computation, the benefits of net cash flow become more apparent. It represents the amount that can be re- moved from the business without impairing its future operations because all of the company’s internal needs have been taken into consideration. This is why net cash flow is frequently referred to as
“free cash flow.”
NCFIC is the only return that accurately portrays the com- pany’s true wealth-creating capacity. It reveals the company’s
return before principal and interest on debt to prevent distortions that could be caused by different borrowing levels. It is a measure of cash flow rather than earnings because investors can spend only cash, not earnings. NCFICis the net return after taxes and also af- ter providing for the company’s internal need for capital expen- ditures and working capital. Thus, it represents the true cash flow available to providers of debt and equity capital, after payment of taxes and the company’s internal reinvestment requirements.
As will be explained further in Chapter 7, the company’s net cash flow can be forecasted in discretely identified future years or for a long-term period. In computing the net cash flow for the long-term or terminal period, specific relationships between com- ponents in the net cash flow computation almost always should be maintained. Capital expenditures should exceed the depreciation Exhibit 6-3 Net Cash Flow to Invested Capital
Math Symbol Component
Net income after taxes
Interest expense, net of income tax (interest expense[1t])
Net income to invested capital
Noncash charges against revenues (e.g., depreciation and amortization)a
Capital expenditures (fixed assets and other operating noncurrent assets)a
or Changes in working capitala,b
Dividends paid on preferred shares or other senior securities, if anyc
Net cash flow to invested capital
a In a forecast, these amounts should be at levels necessary to support anticipated future operations, not simply averages or actual amounts from the past or next year’s expected amounts.
b Remember that the invested capital model is “as if debt free,” so any interest-bearing debt in the current liabilities should be removed. Generally speaking, doing so will reduce the dollar amount of the growth in working capital.
c In most appraisals this item is zero because usually there are no preferred or other sen- ior dividend-receiving classes of securities.
write-off of prior period capital expenditures to reflect inflation and growth. Similarly, the change in working capital should cause a decrease in net cash flow, because the cash outflow required to fund increases in accounts receivable and inventory should ex- ceed the cash inflow provided by increases in accounts payable and accrued payables.
FREQUENT NEED TO NEGOTIATE FROM EARNINGS MEASURES
The M&A market, particularly for middle-market and smaller businesses, is seldom well organized. As mentioned earlier, many participants are involved in only one transaction during their entire career, and most advisors—accountants, attorneys, and bankers—seldom encounter such transactions. The lack of an or- ganized market and inexperienced participants often leaves sell- ers hunting for potential buyers and buyers searching through contacts and industry associations or mailing lists for potential companies in which to invest.
In this environment, expectations are often unrealistic and misinformation abounds as participants look for shortcuts or sim- ple formulas to compute value quickly and conveniently. Values based on multiples of EBIT or earnings before interest, taxes, de- preciation, and amortization (EBITDA) usually fill the resulting void. Sellers, in particular, like these measures because they pro- duce relatively high return numbers that look and sound impres- sive. The problem, of course, is that these are not real returns be- cause income taxes and the company’s internal reinvestment needs have not yet been paid. That is, neither EBITDA nor EBIT represents cash that could be available to capital providers.
So how does either party—a seller who wants to know what a company is really worth, regardless of negotiating strategy, or a buyer negotiating with a seller who is quoting such numbers—
handle the likely confusion that will be present? The key is to con- sistently make all value computations using net cash flow to in- vested capital. With this process the party will be employing the true return available to capital providers along with the most ac- curate and reliable rates of return. When sellers or their interme- diaries quote unsubstantiated EBIT or EBITDA multiples, buyers
must demand an explanation of how the multiples were deter- mined. The informed participant, whether buyer, seller, or inter- mediary, generally will recognize the lack of justification for unre- alistic multiples and, more important, be able to explain why they do not accurately reflect value.
Among the most common ways that EBIT or EBITDA multi- ples distort value include:
• Inaccurate return—the computation of EBIT or EBITDA is unrealistic in comparison to historical or future performance, considering likely industry and economic conditions.
• Confusion of strategic value with fair market value—investment bankers or brokers may quote an EBIT multiple that was derived from one or a few transactions where the buyer paid a particularly high price. Unusual synergies unique to that transaction may have justified that multiple, but it seldom represents “the market,” particularly where such synergies are not available to other buyers.
• Inappropriate guideline company—selection of multiples from public companies that are much larger or industry leaders that are not sufficiently similar to the target company for an appropriate comparison.
• Inappropriate date—selection of multiples from a transaction that is not close to the appraisal date and that may reflect different economic or industry conditions. Similar distortions can occur by mixing returns and multiples—for example, deriving a multiple for net income and applying it to EBIT.
• Choice of average multiple—indiscriminately using the mean or median multiple derived from a group of companies when the target company may vary substantially from the average of that group.
