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I’ve seen a whole host of reasons and incentives. From angel investors, hostile takeovers, friends’ funding, or just family generosity, there are dozens of reasons why you may want to buy or invest in a business. But if you’re buying an existing business for profit and passive income, one thing is clear. You do not want to overpay.
This guide aims to help you estimate how much to pay by knowing the value of a company’s stock.
Trying to cover every single detail of a profession in one article has its challenges. To establish a little bit of order, the presentation will be somewhat (necessarily) academic and limited. That said, this process is completely based on my experience as a former practitioner and consultant. We’ll cover the basics, techniques, and best practices along the way.
Business Valuation definition
Business valuation is the process of estimating the value of a business so you’ll know what’s fair and how much to negotiate. Though it is part art, which means you and I might have different estimates. When we estimate the best case scenario, for instance, we’re probably going to have different assumptions — and, accordingly, different values. In fact, this uncertainty is a huge reason why trading stocks based on business valuations is hard.
Because of this, and the fact that forecasts are uncertain, the best course of action is to present a range of values: Low Case, Base Case, High Case
(High Case uses the most optimistic assumptions and forecasts.)
Despite the uncertainty, it’s an exercise worth doing to help you gauge the fairness of your ballpark price, or justify an offer at the very least.
Business valuation in the Philippines
In terms of costs, business valuation services in the Philippines run the gamut. Reputable and large accounting firms charge hundreds of thousands to millions, depending on the project’s scope. Smaller establishments cost less.
But it is worth noting that, other than for statutory requirements or when mandated by accounting standards, business valuation doesn’t have to be done by a professional. This means you can use this skill in buying (or even selling) a business, shares in the stock market, or even real estate — yes, the same principles apply.
Buying shares in a company
Our focus is on the valuation of a company’s shares (equity), and the assumption is the company you’re investing in is a corporation. Now, you could use the same theories to value a sole proprietor’s business, but the analogy falls when you’re buying just part of the business.
For simplicity, we’ll assume we’re trying to estimate the value of a company’s shares because you have the option to buy a portion of that company.
3 Phases of a Business Valuation
Now let’s go through the 3 phases of a business valuation undertaking.
Phase 1: Industry-specific expertise
Having industry-specific knowledge is crucial. As you’ll see later on, the estimated value is based on a lot of forecasting assumptions, and domain expertise cannot be understated.
Getting the value of, say, a data center, will be markedly different from the value drivers of a company in the food & beverage industry. So when valuation experts estimate value, the clients typically have domain expertise and work with the valuation specialist to explain the industry-specific nuances.
This means you will have to know the company’s industry before any attempts at estimating the value of a company.
Phase 2: Due diligence
Once you’ve acquainted yourself with the industry nuances, a discussion with the company’s management team takes place. This is where you start to hear about a company’s operations, where their struggles are, what distinct advantages they have, and so on.
Management and/or the current owners have incentives to overstate or understate the financial standing of a company, depending on the deal. For example, if they’re desperate for investors to come in, they might exaggerate revenues or other key areas. Or if it’s an unfriendly buyout and they don’t want to sell, they might understate income or overstate expenses.
Due diligence is then the process of verifying the accuracy of information provided (or not provided) by management. Garbage in, garbage out. Your valuation will only be as good as the information you feed it.
Phase 3: Business valuation process
By now you’ll have the historical financial statements of the company from the due diligence phase. Also, try to ask for the company’s 3 to 5-year forecast, if it’s available. Otherwise, we’ll forecast the important items based on the best practices mentioned later.
3 Business Valuation methods
There are 3 valuation methods. Others list more, but the additional methods are really just variants of these 3 broad groups. These are the (1) cost approach, (2) market approach, and (3) income approach.
The cost approach, as it relates to business valuation, is typically the net assets of a business.
The market approach estimates the value based on the price multiples (e.g., price-to-earnings ratio) of similar listed companies.
And the income approach estimates the value based on the future income of the business.
(All 3 approaches also apply to real estate and are further explained in a post on valuing an apartment building for beginners.)
The preferred method
When valuing a going-concern business, the most widely accepted method is the income approach. And that’s justified.
While the cost approach only considers the costs to replace or reproduce the business as of your valuation date, the income approach examines the future income you can get from the company. This is an important distinction because investors buy a business for its prospects (i.e, future benefit). They invest because of what the business can do for them in the future, less so with what it’s done in the past.
Alternatively, the market approach is also an acceptable method for going-concern businesses. But because the differences between the company being valued and the comparable companies can be significant, several adjustments have to be made.
For example, if the company you’re valuing has annual sales of 10 million, and a similar company that’s listed on the stock exchange has annual sales of 10 billion, then that’s a skewed comparison and will require a few significant adjustments.
In practice, we use the income approach to estimate our range of values, and the market approach to check the reasonableness of our range.
Going in-depth on the income approach
The income approach estimates the company’s equity by getting the present value of future cash flow due to equity holders. This is what’s called the Free Cash Flow to Equity.
Let’s break it down.
- We use the present value (i.e., discounted cash flow)
- Free cash flow, not income, is discounted back
- We’re focused on what equity holders get and ignore creditors’ shares
The present value is relevant to us because it considers the opportunity cost of investing elsewhere through the discount rate. It also allows us to compare apples to apples.
