March 19, 2019
Valuation  Art and Science!
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DETERMINING THE VALUE OF YOUR ENTERPRISE
An often asked question by business owners is ‘what’s my number?’, in other words, what is my business worth or valued at. This article summarizes common valuation techniques used to determine the worth of a small business by applying it to a hypothetical small company.
The Importance of Valuation
There are a number of reasons to conduct a company valuation. First, the company’s assets or equity may be in the process of being sold requiring a pricing for the seller and buyer. Second, the company may be attempting to sell or buy back shares of stock and a price needs to be set for offering. Also, more and more companies are ‘employeeowned’ through an employee stock ownership program (ESOP) and the bylaws of the ESOP require an annual valuation. Third, the estate of a late business owner may have to value the owner’s shares for tax purposes. Fourth, a company may be trying to license a new product technology to or from a third party and part of the assessment process may be to develop a ‘value’ for the license based on the future revenues, costs and profits that may be generated from it. Finally, if a company possesses a deferred compensations plan for employees as stock options or share appreciation rights, the Internal Revenue Code Section 409A requires an annual valuation of the company.
Valuation Methods – A primer
Before treading down the valuation path, one major caveat must be discussed. Despite the fact that much analysis is performed using sophisticated quantitative models that compute a value for a business, the process still involves a lot of subjectivity. Usually combinations of valuation methods are used to ascertain a range of values for the interested parties to address this subjectivity providing a range of valuations instead of one number.
Historical and Present Day Techniques: Comparable Companies and Transactions
Similar to the sale of an auto or home, a useful way to value a business is to find a recent acquisition of a similar (e.g., geography, sales, profits, industry, people) type company. For example, the business owner of the Whole Bean coffee house located in Milwaukee, Wisconsin noted that a similar sized coffee house in nearby Chicago sold for $2.5 million would be a good estimate of her business’ worth.
While using a recently sale/acquisition of a similar type company appears rather straight forward, reality interjects a variety of challenges in finding one that truly is ‘similar’ to your company. First, the date of the transaction may be significantly different from the timing of when you want to value your business. For instance, did the sale of a business take place during similar economic conditions as what your business is experiencing? Any entrepreneur whose business is dependent on the general economic conditions knows that an organization’s value can greatly differ based on whether it’s in the midst of an economic boom or recession.
Another timing issue is industry/market life cycle? For instance, a company may be in the early stages of an attractive market or in the consolidating stages of a mature industry where the demand for acquisitions is higher than normal. The existence of the demand tends to drive valuations higher.
Other important issues that may complicate the valuation process when using a comparable company or transaction:
Historical and Present Day Techniques – Book Value
A second method used in company valuation is a firm’s book value. Book value is equal to “Total Assets less Total Liabilities” or a firm’s ‘Shareholder’s Equity’ balance derived directly from a firm’s Balance Sheet. If we refer back to the Babcock Manufacturing Balance Sheet (presented below) we can see that the Book Value as of 12/31/2016 was $549 thousand. An argument supporting the use of Book Value as valuation technique is its simplicity as the computation is taken directly from a company’s Balance Sheet with no need for adjustments to reflect market conditions or future expectations.
Babcock Manufacturing, Years ending 2015 and 2016 (in $000’s)



2015 


2016 





$ 


$ 


Sales 


$ 1,017 


$ 1,015 


Cost of Goods Sold 

808 


805 


Gross Profit 

209 


210 


S, G & A 


128 


135 


Depreciation/Amortization 
40 


45 


EBIT 


41 


30 


Interest Expense 

9 


12 


Earnings Before Taxes 


32 


18 


Income Taxes 

10 


8 


Net Earnings 

$22 


$10 


Table 6.2 Balance Sheet for Babcock Manufacturing as of 1/1/15, 12/31/15, and 12/31/16.


