How Do You Estimate The Value Of A Business?

The value that a company provides to its owners will be the sum of all the cash that flows from the business to the owners. At the end of the year when all the bills are paid and all the current obligations have been met, any cash that is left over belongs to the owners. To get the total value of the business today, we add together the expected cash that flows to owners for each year over the lifetime of the business.

This is the essence of valuing a business from its cash flow. The approach has a certain intuitive simplicity about it that makes it appealing.

Company Value = CF1 + CF2 + CF3 ……….CFn

Where CFn = Annual Cash Flow for year n.

So if we can calculate the future cash flow of the company, we have an estimate of its value.

However, simply calculating the sum of future cash flow is insufficient because money in the future has less value than money today. There are two significant reasons for this:

  • If we have money today we can invest it and start earning a return immediately. To delay earning a return is a risk for an investor.
  • Future money is at risk because the future is unknown.

To compensate for these risks we need to discount future cash flows.

Accordingly, we apply a discount factor to each year's cash flow. The further into the future, the more devastating is the effect of the discount factor. Adding the discount factor to account for the risks, the formula becomes...

Company Value = CF1 + σCF2 + σCF3 ……….σCFn

Where σ is the discount factor

But immediately we can see more questions

  • What discount rate do we use?
  • When do we stop the calculation?

Before looking at the discount rate...

Before we can understand the value of the discount rate, we have to look at the basics of financing a company. The money (capital) used to start and grow a business comes in two forms:

  • Debt - on which the firm has to pay interest and eventually repay the debt
  • Equity - on which investors expect a return

Thus the capital used in a firm has a cost.

When a firm uses its capital, the result has to create enough value to cover the “cost of the capital”. If the return created is less than the “cost of capital” then value has been destroyed. Conversly, if the return created exceeds the cost of capital, value is created - this is the principal economnic goal of any “for profit” business.

We use the “Cost of Capital” as the discount rate. This allows us to estimate the “operating value” of the business including the cost of the capital that is used for operations and growth.

Expressed slightly differently, the “Cost of Capital” represents the hurdle rate that management must achieve in terms of payback on the capital employed. If management fails to earn the cost of capital then value is being destroyed. This is an important point because the drama of rapid sales growth and high expectations can mask the fact the value is being destroyed - that’s why keeping an eye on value is very important.

A simple example

Assume we borrowed $1M from our bank at an interest rate of 10% to expand operations for increased sales. At some point the firm will have to pay back the principal but in the meantime only interest payments are required. In the first year of having the debt, profits increase by $100k. Since this is 10% of the debt amount, management was able to use the investment to earn the cost of the debt, and hence no value was destroyed. In other words the earnings paid for the interest on the loan and the result was a "cash flow breakeven" In the second year profits increased to $150K so that after paying off the interest of $100K the firm is able to retain an additional $50K in cash. In this case, value has been added to the firm. This example is overly simplistic, but it illustrates the point of generating enough profit to pay the cost of the capital. In reality the calculation would be more complicated, because, if nothing else, we should factor in taxes, since interest in the U.S. is tax deductible. In addition this example does not deal with equity, which as we will see below is more complicated.

Discount Rate

We have one discount rate but as we have just seen there are at least two types of financing availableto a firm, debt and equity. This raises the question how do we arrive at a single discount rate? The solution is that the cost of debt and the cost of equity are combined into a single discount rate according to their proportions. This is called the “Weighted Average Cost of Capital” or WACC

Time Period

The other challenging question we have is how far into the future do we make the calculation. There are two approaches:

  • Use a long range time period
  • Use a modified formula

Using a long range time period

We can apply the formula for discounted cash flow over a long period, say 150 years to get an estimate of the value. Some points to note about this approach are:

  • It's straightforward, intuitive, and requires no assumptions
  • It's easy to set up with a spreadsheet
  • The amount of value added by, say year 150, is small compared to the early years, and so while the method may be seen as an approximation, it's close enough for our purposes.

Linking To Value Based Marketing Strategies


Modified Formula Using Forecast Period and Remaining Value

The essence of the differential advantage is that your product offers sufficient unique value that customers choose your product over the competition, but at the same time the sale of the product has to return value to your company. This is the essence of building the company value.

In a competitive market we can expect that the differential advantage will be eroded over some period of time. The result is that the product becomes commodity status and no longer will the revenues add value to the business. From this point on, no additional value is added to the business, regardless of sales volume.

This period in which value is being added is called the Forecast Period and is defined as the period over which the strategy earns returns that are higher than the cost of capital.

Methodology For Calculating the Value Using The Forecast Period

The calculation is split into two periods

The forecast period, which might be something like 5 years, is then used in a DCF calculation to estimate the first component of the value. The value for the remaining period is then estimated by using one of a number of different formulas. One method divides the Net Operating Profit After Tax by the cost of capital. Its beyond the scope of this work to explain why this works, but it does provide reasonable values. There are some challenges in picking the appropriate assumptions when you take this approach. For a more detailed discussion see Valuation: Measuring and Managing the Value of Companies, 5th Edition (Wiley Finance)

Recap

  • The value of a firm can be estimated from its Cash Flow
  • Future cash flows have to be discounted to include future risks
  • The period over which marketing strategies add value to the firm is the “Forecast Period”