(I’ve omitted a thorough discussion on the Time Value of Money concept for brevity and for the sake of those familiar with the notion.)
Free cash flow
Instead of the company’s net income, we’re concerned with free cash flow because it represents a company’s capacity to fund expansions, pay its debt, and distribute dividends. Free cash flow is essentially net income but adjusted for non-cash items, changes in working capital, and capital expenditures.
FCFE (Free cash flow to equity)
But of the total free cash flow, we are actually only concerned with the free cash flow to equity. This is the free cash flow that’s available to equity holders and is the free cash flow adjusted for debt repayments and issuance of new debt.
We do not use net income because it deducts non-cash items such as depreciation and impairment. More on FCFE below.
A quick recap of what we’ve learned so far.
We will be using the income approach to value the business. This involves discounting our future free cash flow to equity. How far into the future? The industry practice is to forecast over the next 5 years and assign a terminal value (ending value) that accounts for years 6 and beyond.
If you’re familiar with discounting, you’ll know that the early years have greater weight (i.e., more impact) on the estimated value of the business. The idea of limiting our forecasts to 5 years is that it’s impossible to truly know what the business will be like in the future. And it’s unproductive trying to forecast further into the future. In other words, we get the most impact from the first 5 years anyway.
We’ve already talked about how FCFE is the free cash flow available to equity holders or stockholders. It is the recurring cash that’s available to shareholders and therefore takes into account the expansionary spending that the business needs, as well as the net cash from debt.
To get the FCFE, there are several starting points you can choose from. You may start with net income, free cash flow to the firm, or the cash flow from operations. Specifically, these are some of the options.
- FCFE = NI + Dep – Capex – Change in WC + Net Debt
- FCFE = FCFF + Net Debt – Interest x (1 – t)
- FCFE = CFO – Capex + Net Debt
- FCFE = Free cash flow to equity
- NI = Net income
- Dep = Depreciation & amortization
- Capex = Capital expenditure
- WC = Working capital
- FCFF = Free cash flow to the firm
- t = marginal tax rate
Regardless of the method or route, our goal is to arrive at the 5-year FCFE forecast.
Forecasting best practices
Forecasting is really where domain expertise shines. There are no absolute rules, and it’s really about being able to justify your forecasts. The idea here is to know the nature and tendencies per item and forecast accordingly.
Forecasting revenues will be very different per industry but some of the initial lists of questions might include: (1) Is your business seasonal? (2) Is it correlated with the economy? (3) Do you depend on a few large customers or many small customers?
The actual inflation numbers matter less. What’s more important is the citation and emphasis of your source.
Payroll and Rent (inflation-based adjustments)
A company’s payroll is relatively stable over time. Other than significant expansion or contraction plans, historical payroll is likely going to persist, adjusted for inflation.
Similar to payroll, rent is somewhat predictable and is based on your plans for expansion or contraction.
Marketing, Advertising & Promotion (percentage-based adjustments)
Unlike inflation-based adjustments, percentage-based adjustments fluctuate and are highly dependent on another variable.
For example, marketing expenses can be pegged to sales. If we’ve seen marketing expenses be 5% of sales, then we might assume the same percentage for our forecasts.
And this doesn’t have to be pegged to sales either. They can be based on another cost item or maybe even an industry statistic. The key is to recognize the patterns, if any, and apply those to our forecasts.
Interest, Depreciation & Amortization (defined schedule)
A lapsing schedule is prepared for these items. This timetable basically outlines the expected decrease over time in assets.
Because we are discounting the free cash flow to equity, the relevant discount rate is the cost of equity and not the weighted average cost of capital. Unfortunately, the computation of a discount rate is complex and deserves a separate post. My recommendation, for simplicity, is to use the build-up method, which is the risk-free rate plus a market premium and additional premiums you deem necessary.
Cost of equity = risk free rate + market risk premium + other premiums
We’re assuming the market risk premium accounts for the company’s volatility relative to the market (Beta). A higher discount rate leads to a lower value and vice versa. (See Investopedia’s guide on discounting and CAPM.)
Bringing it all together
Using the FCFE formula, plot the future FCFE per year and discount them back as of the valuation date.
Discounting is the process of getting the present value of a future cash flow. Let’s say you expect to receive Php100 next year. If the discount rate is 10%, then the present value is Php90.91.
Php100 / (1 + 10%) = Php90.91
If this seems complex, don’t worry. A spreadsheet like Microsoft Excel will have a formula for “PV” or present value.
The present value of all the future FCFEs is your estimated value. Now repeat this with your low case (worst case) and high case (best case) assumptions and you’ll have your range of values.
I realize a lot of the concepts mentioned might be new to some, and that’s fine. This broad guide hopefully puts you on the right track and mindset.
If there’s one takeaway, it’s this: Business valuation is both an art and a science, and is an invaluable tool in negotiating a deal.
When you come to the table to negotiate and present your case, it’s hard to argue with facts backed by data and economic theory. And that is what the business valuation process can do for you. It’s to increase your chances of not overpaying, in a persuasive method, to get the price you want.