1/1/2015 

12/31/2015 

12/31/2016 







% of 



% of 


$ 

$ 

Sales 

$ 

Sales 
Cash 

60 

74 

7.3% 

52 

5.1% 
Receivables 
170 

216 

21.2% 

213 

21.0% 

Inventories 
183 

209 

20.6% 

234 

23.1% 

Other Current Assets 
45 

45 

4.4% 

49 

4.8% 

Current Assets 
458 

544 

53.5% 

548 

54.0% 












PP & E, net 
277 

287 

28.2% 

315 

31.0% 

Other Assets 
45 

57 

5.6% 

28 

2.8% 

NonCurrent Assets 
322 

344 

33.8% 

343 

33.8% 

Total Assets 
$ 780 

$ 888 

87.3% 

$ 891 

87.8% 












Trade Payables 
68 

94 

9.2% 

85 

8.4% 

Other Current Liabilities 
32 

38 

3.7% 

43 

4.2% 

Current Liabilities 
100 

132 

13.0% 

128 

12.6% 

Long Term Debt 
118 

161 

15.8% 

168 

16.6% 

NonOperating & Other 
45 

56 

5.5% 

46 

4.5% 

Non Current Liabilities 
163 

217 

21.3% 

214 

21.1% 

Total Liabilities 
263 

349 

34.3% 

342 

33.7% 












Shareholder's Equity 
517 

539 

53.0% 

549 

54.1% 

Liabilities & Equity 
$ 780 

$ 888 

87.3% 

$ 891 

87.8% 
Second, it may be the only value that can be derived from a company if there is a lack of solid financial information or the company is in poor financial condition.
While in many instances simplicity is desirable, there are reasons not to solely depend on Book Value. First, it represents the value of a firm’s assets based on the historical purchasing costs at the date of acquisition. Assets such as Land acquired many years ago will represent an artificially low asset value on the Balance Sheet as it won’t be adjusted for appreciation to market value. Other noncurrent assets like Patents and Trademarks are valued on the Balance Sheet at the legal costs incurred to finalize them, not reflecting the intrinsic value to a company based on the revenues and profits attributable to the intangible asset.
A Midwestbased agriculture company in the bovine (i.e., cow) artificial insemination sector traditionally valued their cattle on their balance sheet at the original cost of $10,000 when, in fact, if a bull became a successful ‘stud’ typically fetched a multimillion dollar value in the market place. The company’s Balance Sheet simply didn’t reflect the true value of the bull.
Another issue with Book Value is that it is dependent on the quality of the financial accounting practices followed by the firm. A company that applies unethical and improper accounting policies tends to overstate its income over time. As a result, the company’s retained earnings (and Shareholder’s Equity) will be inflated artificially creating a higher Book Value.
Finally, and especially as related to early stage companies, Book Value doesn’t fully capture the future earnings potential of an organization. For instance, it’s not unusual for high technology companies such as firms in the biotechnology space to run large accumulated deficits creating negative net worth (i.e., negative Shareholder’s Equity due to the large Accumulated Deficit.). Yet, such companies may possess leading edge technology that some day will generate enormous profits. It took biotech pioneer Genentech almost 15 years to become a selfsustaining company that generated internal profits that could support its research and development efforts.
Book Value, despite its weaknesses, does represent one basis for valuing a company. Often practitioners will use the Book Value of a company to serve as at least one of several valuation techniques to assist in providing a range of values.
Adjusted Book Value
Valuation experts will sometimes adjust Balance Sheet value to reflect the market value of an asset. For example, appraisers who are attempting to value Babcock might ascertain that the actual value of the company’s Property, Plant and Equipment (PP&E) is not properly reflected on the Balance Sheet. The land that comprises a portion of PP&E on the balance sheet is valued at its original cost of $100 thousand dollars when it was purchased in 1985. In the time following its purchase, land market values soared increasing Babcock’s land to market prices in 2016 of $2 million. Accordingly, they noted that a more realistic book value, adjusted for the increase in property on December 31, 2016 would be as shown:
Adjusted Book Value of Babcock Labs on 12/31/16
Shareholder’s Equity: from Balance Sheet 
$549 
Add: Increase in Land Value 
$1,900 
Adjusted Book Value 
$2,449 
In other circumstances, appraisers will examine the ‘collectibility’ of accounts receivable, the degree of obsolescence in inventory, the market value of major fixed assets, and the market value of an intangible assets like patents, customer lists, brands or trademarks to ascertain a clearer value of a company’s assets.
Adjusted Book Value, while more reflective of a company’s market worth than Book Value still has several of the same issues that Book Value does (i.e., reliance on Balance Sheet, Accounting Methods, etc.). As a result, valuation experts use other valuation techniques that attempt to incorporate market realities and the future prospects of a firm to derive a ‘fairer’ estimation as to a company’s value.
Market Approaches: Pricing Multiples
In addition to use of the Balance Sheet approaches such as Book Value and Adjusted Value, valuation consultants use a variety of ‘market multiples’ of similar industries and companies to approximate the value of the company of interest. Such multiples include “Price to Earnings” (Sales price of the company divided by the annual earnings), “Price to Book Value” (Sales price divided by Shareholder’s Equity), “Price to Sales” (Sales price divided by annual sales) or a variety of other ratios that use the ratios of similar transactions or companies to serve as a ‘proxy’ or approximate a value for the company one is trying to value.
Enterprise Value Pricing Multiple
A common company pricing multiple used in valuation is the Enterprise Value Pricing Multiple (EVPM) method. In using EVPM, a Company’s “Market Value to Earnings” ratio is developed from a sample of publicly held companies. It starts with calculating the Enterprise Value (i.e., economic measure reflecting the market value of a business that includes the sum of claims by all claimants: debtholders and shareholders) adding the market values of interest bearing debt and shareholder’s equity. Then, dividing the Enterprise Value by Earnings before Interest Taxes Depreciation and Amortization (EBITDA, since EBITDA is an operational profit measure before considering tax and financing policy). Then, an average or median of the ratio is developed from the sample and is applied to the valuation target.
The EVPM is a multistep process:
Author’s Note: A more complete calculation for Enterprise Value is common equity at market value+ debt at market value (here debt refers to interestbearing liabilities, both longterm and shortterm)+ minority interest at market value, if any+ preferred equity at market value+ unfunded pension liabilities and other debtdeemed provisions– value of associate companies– cash and cash equivalents).
While the process seems lengthy and complex, it takes little time using published data from sources as Yahoo!Finance, Wall Street Journal and others to derive the comparable company financial information. To illustrate, five hypothetical companies (A – E) that are publicly held are presented below to estimate an EVPM for Babcock in ascertaining both the market value of the enterprise and its equity.
Enterprise Value Pricing Multiples: Comparable Companies
A 
B 
C 
D 
E 

Price per Share 
a 
$8 
$25 
$45 
$4 
$62 

# of Shares (in 000,000s) 
b 
10 
28 
100 
284 
15 

Mkt Value of Equity 
c= a x b 
$80 
$700 
$4,500 
$1,136 
$930 

Mkt Value of Debt 
d 
$20 
$450 
$4,500 
$50 
$100 

Mkt Enterprise Value 
e = d + c 
$100 
$1,150 
$9,000 
$1,186 
$1,030 

Deprec & Amortiz 
f 
$1 
$22 
$250 
$2 
$5 

EBIT 
g 
$16 
$60 
$785 
$51 
$93 

Depr and Amort Expense 
f 
1 
22 
250 
2 
5 

EBITDA 
h = g+f 
$17 
$82 
$1,035 
$53 
$98 

EVPM 
h /e 
5.9 
14.0 
8.7 
22.4 
10.5 

Median EVPM 
10.5 
Use Median 
10.5 

Average EVPM 
12.3 
The following table illustrates the results of the hypothetical EVPM comparable analysis that generates a multiple that will be used to value Babcock. The resulting average EVPM was 12.3 times Babcock’s EBITDA and the median at 10.5 times EBITDA for the five companies. In this case, probably either multiple could be used since they are relatively close together. The median multiple was chosen to value Babcock.
Table  shows the results of applying the multiple to Babcock’s 2016 financial results.
Babcock: 2016 (in $000's) 