The solution: When savvy investors find they must negotiate from earnings multiples, they determine value using NCFIC and then express that value as a multiple of EBIT or whatever other measure of return the other party prefers to use in the negotiating process.
The second compelling reason to choose net cash flow rather than a measure of earnings results from the choices available in developing a rate of return. This rate, or its inverse, a multiple, is applied to the return in a discounting, capitalization, or multipli- cation process to compute value. The reliability of the value de- termined is clearly dependent on the accuracy and dependability of the two primary variables in the equation, the return and the rate of return or multiple. The public markets provide the basis for highly reliable, long-, intermediate-, and short-term rates of return on net cash flow based on many years of historical experience. In the U.S. market, this data dates back to 1926 and reflects actual cash returns that creditors and investors have received and the re- sulting rates of return that have been earned on their investments.
These rates reflect buyers’ prospectivechoices—that is, the current prices paid for the anticipated futurenet cash flow returns on in- vestment. This data provides appraisers with an excellent perspec- tive on investors’ risk versus return expectations and an accurate indication of their required rates of return on investments with varying levels of risk.
It is important to emphasize that no similar historical rate of return data is available on the other return measures that are fre- quently reported, including EBITDA, EBIT, net income before taxes, and net income after taxes. None of these measures reflects net cash returns that actually could be available to shareholders.
And all are merely measures of historical performance with no in- vestment amount attached to them. As such, there is no way to tie these historical results to prices that investors paid for the antici- pated future return on those investments. Chapter 8 illustrates po- tential errors and distortions from use of historical rates.
FINANCIAL STATEMENT ADJUSTMENTS
Adjustments to a target’s financial statements, commonly referred to as normalization adjustments, convert the reported accounting in- formation to amounts that show the true economic performance, fi- nancial position, and cash flow of the company. Differences between amounts shown on the financial statements and market values most commonly result from one or more of the following causes:
• Elections to minimize taxes, including excess compensation, perquisites, rent, or other above-market payments made to owners or other related parties
• Adjustments required to change the basis of accounting, including conversion from cash to accrual or from one inventory or depreciation method to another
• Adjustments for nonoperating and/or nonrecurring items, including asset surpluses or shortages, personal assets carried on the company’s balance sheet, or personal expenses paid by the business, and items of income or expense that are not part of ongoing operations
• Differences between the market value of assets and the amounts at which they are carried on the company’s books The significance of many of these normalization adjustments is greater in the valuation of smaller companies. Midsize or larger businesses may have characteristics that require adjustment, but the effect may be immaterial. For example, $100,000 of above- market compensation could result in a significant change in value to a company with $1 million of annual sales, but it may be imma- terial to a business with sales of $50 million. Smaller companies also more frequently have financial statements that have been compiled or reviewed, rather than audited, or use the cash rather than the accrual basis of accounting. Thus, smaller companies fre- quently require more adjustments and the relative impact of the adjustments tends to be greater.
Adjustments can be made to both the income statement and the balance sheet, or one can be adjusted without a corresponding change to the other. For example, a nonrecurring gain or loss can be removed from the income statement without any required ad- justment to the balance sheet.
Most often in merger and acquisition the buyer is acquiring a controlling interest in the target. This gives the buyer the au- thority to control and, if desired, manipulate the company’s in- come. Minority owners, however, generally lack the authority of control. For this reason, the first category of adjustments listed above is referred to as the “control adjustments” and generally should be made only when a controlling interest in a company is being appraised. Typical control adjustments include:
• Above- or below-market compensation, in any form, paid to controlling shareholders
• Above- or below-rent paid on real estate or equipment owned by the controlling shareholder and leased to the company
• Related or favored parties on the payroll who are paid above or below market compensation
• Assets such as automobiles, airplanes, condos, memberships, and so on that are owned and/or paid for by the business for the benefit of controlling shareholders but that would not need to be provided to an arm’s length employee hired to provide the same services
• Insurance premiums for policies on which the corporation is not the beneficiary
• Above- or below-market-rate loans to and from the corporation to controlling shareholders
In those less common M&A valuation circumstances where the target is a minority equity interest, the decision not to make control adjustments to income may result in a very low or zero value for that minority interest. This low value often reflects the disadvantages of the minority owner versus that of the control owner. (The value of the minority interest can be increased by pro- visions in a shareholder agreement that restrict the majority owner’s access to the company’s cash flow.) Alternatively, the re- turn to the controlling shareholder can be used after control ad- justments and then a minority interest discount can be applied to the resulting value. Doing this is not recommended and fre- quently distorts value because the minority interest discount may not reflect the magnitude of that particular company’s minority versus control income difference. These adjustment points are dis- cussed further in Chapters 11 and 12.
Adjustments to the Balance Sheet
Adjustments to the balance sheet primarily reflect the need to convert assets from book value to market value. In the context of the going concern enterprise, market value is usually the value of the asset “in place in use” as opposed to either the historical cost and depreciation-based book value or value in contemplation of