Stock Market Business Valuations
Understanding Business Valuations
When private businesses are put up for sale they generally have a professional valuation done by a business valuator. Similarly when a prospective business purchaser is looking at buying a particular business they have an independent valuation done which is also performed by a business valuator.
Just like a real estate valuator who values property, business valuators value businesses.
A common method business valuators use to value a business is the discounted cash flow method. These valuations are largely based on what prospective business purchasers are willing to pay for a business. After all there is no point in valuing a business at such a high price that no one will ever buy it.
Typically the business seller's valuation will be slightly optimistic and the prospective business buyer's valuation will be slightly pessimistic. This is exactly the same with real-estate where the seller seeks a higher price and the buyer is looking for a better price.
Thus the process of negotiating begins and the final sale price ends up being a compromise between the two parties. This is the same whether it's a real-estate sale or a business sale.
The prospective buyer of a business is primarily concerned with the annual profit that the business in question will make based on the purchase price. Private businesses with a stable earnings history which are fundamentally sound tend to sell for around five times their annual profit. That is a PE ratio of 5? Compare this to the typical PE ratios of listed companies of around 15 to 20 and the stock investor may well wonder why such a discrepancy between private businesses and public companies
Some investors will justify the discrepancy in PE ratios between public companies and private businesses as being due to the relatively small size of private business. While market-cap size is certainly a factor it does not account for the average PE ratio of around 15 to 20 for large-cap stocks. In fact business valuations suggest that their PE ratios should be around 10.
Further more the PE ratios of small-cap stocks with stable earnings histories will often have PE ratios well above 20. This is the exact opposite of what they should be? The general justification is that they have more growth potential thus the higher PE ratios are justified. The problem with this is that they have much higher risks and investment philosophy states that the greater the risk is then there should be a greater compensation. This implies that the PE ratio should be lower and not higher. In fact that is exactly the way it is with private businesses. The smaller they are, the lower the PE ratios tend to be.
So what else explains the difference between private businesses and public companies?
To understand this, the reasoning behind the private business buyer needs to be understood. A prospective buyer of a private business has the option of placing their capital in a guaranteed investment such as Treasury bonds which might be currently paying a 5% coupon rate. This effectively gives a guaranteed return but it is a low return. For a higher return an alternative is to buy a private business and of course they will want a significantly higher return than 5% for the risks involved.
Let's suppose the prospective business buyer has $1 million to spend. They could simply buy $1 million in 10 year Treasury bonds at 5% and receive $50,000 a year effectively guaranteed. Further more their invested capital is secured and will be returned at maturity.
Prospective buyers of a private business are primarily concerned with the income that the business will generate. The resale value is not of prime concern as private business owners buy a business with the intention of running the business over the long-term which means decades.
When buying a business there are all sorts of risks, even with a business which has a stable earnings history. All it takes is for a large competitor to enter their industry and the likelihood is that the prospective business will be hit hard, both in reduced earnings and with reduced resale value.
Thus nobody in their right mind would pay $1 million for a business that only makes $50,000 a year since they can get this from Treasury bonds effectively guaranteed. To pay $1 million the prospective business buyer will want considerable more annual profit than a lousy $50,000 to compensate for all the risks.
So if Treasury bonds are paying 5% what would a prospective business buyer look for with a private business? This largely depends on the risks of not receiving the profits into the future. After all nobody wants to spend $1 million and get nothing back. Business buyers are paying around five time's annual profit for business with stable earnings histories. This works out to 20% annual profit or $200,000 a year for a $1 million private business.
Business buyers pay around five time’s annual profit
for business with a stable earnings history
The noticeable difference between a prospective buyer of a private business and a stock market investor is in the way they treat what they have bought.
- The private business buyer is concerned about how much profit the business will make for the capital used to purchase the business. They are primarily interested in the income and hold these businesses for decades - and even hold them through economic recessions.
- The stock market investor for the most part is only concerned about the stock price going up and has no real interest in the company's profits, other than if it can be used to justify an even higher stock price. Stock market investors often have short-term views and will often sell when stock prices fall.