Interest Bearing Debt 
$168 

EBIT 
$30 

Depreciation and Amortization Expense 
45 

Earn B4 Taxes 
$75 

x Median EVPM 
10.5 

Market Enterprise Value 
$788 

Less: Interest Bearing Debt 
$168 

Market Value of Equity 
$620 
As shown, the Market Enterprise Value at the end of 2016 for Babcock is estimated at $$788 thousand, deducting the $168 thousand in longterm debt results in a Market Value of Stock at $620 thousand.
As with the other valuation methods, the reader will note how certain changes in assumptions could dramatically change the ultimate valuation for Babcock. First, a different set of comparable companies could possess dramatically different EVPMs resulting in a much higher EVPM. Second, if we had applied the average EVPM instead of the median, the value for Babcock would have increased by approximately $135 thousand. An alternative could be to use a simple average of the ‘average’ and ‘median’ multiples.
Price to “Seller’s Discretionary Earnings”
An earnings multiple that is commonly used is based on a multiple of the company’s selling price relative to the “Seller’s Discretionary Earnings” (i.e., SDE). SDE represents EBITDA (i.e., Earnings Before Interest, Taxes, Depreciation and Amortization) adjusted for the business owner’s salary and benefits including perks. Valuation experts are partial to SDE because it values a company regardless of the level of compensation received by the ownership. There are a variety of calculations for SDE, one of the most popular is presented in the “2005 Business Reference Guide” which defines SDE as[1]:
Net Earnings
Add: Depreciation Expense (normalized)[2]
Add: Amortization Expense (normalized)
Add (Deduct):Nonrecurring Expenses (Nonrecurring Revenue or Income)
Add: Interest Expense
Add: Tax Expense (normalized)
Add: Owner’s Compensation (Salary + Benefits + Perks)
Equals: Seller’s Discretionary Earnings
The SDE result estimates cash flow from operations available for a firm’s owners to reinvest back in the company, pay out in the form of salary and benefits or pay taxes. As a rough ‘ruleofthumb’ multiples using SDE will typically range from “0 to 4 times SDE” to estimate the value of a company depending on the industry, the attractiveness of the target, and other factors.[3] Most will range in the 2 to 4 time SDE value with many using ‘3x SDE’ as a ‘quick and dirty’ pricing and valuation method.
Using Babcock as example to apply the SDE valuation multiple:
Table  Seller’s Discretionary Earnings for Babcock: 2016

2016 
Net Earnings 
10 
Add: Depreciation 
45 
Add: Amortization 
0 
Add: Interest Expense 
12 
Add: Tax Expense 
8 
Equals: EBITDA 
75 
Add: Owner’s Compensation 
65 
Seller’s Discretionary Earnings 
140 
Babcock’s owner/manager’s takehome salary and benefits totaled $65 thousand in 2016 as she limited her draw based on the company’s limited profits. Using the rule of thumb range of 2 to 4x SDE, a rough valuation would be estimated at $280 thousand to $560 thousand with a midpoint of $420 thousand.
An interesting problem exists with the Babcock example that is typical in many valuation cases using SDE. Market estimates (hypothetical) showed that the owner/manager of similar sized companies and industries earn salary and benefits of $150 thousand per year. From a value standpoint, a buyer of a company will apply the actual lower salary currently paid to the Babcock owner as generating a lower value. As a seller it’s hard to negotiate against as the ‘proof is in the pudding’ (so to speak) reflected by the financial results of the firm. The buyer will argue that earnings are what they are and valuation should be based accordingly.
A seller might address this issue through a variety of means. First, a seller could argue that a higher multiple of SDE should be used based on the type of business it is. If it’s in an industry with significant growth potential or the business has future strategies in place (i.e., such as a contract with a new customer where past sales and earnings aren’t reflected), the seller must convince the buyer that earnings will be higher in the future to justify the higher multiple.
Second, a company such as Babcock may own real estate or other tangible assets that have much higher value than that represented in the balance sheet and related depreciation expense.
Third, the seller could propose a unique financing structure where he/she finances part of the sale through an ‘earnout’ where, if the seller receives a portion of the sales price upfront at the negotiated price (usually 30% or so) and if the company’s earnings increase dramatically in the future, the remainder owed to the seller will be increase along with the company’s overall value.
Finally, the seller can argue that a multiple using SDE is not the appropriate valuation method to base the company’s value on. Instead, the seller would need to convince the buyer that industry practices use other methods that hopefully justify a higher valuation for the business.
Price Multiples: Balance Sheet Approach
A variety of pricing multiples have been developed that attempt to estimates the value that the market places on Balance Sheet components such as the invested capital (i.e., long term debt and equity) or only the equity invested in a firm. These multiples have a variety of names include “Market Value to Invested Capital”, “Price to Book Value”, etc. To illustrate, let’s use the Babcock Manufacturing balance sheet as a starting point.
Babcock, a small, privatelyheld pharmaceutical manufacturer, develops, manufactures and sells both proprietary and generic drugs for a variety of markets. At the time, management was contemplating to either sell part of the company’s equity to a larger strategic investor or undergo an Initial Public Offering. In either case, the company and its investment banking advisors need to develop a comprehensive valuation of the company for either decision.
Since Babcock is a mature firm with earnings, positive cash flow, and a relatively stable asset base, it’s appropriate to use either a net earnings (i.e., P/E ratio) or invested capital base to value the company. In trying to determine which price multiple might be most appropriate for Babcock, there are several references that can be easily accessed for guidance. For the past several years, Inc. Magazine has published a valuation guide for businesses by industry type.[4]In association with BV Resources, Inc. provides a summary of business valuations by industry using a selected number of sales transactions over a threeyear period. In addition to providing a range of valuations, it also indicates which valuation method was the best indicator of the final price for the business sales.
(Author Note: We are using data from 20034 provided by Inc Magazine since it is the most recent data in the author’s possession. In reality, one wants to find data as close to the date of valuation as possible, for this article, the numbers are used for illustrative purposes)
Using the guide, under the category “Manufacturing” industry, there exists a subsegment called “Pharmaceutical Preparations”, a relatively close fit for Babcock. Examination of the information presented for the segment is shown in the table below:
Market Multiples for Pharmaceutical Preparation companies
Industry 
Median Annual Revenue (000’s) 
Median Sales Price (000’s) 
Median MVIC divided by EBIT 
Median Equity Price divided by Earnings Before Taxes 
Median Equity Price divided by Book Value 
Sales Price Ranges (000,000’s) 
Pharmaceutical Preparations (15) 
$9,344 
$55,000 
34.72 times 
27.80 times 
14.32 times 
$2.5  $500 
Multiple based Valuations for Babcock Labs – 2016
Industry ($ in 000’s) 
Median MVIC divided by Earnings Before Interest and Taxes 
Median Equity Price divided by Earnings Before Taxes 
Median Equity Price divided by Book Value 
Pharmaceutical Preparations 
34.72 times (1) 
27.80 times (3) 
14.32 times (5) 
Babcock 2016 EBIT 
$30 (2) 


