Business Valuation Demystified

By Edward Nelling

Priceless business valuation methods made easy!

Business valuation is one of the toughest classes in any business curriculum. And it's one of the most important. Master this critical topic, and you've removed a major obstacle standing between you and a 4.0, and taken a major step toward a successful career in business.

Breaking down business valuation methods into easy-to-digest parts, this self-teaching guide provides all the skills you need to determine a company's worth--easily and accurately. Business Valuation DeMYSTiFieD offers expert insight from both buyers' and sellers' points of view and provides examples and exercises illustrating the concepts driving the practices.

This fast and easy guide features:

• In-depth coverage of the three main methods of valuing businesses: discounted cash flow, price multiple, and liquidation
• Easy-to-understand descriptions of financial ratios
• Tools and techniques for deciphering valuation reports, financial statements, and guidelines for specific businesses
• Chapter-ending practice exercises and a quiz for testing and reinforcing what you've learned

Simple enough for a beginner but challenging enough for a more advanced student, Business Valuation DeMYSTiFieD is your shortcut to building a solid foundation in this critical business topic.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Feb 11, 2011
• ISBN: 9780071759489

Book preview

Business Valuation

DeMYSTiFieD®

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Business Valuation DeMYSTiFieD®

Edward Nelling

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

ISBN: 978-0-07-175948-9

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This book is dedicated to my mother, Lorraine Nelling, who taught me the value of the most important things in life.

About the Author

Edward Nelling, Ph.D., CFA, is Professor of Finance and a Fellow in the Center for Corporate Governance in the LeBow College of Business at Drexel University, where he teaches courses in investment analysis and financial management. He has served as a consultant on mutual fund and exchange-traded fund performance, and as an expert witness. He holds the Chartered Financial Analyst® designation from the CFA Institute, and is a member of the CFA Society of Philadelphia. He has also taught at the Wharton School, the Georgia Institute of Technology, and Korea University.

Contents

Introduction

CHAPTER 1 Commonly Used Valuation Methods

Chapter Objectives

Applications of Business Valuation

The Discounted Cash Flow Valuation Method

The Price Multiple Valuation Method

The Liquidation Valuation Method

Chapter Summary

Quiz

CHAPTER 2 An Overview of Financial Statements

Chapter Objectives

Different Types of Financial Statements

Other Sources of Information

An Overview of the Balance Sheet

An Overview of the Income Statement

An Overview of the Cash Flow Statement

Chapter Summary

Quiz

CHAPTER 3 Analyzing Historical Financial Performance

Chapter Objectives

Common-Size Financial Statements

Calculating and Interpreting Ratios

Ratio Classification

Return on Equity and DuPont Analysis

Analyzing Performance with Return on Invested Capital

Segment Analysis for Multibusiness Companies

Limitations of Ratio Analysis

Chapter Summary

Quiz

CHAPTER 4 Forecasting Future Performance

Chapter Objectives

Applications of Forecasting

The Length of the Forecast Horizon

Forecasting Sales

A Simple Forecasting Example

The Use of a Plug Figure

A Closer Look at Forecasting the Income Statement

A Closer Look at Forecasting the Balance Sheet

Forecasting the Cash Flow Statement

Forecasting with Profit Margins and Turnover Ratios

Scenario Analysis and Financial Forecasting

Chapter Summary

Quiz

CHAPTER 5 Discounted Cash Flow Valuation

Chapter Objectives

Basic Principles of DCF Valuation

Estimating Free Cash Flow

More on the Growth Rate

More on the Discount Rate

From Enterprise Value to Equity Value

An Example of DCF Valuation

The Effects of Changing Assumptions

Advantages and Disadvantages of DCF Valuation

Chapter Summary

Quiz

CHAPTER 6 Price Multiple Valuation

Chapter Objectives

The Basics of Price Multiples

Types of Price Multiples

Choosing the Right Multiple

Choosing a Set of Comparable Companies

Determining the Appropriate Value of Our Multiple

Example of Price Multiple Valuation

The PEG Ratio and Valuation

Chapter Summary

Quiz

CHAPTER 7 Valuation and the Cost of Capital

Chapter Objectives

The Intuition behind the Cost of Capital

Financing Decisions and Company Value

Required Returns on Debt

Required Returns on Equity

Putting It All Together—Estimating the WACC

Chapter Summary

Quiz

CHAPTER 8 Small Business and Private Company Valuation

Chapter Objectives

An Overview of Small Business Valuation

Discounted Cash Flow Valuation of Small Businesses and Private Companies

Price Multiple Valuation of Small Businesses and Private Companies

Applying Discounts and Premiums in Business Valuation

A Small Business Valuation Example

Chapter Summary

Quiz

CHAPTER 9 Key Questions That Business Buyers and Sellers Need to Ask

Chapter Objectives

The Five Key Questions That Buyers Need to Ask

The Five Key Questions That Sellers Need to Ask

The Critical Question That All Buyers and Sellers Need to Ask

Chapter Summary

Quiz

Final Exam

Answers to Quizzes and Final Exam

Appendix

Index

Introduction

Congratulations on your decision to learn about the world of business valuation! Studying this topic and learning it well can be very rewarding, both intellectually and financially. This book is designed primarily for undergraduate or graduate students interested in learning about valuation. This is a natural topic for many students in business, but students in many other fields should understand the basics of valuation. However, my goal was to make the material accessible for a general audience—all the way from an old school proprietor who has worked his whole life to build his business, to someone serving on the board of directors of a public company. Midlevel managers and rank-and-file employees all need to know how their company is valued and how their actions and decisions can enhance this value.