Stock market investors are generally not interested when a company pays a dividend because it is such a small amount. The dividend is small partly due to the high price paid for the stock.
Stock market pundits have a misguided perception of risk. A lot of stock investors are really only investing in a rising stock price rather than investing in the business. They have no interest in the company's business or they are even not even aware that it is a business in the first place. This is highlighted below in Figures 1. and 2.
Figure 1. Investors buy stock
due to uptrend
Figure 2. Business buyers buy at business valuation
From Figures 1. and 2. above, looking at a stock for what it really is - which is a business - puts the stock price and its associated risk into perspective. A lot of stock investors especially beginners will over pay for no other reason than that the stock price is in a strong uptrend. Unfortunately this makes the stock price vulnerable to a correction and bear markets are especially cruel to overly inflated stock prices. Bear markets are simply a process of ridding the market of excess prices.
Private business buyers simply pass up on a business if the price is too high and the returns are not adequate to justify the risk. In stark contrast some stock investors are under the illusion that the higher the stock price is then the safer the investment is. This attitude simply turns a moderate risk investment into a high risk investment.
Stock investors can learn a lot from private business buyers. The famous investor - Warren Buffett thinks like a private business buyer and when he evaluates listed companies he only buys at prices which will provide a satisfactory return for the risks taken. The article Valuing Stocks like Bonds gives examples of how to estimate the future return.
Discounted Cash Flow
Business valuators prefer to use this valuation method
Discounted cash flow (DCF) is a valuation approach that is commonly used by business valuators when conducting valuations on both private businesses and public companies.
DCF is based on the idea that a business is worth the sum of the future cash flow it can generate.
DCF is a relatively complex method of valuing businesses but it does provide a good guide as to what a business is worth. DCF is however based on numerous assumptions and if these are incorrect it can make the valuation meaningless. Business valuators base their assumptions on industry specific knowledge and experience.
For the most part a DCF valuation is a relatively simple calculation process that the average stock investor can calculate. What makes it complex is determining the input data required and if this is inappropriate then the valuation will bear no resemblance to its true business value.
Obtaining appropriate input data is what makes using DCF difficult for the average stock investor, but it is beneficial to understand the basic process involved as this is how business valuators determine the valuation for both private businesses and public companies.
Understanding the basics of the DCF valuation process allows the stock investor to see just how easy it is to manipulate DCF in order to arrive at a preconceived valuation. Analysts who are employed by stock brokers can readily manipulate DCF to provide overly optimistic valuations in order to justify a high stock price. This is in contrast to business valuators who take into account what private business buyers will pay for the return on investment they require for the risks taken.
To provide the stock investor with an understanding of DCF, an overview of the steps involved in the process of determining a DCF valuation is outlined as follows.
DCF is essentially a cash flow forecasting model and the first step involves making assumptions regarding the future economic and business conditions in order to forecast the businesses future revenue.
The future revenue is forecasted over the forecast period which is usually around five years. The valuator takes into account the current and expected future economic and industry conditions. Any possible future competition is also taken into account. Future revenue growth which is not reflected in the current financial statements is also factored into the revenue forecasts as is any new products in the developmental stage.
The businesses past financial statements are analyzed and their revenue is projected for the next five years allowing for the expected future economic and industry conditions.
The future expenses are then forecasted which include the operating costs, new investment in equipment, expenditure on research and development and tax obligations. Future expenses which are likely to be incurred are included even if they are not reflected on the current financial statements
The cash flow for each of the five future years is then calculated by subtracting the expenses from the revenue.
Discounted Cash Flow
The future years cash flows are discounted back to the present day. A discount rate is determined and applied to each year. The discount rate is determined based on the risk of the business in meeting its revenue forecasts.
The discount rate determined by valuators is essentially the same as the fundamental valuation risk premium used to evaluate the return on investment for private business.
The continuing value is based on the business continuing to be operational after the forecast period rather than the business ceasing. The typical continuing period is 50 years after the forecast period and is also discounted back to the present day.