Babcock 2016 Earnings Before Taxes 

$18 (4) 

Babcock 12/31/16 Book Value 


$549 (6) 
Babcock Estimated MVIC 
$1,041.6 (1 x 2) 


Babcock’s Estimated Market Value of its Equity: Earnings B/4 Taxes 

$500.4 (3 x 4) 

Babcock’s Estimated Market Value of its Equity: Book Value 


$7,861.7 (5 x 6) 
Using the three valuation multiples shown to have the most accurate predictive value by Inc. Magazine, Babcock’s value would range from $500.4 thousand to $7.86 million. The immediate question that arises is ‘why the vast range in values?’ There may be a number of reasons for this condition.
First, Babcock is barely operating above breakeven in 2015 and 2016 despite having a relatively healthy balance sheet. It may be a sign that there is ‘hidden value’ in Babcock that is locked in the asset base of the company. Possibly, a new owner/management team could dramatically improve the earnings from operations unlocking a dramatic amount of value.
Second, the difference may simply be due to the industry sector selected to compare Babcock with. Babcock is a manufacturing company in the pharmaceutical sector but its characteristics (i.e., location, product line, size) may be dramatically different from the companies in the sample group.
Which value of the three should Babcock owners/managers rely on? Before answering that question, one additional valuation metric – Price to Revenues – may provide some additional insight as to which value within the estimated by the three other methods to use. Referring to Table 6.5 that presents the industry data from BV resources, note that it provides the “Median Annual Revenues” and “Median Selling Price” at $9.344 million and $55 million, respectively.
By dividing selling price by revenues ($55 million / $9.344) we can roughly estimate a PricetoSales multiple of 5.89 times (note: for this example, we’ll assume that the $55 million selling price of the median company is the price of their equity. In reality, one would have to determine if this was the selling price for the equity, assets, or enterprise value which includes both equity and debt). While this is a multiple for only one company in the sample (median being the midpoint of the sample of 15 transactions) it at least provides an outside reference point. Applying the 5.89 times revenue multiple to Babcock’s 2016 revenues of $1.015 million would estimate a value of $5.974 million. Thus, the Price to Revenue multiple provides a value closer to high end of the previous range. Again, reemphasizing that the company may be underperforming on an earnings basis.
Range of Market Multiple Values for Babcock Labs (with Price/Sales)
Industry ($ in 000’s) 
Estimated Market Value 
Babcock’s Estimated Market Value of its Equity based on “MV of Equity to Earnings Before Taxes” 
$500.4 
Babcock Estimated MVIC based on “MVIC to EBIT” 
$1,041.6 
Babcock’s Estimated Market Value of its Equity based on “MV to Annual Revenues” 
$5.974 
Babcock’s Estimated Market Value of its Equity based on “Market Value of Equity to Book Value” 
$7,861.7 
So, back to the question as to which value should Babcock use? Two suggestions – at present, one would suggest that the lower end of the valuation range should be used with an understanding that if Babcock management could significantly increase earnings, the resulting value will tend more towards the higher end.
This illustration presents one of the most common challenges faced by buyers and sellers negotiation process during a sale and purchase of a business. Buyers by nature will attempt to use a lower valuation as a basis for price following the old axiom ‘buy low…’. On the other hand, sellers will almost always attempt to justify price based on a higher valuation in order to maximize their harvest. For either party, it’s helpful to have a variety of ways to support the price they hope to pay or receive.
Pricing multiples such as Price/Earnings ratios uses historical income from the previous twelve months to derive a value for a firm. The next sections of this chapter will address situations where ‘Futurebased Valuations’ are typically used including the early stage startup venture and the fast growth organization.
Future Valuations  Net Present Value/Discounted Cash Flow: Early Stage Companies
For startup companies it may be months or years before it has profits or even sales making traditional valuation methods based on historical earnings or book value irrelevant. Instead, investors like venture capitalists will use a variety of valuation methods to derive a range of values to support their final negotiation price for the next round of investment. In addition to methods like DCF/NPV, investors will also examine the valuation used in other investments in similar companies at the same age in the life cycle (i.e., Comparable Transaction approach). DCF/NPV requires a business owner to create financial projections for five to seven years to derive a ‘present value’ (See Appendix A for ‘Primer – Net Present Value) for his/her organization.
Wisconsin Microscopic was an early stage venture designed to commercialize a high speed analytical microscope to be used by the semiconductor industry in their research and development of next generation computer chips. At the time of its plan, Wisconsin was facing the need for over $10 million in outside financing to continue its commercialization efforts requiring management to ascertain what value the company’s equity was at that to price a new offering of stock
.
Wisconsin Microscopic Income Statement Projection – 2015 to 2019
As shown, the company projected minimal revenues until 2016 with profits occurring the following two years in 2017 and 2018. At this point, WM’s value will be estimated by ‘discounting’ the future profits or cash flows (as represented by EBITDA) to the present using Net Present Value.
In addition to projecting profits, the company also needs to address at least two other issues. First, instead detailing faroff forecasts (2020 and beyond), WM’s managers can estimate a sale value (or terminal value) for the company at the end of 2019 as a proxy for the present values from 2020 to infinity. Once the sales value is estimated, the total value must then be ‘discounted’ back from the end of 2019 to the present (12/31/14).
Second, Wisconsin Microscope’s management has to estimate an appropriate discount rate for determining present value of EBITDA. Some will recommend use of the Capital Asset Pricing Model’s (CAPM) estimate of the ‘cost of equity’ as a proxy for a discount rate. However, is most readily used with publiclyheld companies with a widely held stock. For privately held companies, this author recommends use of a ‘buildup’ discount rate where one starts with the typical return investors earn from the Standard & Poor’s Index or other large portfolio indexes.
History has shown that an investment in the entire stock market or at least an index replicating it will produce returns of ranging from 10% to 13% per year over the long term (with wide variations on a shortterm basis). Thus, investors could put their money in a large portfolio of big company stocks and earn a respectable return of at least 10% without a tremendous amount of risk. Studies have shown that investors increase their rate of return by 30% or higher for stocks in small capitalized companies where the risk of failure may be greater (even though the stock is public and can be bought and sold on the market) and another 30% or so for privately held stock that is illiquid (can’t be easily bought and sold). Add on other risks such as technology, market, and management team risk and it’s not unusual for investors to incorporate required rates of return of 25% or higher for privately held companies. For early stage life science firms, this may reach 70% or higher due to the high failure level of such firms.
The Wisconsin Microscopic management team spent time attempting to ascertain a terminal value (i.e., value if sold at the end of year five) and a discount rate. For the terminal value, WM examined the “Price/EBITDA” (Stock Price divided by EBITDA per common share) multiples of several similar public companies to estimate a multiple for the company in 2019. After finding a median of approximately “15 x EBITDA” from the sample of companies, they reduced the multiple by approximately 50% to account for the risk, uncertainty and lack of liquidity (similar reasons used in applying a higher discount rate).
For the discount rate, they determined that a 30% discount rate for the valuation of the company for this round of financing they would apply. They established that the company didn’t warrant rates at 50% per year or higher required for high tech/biotech firms because they had a working product that was close to customer sales but yet there was still risk due to it being a small, privately held company.
The following table represents the cumulative Net Present Value calculated by WM:
$ in Millions (rounded) 
2015 
2016 
2017 
2018 
2019 
EBITDA (a) 
($2.6) 
($5.2) 
 