Many companies require employees to make their own investment decisions shortly after starting work, as they choose to invest in company stock and among alternatives in a retirement plan. It seems that these days everyone needs to know about valuation. Even if you don’t have an extensive mathematical background, you should be able to comprehend all the important concepts and most of the basic calculations in the book. Valuation is not easy, but it is not rocket science, either.

The heart of the book is in the chapters on discounted cash flow and price multiple valuation. Make sure that you know this material well. Readers without mathematical backgrounds might choose to skip the chapter on the cost of capital and will still understand the broad topic well. Anyone who works in a family business should read the material on small business and private company valuation closely. If you are thinking of buying or selling a business, devote some time to thinking about the key questions posed in the last chapter.

To master the material, I suggest that you try to work through the chapter quizzes and final exam. However, even if you just give the book a quick read, I think you will find yourself wondering more and more about the value of the company for which you work—or perhaps own. This book is not intended to make you an expert. The valuation process is quite complex, and if you plan to buy or sell a business, it is worthwhile to retain the services of experts such as accountants, attorneys, and valuation consultants. Even though you won’t be an expert, you will probably know the right questions to ask, and you will be able to participate more fully in the process. Business valuation is a fascinating topic, and every company presents its own set of challenges and unique considerations.

How to Use this Book

The topic of business valuation incorporates material from other courses in finance and accounting. The subject is fairly quantitative, but the mathematical calculations are fairly straightforward and do not require any knowledge beyond basic algebra. I assume that you have a basic familiarity with financial statements, but even students with no accounting background should be able to grasp the fundamental concepts.

The best way to approach this material is to read each chapter, and then take the multiple-choice quiz for that chapter. Feel free to take the quizzes in an open-book format, in which you refer back to the relevant chapter material. Ask a friend or coworker to determine your score on the quiz. They should tell you your score, but not which questions you got wrong. You should review your answers and rework the quiz until you get a score of at least 80 percent. Then, you should refer to the answers to make sure that you understand the material thoroughly.

I suggest that you try to complete one chapter a week. Allocate an hour or two to read each chapter, and another hour or two for the quiz. The material in later chapters builds on the fundamentals in the earlier chapters, so proceed at a pace that is comfortable for you. To gauge how well you know the material in each chapter, try explaining it to a friend (this may really test your friendship). If your friend can follow your explanation, you’re on the right track.

There is a final exam at the end of the book. After you have completed all chapters and feel that you have a good working knowledge of the material, take the final exam. Try to complete it without referring to the text. Again, ask a friend or coworker to determine your score. The person helping you can note which questions you got wrong. You should then review these questions and rework them, until you get an overall score of at least 80 percent.

When you are finished with the final exam, you may want to practice your valuation skills by examining financial statements and valuing stocks of public companies. Plenty of information is available, and it is fascinating to discover the unusual challenges that arise when valuing companies in different industries. Be forewarned, however. When you value companies for real, there is no right answer. Don’t worry, though—right or wrong, business valuation is interesting and enjoyable. Have fun learning!

Business Valuation

DeMYSTiFieD®

chapter 1

Commonly Used Valuation Methods

There are many useful applications of business valuation. If we are faced with the need to value a business, how do we get started? In this chapter, we introduce the valuation methods that are used most often and describe when each method is appropriate.

CHAPTER OBJECTIVES

After completing this chapter, the student should have an understanding of

• The motivations for valuing a business

• The discounted cash flow valuation method

• Business valuation using price multiples

• The liquidation valuation method

Applications of Business Valuation

Are you buying or selling a business? If the answer is yes to either, then you certainly have an interest in valuation. After all, the transaction is likely to have a significant effect on your financial situation. If you’re a buyer, you don’t want to pay more than necessary; if you’re a seller, you want to receive as much as possible. However, the need to understand the valuation process is not limited to buyers and sellers. Consider the situations faced by the individuals below:

• Mary Simpson graduated from college 10 years ago and has been working in the small software business started by her father in Boston. Mary’s father just received an offer for the business and has asked Mary for her opinion. Mary is trying to decide if it is time to sell the business, or instead expand by buying one of her company’s main competitors in California.

• Victor Martinez is the owner and chef at one of the most popular restaurants in New Orleans. He feels that the time is right to expand and is planning to contact a group of potential investors for financing.

• Arthur Robinson and his son established a successful painting business over 20 years ago. Arthur is nearing retirement and is planning for his son to run the company.

• Tom Young owns a small chain of hotels. He is considering the creation of an employee stock ownership plan to give his employees a stake in the business.

• Ramesh Patel is an executive running a division of medium-sized chemical company. His division has been performing well, but Ramesh feels that it could do even better if it was spun off into a stand-alone company.

All the situations above involve business valuation. In addition, other events that prompt