The forecast cash flow for fifth year is used and is projected forward for the next 50 years based on an expected future long-term average growth rate.
The final step is to add up the discounted cash flow values for the forecast period of five years and also add the discounted continuing value. The total of these six values gives the DCF valuation. An example of a DCF valuation is shown below in Table 1.
Table 1. Discounted Cash Flow Valuation
From Table 1. above, the discount rate used is 10% and the continuing long-term growth rate is 5%. The discounted cash flows are calculated as follows:
The discount rate is first converted to a Discount factor.
Discount factor = (1 + 10%) / 100 = 1.1
The Discount factor is then divided into each year's cash flow in order to calculate the discounted value for the cash flow.
Year 1. 5,500,000 / 1.1 = 5,000,000
Year 2. 6,000,000 / 1.1 / 1.1 = 4,958,678
Year 3. 7,000,000 / 1.1 / 1.1 / 1.1 = 5,259,204
Year 4. 7,500,000 / 1.1 / 1.1 / 1.1 / 1.1 = 5,122,601
Year 5. 8,000,000 / 1.1 / 1.1 / 1.1 / 1.1 / 1.1 = 5,000,000
The continuing value is calculated using the Gordon Growth Model which requires a long-term growth estimate for the cash flow beyond the fifth year.
Assuming a 5% long-term growth rate, this is first converted to a Growth factor.
Growth factor = (1 + 5%) / 100 = 1.05
The Continuing value calculation involves the cash flow from the fifth year and both the Discount factor and the Growth factor.
Continuing value = 8,000,000 x 1.05 / (1.1 - 1.05) = 168,000,000
The Continuing value is then discounted back to the present day. The Continuing value was based on the fifth year and is divided by the Discount factor five times.
Discounted Continuing value = 168,000,000 / 1.1 / 1.1 / 1.1 / 1.1 / 1.1 = 104,314,782
The business valuation is simply the total of the discounted cash flows for the five year period and the discounted continuing value.
The total of the discounted cash flows and the discounted continuing value gives a business valuation of $129,622,635.
Assuming there are 10,000,000 shares outstanding, the per share valuation is.
Valuation = 129,622,635 / 10,000,000 = $12.96 per share
The actual calculation process is not that difficult however obtaining the appropriate data values to use is extremely difficult. While approximate DCF valuations can be calculated based on current revenue and expense data for a business, this does not take into account future business conditions and prospects. Also the discount rate and long-term future growth rate need to be realistic. If any of these values are inappropriate the calculated DCF valuation will be meaningless.
Business valuators consider DCF valuation more of an art than a science and they base their information on experience and intimate knowledge of the industry which the business belongs to.
It is extremely easy to manufacture a desired DCF valuation result. Increasing the forecast revenue or decreasing the expenses, especially for the fifth year will increase the DCF valuation. The fifth year is the most sensitive since the fifth year cash flow is used to calculate the continuing value which is actually the largest value of the six discounted values used for the DCF valuation.
Simply decreasing the discount rate or increasing the long-term growth rate will significantly increase the DCF valuation. The calculation is extremely sensitive to changes with these two rates.
While a stock investor can calculate a DCF valuation themselves, it would be wise to compare the result with other valuation techniques before relying on the result. This also applies when using valuations provided by analysts.
Some stock investors get caught up in trying to justify a ridiculously high stock price. Some of the arguments revolve around the idea that stock price reflects the internally generated intangible value. Certainly manipulating DCF can provide a sufficiently high valuation.
Stock investors can follow the lead from business valuators and view the valuation of a public company as what someone would pay to buy this company if it were a private business.
Intangible Assets and Goodwill
These balance sheet items can cause a lot of confusion for investors
The balance sheet statement for public U.S. companies contains an item for intangible assets and an item for goodwill. A lot of stock investors especially beginners are not clear on just exactly what these items really mean.
Let's first begin with tangible assets. These are assets which are physical, meaning they can be touched and includes anything from plant, equipment, motor vehicles, office furniture, land and buildings. These tangible assets are sometimes referred to as hard assets and can be readily valued. Also included with tangible assets is cash or any thing that can be sold for cash such as corporate or treasury bonds. These tangible assets are sometimes referred to as cash equivalents.