$15.2 
$37.0 
Terminal Value in 2005 (10 x 2005 EBITDA) (b) 




$370.0 
Annual Value (c) = (a) + (b) 
($2.6) 
($5.2) 
 
$15.2 
$407.0 
Present Value Factor @ 30% (d) 
.769* 
.592* 
.455* 
.350* 
.269* 
Present Value equals (c) x (d) 
($2.0) 
($3.1) 
 
$5.3 
$109.5 
*  Present Value Factor is 1/(1+ discount rate) n year For example 2001, 1/(1+.3)1or 1.31
Adding the annual Present Values together provides a cumulative present value of $109.7 million. In other words, Wisconsin Microscopic estimates that the company is valued at almost $110 million as of the end of 2000 after projecting forward five years and discounting to the present at a 30% discount rate. Since WM is seeking $10 million in financing a rough estimate of the ‘percentage ownership’ the new investors will acquire is 9.1% ($10 million in new financing / Company Value of $110 Million).
There are several items of importance regarding this illustration. First, note that all of the company’s present valued is tied up in the Year 5 present value numbers, primarily driven by the $370 million terminal value (Year 5 present value of $109.5 million of the company’s total $109.7 million value). This is not unusual for an early stage company as much of the value is either earned through an exit or from the tremendous growth expected in the later years. Investors will place a lot of attention of this portion of the total present value especially with the assumptions that drive the overall terminal value.
Issues like:
Investors will not examine these assumptions on an individual basis. Instead, their own calculations may reduce EBITDA in year 5 by a significant amount, use a lower multiple of EBITDA, and/or increase the discount rate to 50% or higher in making their valuation and investment decision. As a result, ‘sophisticated’ investors will almost always argue that the value generated by the company is too optimistic and attempt to negotiate a lower value in order to obtain a higher ownership percentage for the same amount of investment.
Future Valuations  Net Present Value/Discounted Cash Flow: Mature Companies
The process of valuing a mature company using NPV/DCF is generally the same with some slight differences. First, an existing company with sales and profits has an operating history that can be used as a guide into the future. For instance, Babcock Manufacturing (2015 and 2016 Income Statement presented below) shows that Sales are flat for the two years that will be used as base for future projections. The historical data can also be used to estimate expenses into the future as each expense category can be calculated as a % of Sales. For instance, “Cost of Goods Sold as a % of Sales” in 2016 is roughly 79.3% ($805/$1,015) and 79.4% ($808/$1,017) in 2015, respectively.
Babcock Manufacturing, Years ending 2015 and 2016 (in $000’s)



