Business valuation – theory vs practice

Lately the writer of this blog has been asked to value a number of businesses. The parties I did it for were interested in a correct valuation of the shares, and I decided to use the Discounted Future Cash Flow method as these business have been showing consistent returns for a couple of years. As I worked through my excel sheets, I want to share my thoughts on the relevance of a number of concepts typically found in finance courses:

NPV: net present value is taught as the best method for determining value created. For this we will discuss 2 things: the right discount rate (WACC) and a good estimate of future cashflows.  It is worth pointing out that NPV has only 1 way to handle the time factor of the future cash returns: it discounts them. The further out these cashflows, the more they get discounted. A big cash inflow at the end of a project is factored in for a smaller amount in order to reflect the waiting time. But NPV method will assume this inflow WILL occur; in real business life, an investor will not care about this as he will want to see his investment sooner rather than later.

Future cashflows: normal financial doctrine says that exceptional cashflows should be filtered out of the future estimations of cashflows. Though this is generally true, there are cases where it is wise to include them. If a business is loss making and a turnaround plan is presented, the only right option is to include both cash outflows and the forecasted return of this plan. Moreover, it is important to look at how steady the cashflow is going forward.

WACC: It is hard to decide at which rate cashflows need to be discounted. CAPM is a widely used concept, but it is theoretical and fails to reflect the true business dynamics. The Beta used in CAPM can only be observed on big, publicly traded companies and is then applied on other firms of the same sector. It is easy to see how that is an imperfect way of looking at a company and and easy trap to underestimate risks. What is particularly true with very young companies and startups is that the discount rate should be set higher than the WACC; also it is a good idea to vary it over the future years. So first and second year would be discounted (relatively) more heavily (say 30%), then a ‘normal’ rate of 20% can be applied for later years. The first years are riskiest and a constant WACC is a poor way to model that.

Some caution could be advisable for estimating the borrowing rate of the bonds and loans of a company. What counts is the refinancing rate, not the actual current rate. But of course the refinancing rate is much harder to determine as it cannot be observed. Finally this we are supposed to take the target capital structure, rather than the current situation. Of course, the target company will know this and might be overly optimistic about the leverage they foresee. In reality, often the current financing structure will do just fine.

These are just a few observations from my side, I’m keen to hear some other!


About curiousmanager

In life there are generalists and specialists. Although your job pushes you down towards a certain specialization, I feel it's important to keep your eyes and mind open for new stimuli. And I want to share my journey through arts, literature and sciences with other knowledge workers and managers. You don't have time to read. Let me do that for you and present only the best of the best in my blog!
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