Intangible assets on the other hand are not physical assets in the sense that they cannot be touched. Examples of intangible assets include brand names, copyrights, software rights, trade marks and patents.
Goodwill is also an intangible asset but is distinguished from the other intangible assets with its own special name. This is because goodwill cannot be classified within the standard intangible assets classifications.
Basically goodwill arises when a business valuation is preformed on a company by a business valuator or when the company is actually sold. The valuation is generally performed with the discounted cash flow method.
Goodwill is simply an excess valuation over what the net tangible assets plus the intangible assets are valued at. Thus the three components of a business valuation are net tangible assets, intangible assets and goodwill. Another way of looking at goodwill is that it is a calculated value and is not determined by a valuation. Note that the intangible assets are determined by valuation.
Goodwill can also be thought of as a value for a company's future earnings ability. The business valuation is generally conducted by the valuator using the discount cash flow method and the calculation for goodwill is simply:
Goodwill = Business valuation - net tangible assets - intangible assets
The intangible assets and goodwill are reported on the balance in accordance with the U.S. General Accepted Accounting Principle (GAAP) standard.
Companies using this reporting standard cannot include the intangible assets and goodwill of their own company on the balance sheet statement. Only the intangible assets and goodwill of any business acquired by the company are included on the balance sheet statement. These are sometimes referred to as purchased intangibles and purchased goodwill.
The Stockholder Equity as reported on the balance sheet statement is the company's net assets. This includes all of the net tangible assets but only includes the intangible assets and goodwill of acquired business.
What's missing from the balance sheet statement are the intangible assets and goodwill that the company produced from within the company rather than what it bought via purchasing other companies.
Thus the Stockholder Equity as reported will not reflect a business valuation since their own intangible assets and goodwill are missing from the balance sheet statement.
The Stockholder Equity can only equal the business valuation when all the assets owned by the company were acquired by purchasing other businesses. Some listed companies expand primarily through acquisitions and thus the Stockholder Equity will be reasonably close to the business valuation since there is little of their own internal intangible assets and goodwill.
Also companies which are heavy on hard assets such as manufacturing due to their cost intensive plants will have relatively low levels of intangible assets and goodwill. The Stockholder Equity with these companies will be reasonably close to their business valuation, especially if the company has been acquiring other businesses.
Conversely companies which are light on with hard assets such as service based business generate their income primarily through providing a service rather than a product and these companies will have relatively high intangible assets especially goodwill. The Stockholder Equity with these companies will be a long way off from their business valuation. This is especially the case if there have been little or no acquisitions.
Whenever a company acquires another business the goodwill amount is recorded on the balance sheet statement. The goodwill shown on the company's balance sheet reflects the total goodwill paid for all of the businesses it has acquired.
Under the GAAP standard, companies must annually revalue each business they have acquired. The business valuation for each acquired business is conducted by a business valuator and is usually valued using the discounted cash flow method.
The goodwill is then calculated for each acquired business and if the goodwill is less than that recorded for that acquired business then the goodwill reported on the balance sheet must be reduced to reflect the new lower goodwill amount.
This is in effect a goodwill depreciation which can occur if the business valuation of an acquired business is now less than what it was when acquired and is known as goodwill impairment.
If the calculated goodwill for an acquired business is now higher, then no adjustment is made to the goodwill recorded on the balance sheet statement.
Thus the purchased goodwill must be depreciated if lower, but it cannot be appreciated if higher.
The goodwill recorded on the balance sheet statement increases whenever the company makes new acquisitions. Should the company sell a previously acquired business then the goodwill on the balance sheet statement is reduced by the amount of goodwill that was previously recorded for that business (and not the goodwill received for selling that business).
Another point to note with purchased goodwill is that when the goodwill of each acquired business increases, this is not reflected on the balance sheet statement and hence not reflected in the Stockholder Equity. Thus purchased goodwill does not keep pace with a growing business and does not reflect the increased earnings capacity of any acquired businesses.