2015 

2016 




$ 

$ 

Sales 


$ 1,017 

$ 1,015 

Cost of Goods Sold 

808 

805 

Gross Profit 

209 

210 

S, G & A 


128 

135 

Depreciation/Amortization 
40 

45 

EBIT 


41 

30 

Interest Expense 

9 

12 

Earnings Before Taxes 


32 

18 

Income Taxes 

10 

8 

Net Earnings 

$22 

$10 

A potential acquirer of Babcock, after projecting annual sales for three to five years into the future, can estimate related costs as a percentage of sales. If we assume that sales are projected to grow 5% per year, the future Sales and Cost of Goods Sold would be calculated as shown in the following Table. From the projected amounts we can estimate Gross Profit as well. At the 5% growth rate, Revenues increase to an estimated $1.295 million and Gross Profit to $272 thousand in year 2021, respectively.
$’ 
2017 Projected 
2018 Projected 
2019 Projected 
2020 Projected 
2021 Projected 
Revenues 
1,066 
1,119 
1,175 
1,233 
1,295 
Less: Cost of Goods Sold (at 79% of sales) 
842 
884 
928 
974 
1,023 
Gross Profit 
224 
235 
247 
259 
272 
From there, Operating Expenses such as “Selling, General and Administrative” expenses can also be estimated using historical costs as a percentage of sales. Calculated in a manner similar to Cost of Goods Sold, “S,G & A” expenses were 12.6% of Sales in year 2015 (SGA in 2015: $128/Sales in 2016: $1,017) and 13.3% of Sales in year 2016 ($135/$1,015). Using 13% of Sales as a rough estimate, a projection of Gross Profit and S,G&A can be conducted resulting in an estimate of ‘EBITDA’ (Earnings Before Interest, Taxes, Depreciation and Amortization) for the five years.
In $000’s 
2017 Projected 
2018 Projected 
2019 Projected 
2020 Projected 
2021 Projected 
Revenues 
1,066 
1,119 
1,175 
1,233 
1,295 






Gross Profit 
224 
235 
247 
259 
272 
Less: SG,&A (at 13% of sales) 
139 
146 
153 
160 
168 
EBITDA 
85 
89 
94 
99 
104 
There are questions that arise at this point when projecting sales, costs and profits from historical data. For example, Babcock’s sales showed a small decline from 2001 to 2002 yet in this forecast, the valuation expert estimated that the sales would increase 5% a year for the five year period. When conducting a valuation for an acquisition, the buyer typically evaluates the target in two ways.
One is the value he/she believes the target company will generate under new ownership. In the case of the Babcock example, the acquirer feels that when taken over, the new management team will be able to implement new strategies such as price increases or others that result in higher market share driving a faster growth in Sales. The buyer may see a higher growth rate in the industry that Babcock competes in where the Babcock management has been unable to stay pace with. The buyer will also evaluate whether the cost assumptions such as “Cost of Goods Sold” and “S,G, & A” expenses as a percent of sales are realistic or whether they can be reduced or need to be increased.
Ironically, the buyer will calculate a separate value when discussing the actual ‘price’ he/she will be paying to the seller. Under that valuation scenario will be based on the historical performance of Babcock under current management. The buyer can then take the difference between the two valuations to ascertain how much ‘intrinsic’ value they can generate (i.e., “intrinsic value” equals “value under new management” less “value under previous management”).
In the Babcock example, the valuation for the company is almost complete. Recall in the previously discussed valuation for early stage companies that a terminal value can be used to estimate the value of a company at the last year of the projections to approximate later year earnings. The same condition exists for mature companies where terminal values are typically used to estimate the value of the company at the end of year five based on EBIT or EBITDA. For Babcock, the buyer noted that the in the “The 2010 Business Reference Guide”, pharmaceutical preparation companies typically sell for six times EBITDA.
Finally, while discount rates of 30% or higher are often used for early stage companies without revenues or profits, valuation experts lower the required rate of return for businesses such as Babcock as the risk of failure is less due to the company’s operating history. Using a publiclyheld company’s discount rate of 10% to 15% as a starting point, investors will increase the rate for smaller, privatelyheld firms for higher levels of perceived risk. In Babcock’s case, buyer’s estimated that a 20% discount rate would be adequate for the risk of the investment. The table below presents the result of the Babcock Net Present Value.
In $000’s 
2017 Projected 
2018 Projected 
2019 Projected 
2020 Projected 
2021 Projected 
EBITDA 
85 
89 
94 
99 
104 
Terminal Value (6 x 2007) 




624 
Annual Values 
85 
89 
94 
99 
728 
Present Value Factor @ 20% 
.833 
.694 
.579 
.482 
.402 
Present Value 
71 
62 
54 
48 
293 