A guide to what a company is worth
The stock market is based on the notion that the stock price at any point in time is what a public company is worth. The problem with this view is twofold:
The Stock Price vs. What a Company is Worth:
- Only a small portion of shares of a public company's float are traded at any one time. That is, not all of the company is sold, but only a small fraction.
- The buyers and sellers of these shares in a public company are often the general public who have no understanding of what a business is worth. The buyers are simply buying because they think the stock price will go up and sellers are simply selling because they think stock prices will go down. Neither the buyers nor the sellers actually want the business. In other words they are simply buying a rising stock price.
One of the biggest problems that savvy stock investors face is what the business of a public company is actually worth.
When private businesses are sold they have a business valuation performed by a business valuator who typically uses the discounted cash flow method. Business valuators come up with valuations which will be attractive to prospective business buyers. After all there is no point in coming up with such a high valuation which would never sell the business.
While stock investors can perform a discounted cash flow analysis themselves, the results are generally not accurate enough to be useful. This leaves the stock investor with the problem of coming up with a fundamental valuation. Such a valuation could be used as a guide to determine whether the current stock price is justifiable based on the associated risks.
The discounted cash flow method produces inaccurate
valuations when performed by retail investors
The first step in coming up with a useful fundamental value for a public company is to understand how private business buyers determining whether a business for sale is attractive or not.
A prospective buyer of a private business has the option of placing their capital in a guaranteed investment such as Treasury bonds which might be currently paying a 5% coupon rate. This effectively gives a guaranteed return but it is a low return. For a higher return an alternative is to buy a private business and of course they will want a significantly higher return than 5% for the risks involved.
Return on investment (ROI)
The return from bonds is referred to as the risk-free return. The return from an investment is referred to as the return on investment (ROI). Thus the ROI with treasury bonds is the risk-free return.
When private business buyers evaluate prospective businesses they expect a ROI that is higher than the risk-free return to compensate for the higher risks. The additional return above the risk-free return is referred to as the risk-premium. The ROI with buying a private business is equal to the risk-free return plus the risk-premium.
The following is a guide for ROI for Established businesses with high levels of tangible assets, good earnings history and a predictable future:
ROI for Established businesses:
- Large sized businesses: Risk premium 5%
- Medium sized businesses: Risk premium 10%
- Small sized businesses: Risk premium 15%
- Add an additional 5% risk premium if business has low levels of tangible assts
- Add an additional 5% risk premium if variable earnings history
Example: A prospective business buyer looking to buy a small business with high levels of tangible assets which is fundamental sound would expect a ROI of
ROI = 5% risk-free + 15% risk-premium = 20%
A ROI of 20% equates to a PE ratio of 5 which is a typically ballpark figure for small fundamentally sound businesses. If this small business makes a profit of $200,000 a year then the private business buyer would pay
Business value = 200,000 / 20% x 100 = $1,000,000
Example: A fundamentally sound large business with high levels of tangible assets gives a ROI of
ROI = 5% risk-free + 5% risk-premium = 10%
If this large business makes a profit of $10,000,000 a year then the private business buyer would pay
Business value = 10,000,000 / 10% x 100 = $100,000,000
An ROI of 10% for a company equates to a PE ratio of 10 which is now getting closer to what stock investors are used seeing in the stock market. With a low inflation environment the average PE ratio for the S&P 500 stocks tends be around 15 to 20.
The typical PE ratios for public companies tend to be higher than private businesses; however bear markets may correct these so they are closer to that of private businesses.
Private Business buyers are primarily concerned with the ROI and this is obtained from the business profits in the form of income. In other words the return is cash. Private Business buyers have no interest in over paying and if a business for sale is too expensive to justify the risks based on the ROI they simply pass it up. Unlike the stock market pundits who will pay all sorts of silly high prices.
Private Businesses vs. Public Companies
While the business valuation for a public company is not known, the approach used with private businesses provides a good guide as they are all businesses. Public companies generally reinvest most of their profits back into the company rather paying out all their profits via a dividend. Private businesses also reinvest some of their profits but tend to take a higher portion as a dividend than what the public companies do.
Working through the basic components of discounted cash flow analysis, the main determinate for its valuation is the future cash a business generates. This cash is essentially the business profits. This is exactly what the private business buyer is after and they base the profits on a desirable ROI. The business valuation is based on the discounted cash flow and the business buyers ROI must match the business valuation otherwise a private business will never sell.
Public companies generally reinvest their profits rather than paying them out as a dividend. While this can lead to higher profits in the future for the current years retained profits, the retained profits from prior years is already reflected in the current financial statements. Thus any growth rates from these prior years retained profits is already evident.
Private business buyers simply will not pay for speculative future profits. Thus private business buyers do not care about promised future profits. The only people that will pay for speculative future profits are stock market pundits so long as the stock price is increasing.
Applying the ROI expectations of private business buyers to public companies gives the savvy stock investor an indication of what it would sell for if it were a private company.
The only catch with using a ROI is that of earnings. If the current years earnings are used in isolation the ROI may not be realistic. It is better to examine the earnings, cash flows and revenue from the last five to ten years and base an earnings figure on the earnings trend.
Rather than using last years earnings, it is better to
examine the trend over the last five to ten years
The ROI approach is best used with fundamentally sound companies and also used in conjunction with the balance sheet items such as Stockholders' Equity and Net Tangible Assets.
Valuation for a Fundamentally Sound company
Determining a reasonable fundamental valuation for a public company begins with calculating a valuation based on the ROI. This is only applicable if the company is profitable.
If the ROI valuation is greater than the Stockholders' Equity, then a reasonable fundamental valuation is the ROI valuation.
If the ROI valuation is less than the Stockholders' Equity, then there is some additional future earnings factored into the balance sheet items that is not reflected in its current and past earnings. The additional future earnings are most probably recorded in the purchased goodwill and/or intangible assets. In this case the Stockholders' Equity will be closer to its business valuation and can be used as an indication of a conservative fundamental valuation.
The Stockholders' Equity is especially conservative with companies that are service based and have low levels of tangible assets.
Valuation for a Financially Distressed company
If the company is financially distressed but still makes a profit then the same approach can be used but an allowance is made with risk-premium.
If there are no earnings or erratic earnings then it is best to use the balance sheet. The Stockholders' Equity is a reasonable figure to use as a fundamental valuation providing that the company is not a high bankruptcy risk which can be determined using the Z-score.
If the company's financial future is uncertain a more conservative approach is to ignore any purchased goodwill and intangible assets and simply use the Net Tangible Assets as a conservative fundamental valuation.
There is no difference in the risks of buying a private business or a public company as they are both businesses. Some people view private businesses as higher risks but this is purely because there are more small private businesses than there are large public companies. It is the smaller companies that are the higher risk.
Any risks have nothing to do with a business being private or public, but it does have everything to do with the size of the business and the price paid for the business.
Investing is a calculated risk and having a general idea of what a business is worth (whether it is large-cap or a small-cap company) allows a savvy stock investor to make an informed decision regarding its current stock price.
The fundamental value determined is only a guide and it's either close to the business valuation or it's a conservative value. While it's not known which it is, at least it provides an indication of whether a stock price might be too high.
The worst that happens if the fundamental valuation is overly conservative is that a stock may have been considered overvalued when in fact it was fairly valued or even undervalued. For a value investor this simply means a missed opportunity.
The best that happens is that the fundamental valuation reasonably reflects the business valuation and the savvy investor can determine whether it is worth paying the current stock price. As a general rule the above valuation technique does not lead to overvaluing a business provided that a reasonable earnings figure is used for the ROI.
The fundamental valuation is only an approximate value of what the business valuation might be and the worst that happens is that it is an overly conservative valuation.
It is always a good idea to be aware of what the Stockholders' Equity and Net Tangible Asset values are for any business. The Net Tangible Asset value gives idea of how much business value is left if the business runs into financial trouble and is no longer profitable.