Cumulative Present Value 
$528 




(Note: For this example the ‘6X EBITDA’ multiple, note that this is a general ‘ruleofthumb’ valuation multiple. In reality, a valuation expert would evaluate the company’s management, market potential, and other variables that could justify a lower or higher multiple. Many will use a range of 4 to 10X EBITDA with 6 or 7X as the midpoint. More attractive companies will attract an 8 or higher multiple whereas poorly performing companies will drop to the 4 range or lower.)
Under these assumptions, the evaluator would estimate that Babcock’s value is $528 thousand. When entering the negotiating process, an acquirer would attempt to pay no more than what he/she believes it’s truly worth based on the above analysis. Of course, the seller of a company will hopefully perform his/her own projected valuation and come up with a much higher number. Thus, the negotiation process will eventually lead to a final price for the company being acquired some where between the buyer and seller’s figures.
Conclusion
This chapter provides a quick synopsis of some valuation methodologies used in the business world. Such methods include the Book Value approach using a company’s Balance Sheet, a Market Approach where the values from other companies and transactions are used to approximate the current value of the business, and finally, the use of future earnings/cash flow prospects presented on a presentday basis using Net Present Value and Discounted Cash Flow.
The major points that the reader should remember when conducting valuations are: (1) the more information you can gather will only help your analysis; (2) A variety of methods are used, not just one, when valuing a company; (3) the valuation is as much an ‘art’ as a quantitative ‘science’ as final values are based on a variety of subjective assumptions that are open to argument; and, (4) the value one calculates may not be the actual ‘price’ of the transaction as market conditions, negotiation, timing, and the condition of the asset will ultimately influence what is finally paid.
Appendix A
Net Present Value/Discounted Cash Flow: A Primer
What Is Time Value?
If you’re like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctual. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn’t it? Actually, although the bill is the same, you can do much more with the money if you have it now: over time you can earn more interest on your money.
Back to our example: by receiving $10,000 today, you are poised to increase the future valueof your money by investingand gaining interest over a period of time. For option B, you don’t have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:
If you are choosing option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for option B, on the other hand, would only be $10,000. But stay tuned to find out how to calculate exactly how much moreoption A is worth, compared to option B.
Future Value Basics
If you choose option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investmentat the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rateof 4.5% and then adding the interest gained to the principal amount:
Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450
You can also calculate the total amount of a oneyear investment with a simple manipulation of the above equation:
The manipulated equation above is simply a removal of the likevariable $10,000 (the principal amount) by dividing the entire original equation by $10,000.
If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920:
Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25
The above calculation, then, is equivalent to the following equation:
Future Value = $10,000 x (1+0.045) x (1+0.045)
Think back to math class in junior high, where you learned the rule of exponents, which says that the multiplication of like terms is equivalent to adding their exponents. In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be represented as the following:
We can see that the exponent is equal to the number of years for which the money is earning interest in an investment. So, the equation for calculating the threeyear future value of the investment would look like this:
This calculation shows us that we don’t need to calculate the future value after the first year, then the second year, then the third year, and so on. If you know how many years you would like to hold a present amount of money in an investment, the future value of that amount is calculated by the following equation:

Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because present value is what your investment gives you now if you were to spend it today. If $10,000 were to be received in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulated as follows:
Let’s walk backwards from the $10,000 offered in option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the twoyear mark, we would discount the payment back one year. At the twoyear mark, the present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two
Note that if today we were at the oneyear mark, the above $9,569.38 would be considered the future value of our investment one year from now.
Continuing on, at the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:
Present value of $10,000 in one year
Of course, because of the rule of exponents, we don’t have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as FV. So, here is how you can calculate today’s present value of the $10,000 expected from a threeyear investment earning 4.5%:
So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000  $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from option A, your choice gives you a future value that is $1,411.66 ($11,411.66  $10,000) greater than the future value of option B.
Present Value of a Future Payment
Let’s add a little spice to our investment knowledge. What if the payment in three years is more than the amount you’d receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let’s find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:
In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:
Present Value
From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years!
Conclusion
These calculations demonstrate that time literally is money—the value of the money you have now is not the same as it will be in the future and vice versa. So, it is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.
An approach used in capital budgeting where the present value of cash inflows is subtracted by the present value of cash outflows. NPV is used to analyze the profitability of an investmentor project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Formula:
NPV compares the value of a dollar today versus the value of that same dollar in the future, after taking inflation and return into account.
If the NPV of a prospective project is positive, then it should be accepted. However, if it is negative, then the project probably should be rejected because cash flowsare negative.
Appendix B
Discount Rates
Textbook Definition: The discount rate is calculated by taking a riskfree return (the yield on 30year US Treasury Bonds) and adding a risk premium to account for the uncertainties involved in holding equities. I like to think of the discount rate as the rate I would expect to earn if I was able to invest in a company at its intrinsic value. For example if I wanted to earn a 15 percent return on my investment I would use 15 percent as my discount rate. An investor would earn a 15 percent rate of return if the investor was able to purchase the investment at its intrinsic value.
The Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM)
A major contribution to the field of corporate finance is the concepts of Capital Asset Pricing Model (CAPM) and Weighted Average Cost of Capital. Both are instrumental in developing a discount rate (or cost of capital) for firms to utilize in their capital budgeting and valuation decision analysis when using Net Present Value or Discounted Cash Flow.
Capital Asset Pricing Model
CAPM is a process to assist firms in estimating a cost of capital for their shareholders, or Re, the estimated rate of return for equity investors. CAPM estimates a firm’s Re by using historical stock return to data in deriving what level of ‘premium’ shareholders will desire in relation to a risk free return and the stock market as a whole. The following equation is the basis for CAPM:
Re = Rf + B (Rm – Rf)
Where:
Re = Required rate of return on company’s stock by shareholders
Rf = the risk free rate return ( usually the annual return on 10 or 30 year US Treasury Bill)
B = Beta, the historical correlation between the company’s stock and the stock market, between 1.0 to +1.0.
Rm = the historical return of the overall stock market, for example the S&P 500 Index, usually 1012% per
year;
Most of the data required to estimate the Re in the CAPM is readily available from sources such as YahooFinance, the Wall Street Journal, and any online stock research database. The following is an example used to illustrate CAPM. Let ‘s use General Electric as of May 18th, 2005 stock data:
Rf = 4.44% per Wall Street Journal on 5/18/05 for 30 Year Treasury Bond.
B = 0.901 http://finance.yahoo.com/q/ks?s=GE(this beta implies that as the overall stock market changes
by 1%, GE’s stock changes by 0.91% or that historically the GE stock varies less than the market
does).
Rm = 8%, taking the close of the S&P 500 at its lowest point on June 1932 of 4.44 to the S&P 500 on May 18,
2005 at 1186. The compounded annual growth rate is roughly 8%.
Re = 4.44% + 0.901 ( 8%  4.44%)
Re = 4.44% + 3.21%
Re = 7.65% for GE.
Thus, CAPM estimates that the Required return by equity shareholders under the assumptions provided is 7.65% per year.
Weighted Average Cost of Capital (WACC)
The WACC of a company builds on the Re for shareholders by also including the annual rate of interest paid to debt holders so that a ‘cost of capital’ based on the entire capital structure, whether a company is financed by debt or equity, can be computed.
Using the aforementioned example, suppose that GE maintains a debt/equity structure of 50%/50% meaning that for every dollar of equity financing, GE also possesses one dollar of debt financing. Also, assume that analysis showed the average interest rate on debt owned by GE is 5%. The WACC is calculated as followed:
D = Debt level, 50% of total financing (hypothetical)
E = Equity level, 50% of total financing (hypothetical)
Rd= Annual Interest rate on debt, 5% (hypothetical)
Re = Equity Return, 7.65% calculated in CAPM discussion
WACC = [{D/(D+E)} x Rd] + [{E/(D+E)} x Re]
WACC = [{50/(50+50)} x 5%] + [{50/(50+50)} x 7.65%]
WACC = 2.5% + 3.825%
WACC = 6.325%
Appendix C
‘Rule of Thumb’ Valuations
"Rules of thumb" are often used to make quick estimates of business values  however, true values can vary materially. For example an innovative business with a high growth rate and great future prospects will be valued much higher than a competitor with low or negative growth and dim future prospects  even if both businesses have identicalrevenues at the date of valuation. Consequently, rules of thumb should be used only as an initial reality check and should notbe relied upon to value a business.
The following data is supplied from The Business Reference Guidepublished by Business Brokerage Press(http://bizstats.com/rulesofthumb.htm). This is a resource for any individual involved in valuing, buying or selling privately held businesses. This 700 page guide also details reasoning, alternative methods, outside references and pricing tips for valuing small businesses  as well as the limitations of relying on rules of thumb. Following is a selected portion of the businesses covered and methods outlined within the guide.
Type of Business 
"Rule of Thumb" valuation 
Accounting Firms 
100%  125% of annual revenues 
Auto Dealers 
23 years net income + tangible assets 
Book Stores 
15% of annual sales + inventory 
Coffee Shops 
40%  45% of annual sales + inventory 
Courier Services 
70% of annual sales 
Day Care Centers 
23 times annual cash flow 
Dental Practices 
60%  70% of annual revenues 
Dry Cleaners 
70%  100% of annual sales 
Employment & Personnel Agencies 
50%  100% of annual revenues 
Engineering practices 
40% of annual revenues 
Florists 
34% of annual sales + inventory 
Food/Gourmet Shops 
20% of annual sales + inventory 
Furniture & Appliance Stores 
15%  25% of annual sales + inventory 
Gas Stations 
15%  25% of annual sales + equip/inventory 
Gift & Card Shops 
32%  40% of annual sales + inventory 
Grocery Stores 
11%  18% of annual sales + inventory 
Insurance Agencies 
100%  125% of annual commissions 
Janitorial & Landscape Contractors 
40%  50% of annual sales 
Law Practices 
40%  100% of annual fees 
Liquor Stores 
25% of annual sales + inventory 
Property Management Companies 
50%  100% of annual revenues 
Restaurants (nonfranchised) 
30%  45% of annual sales 
Sporting Goods stores 
30% of annual sales + inventory 
Taverns 
55% of annual sales 
Travel Agencies 
40%  60% of annual commissions 
Veterinary Practices 
60%  125% of annual revenues 
Appendix D
Terminal Value
In a discounted cash flow valuation and net present value, the earnings (or cash flow) is projected for each year into the future for a certain number of years, after which unique annual cash flows cannot be forecasted with reasonable accuracy. At that point, rather than attempting to forecast the varying cash flow for each individual year, one uses a single value representing the discounted value of all subsequent cash flows. This single value is referred to as the terminal value.
The terminal value can represent a large portion of the valuation. The terminal value of a piece of manufacturing equipment at the end of its useful life is its salvage value, typically less than 10% of the present value. In contrast, the terminal value associated with a business often is more than 50% of the total present value. For this reason, the terminal value calculation often is critical in performing a valuation. The terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern.
Terminal Value if Liquidated
If the firm is to be liquidated, the liquidation value can be based on book value, salvage value, or breakup value, but liquidation value usually understates the terminal value of a healthy business. One must make assumptions about the salvage value of the assets and net working capital. The net working capital may have a certain recovery rate since it might not be readily liquidated at balance sheet values. In the pro forma projections, one often may assume that net working capital will grow at the same rate as cash flow. The terminal value if the firm is liquidated then is the sum of the discounted value of the cash flow, the recovered net working capital, and the salvage value of the longterm assets, including any tax benefits.
Terminal Value of the Ongoing Firm
For an ongoing firm, the terminal value may be determined by either using discounted cash flow (DCF) estimates or by using multiples from comparable firms.
For the DCF method, if the unlevered free cash flow is growing at a rate of g per year for a set number of years, the terminal value can be calculated by modeling the cash flow as a Tyear growing perpetuity. At the end of T years, one can assume a different growth rate (possibly zero) or liquidation. If multiples from comparable firms are used, the price/earnings ratio, market/book values, or cash flow multiples are commonly used.
The unlevered terminal value is calculated using the return on assets (rA) as the discount rate. The levered terminal value is calculated using the weighted average cost of capital (WACC) as the discount rate.
Terminal Value of the Debt
The terminal value of debt or preferred stock is simply the projected book value of the debt or preferred stock in the year that the terminal value is being calculated.
Terminal Value of the Common Stock
The terminal value of the common stock is the total levered terminal value less the terminal value of the debt, less the terminal value of the preferred stock (adding in the amount from any warrants that are exercised at their exercise price), plus the cash gained from the exercise of any common and preferred warrants.
[1]The 2015 Business Reference Guide: The Essential Guide to Pricing a Business, , written and compiled by Tom West, 25thEdition, Business Brokerage Press.
[2]‘Normalized’ is defined as what a normal level of expense would be for a typical business in an industry.
[3]Ibid, 2015 Business Reference Guide, p. 2.
[4]“The Ultimate Valuation Guide”, Inc. Magazine, August 2004, p. 7982.
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