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Subject 4. Valuation Approaches, Earnings Normalization and Cash Flow Estimation Issues PDF Download
Valuation Approaches

There are three major approaches to estimate the value of a private company.

The income approach: the value of a private company is computed as the present value of future income discounted at a rate of return that reflects the riskiness of the investment. The result is generally the fair market value.

The market approach employs price to earnings or similar multiples of a return of the latest historical period rather than an estimate of the future. It is very similar in many respects to the "comparable sales" method that is commonly used in real estate appraisal.

The difficulty lies in identifying public companies that are sufficiently comparable to the subject private company for this purpose. Also, as for a private company, the equity is less liquid than for a public company, its value is considered to be slightly lower than such a market-based valuation would give.

The underlying theory of the asset-based approach is that the value of a business is equal to the sum of its parts. Instead of making subjective judgments about capitalization or discount rates, the adjusted net book value method is relatively objective.

Analysts must exercise discretion when determining which of these approaches to use. Each approach has advantages and drawbacks, which must be considered when applying those techniques to a particular private company.

Earnings Normalization Issues

Normalizing adjustments adjust the income statement of a private company to show the prospective purchaser the return from normal operations of the business and reveal a "public equivalent" income stream. These adjustments eliminate one-time gains or losses, other unusual items, non-recurring business elements, and the like. They also normalize officer/owner compensation and other discretionary expenses that would not exist in a reasonably well-run, publicly traded company.

Consider XYZ, Inc., a 410 million sales company.

  • XYZ Inc. settled a lawsuit regarding damages when one of its vehicles was in an accident. The settlement, inclusive of attorneys' fees, was $200,000 in the most recent year. Expenses associated with the lawsuit should be eliminated from operating expenses.
  • Cousin Joe takes a substantial salary out of the business. Based on a salary survey, earnings should be adjusted by $600,000 for his excess compensation to lower the expense to a normal, market level of compensation.
  • Big Daddy owns a chalet, which costs the company about $400,000 a year. Expenses associated with Big Daddy's vacation home must be adjusted accordingly.

Cash Flow Estimation Issues

Which cash flow definition should we use? Free cash flow to the firm (FCFF) or free cash flow to equity (FCFE)?

What is the valuation for? Do we try to value minority interest, or the intention is to gain majority control?

Can we reliably estimate the possibilities of different scenarios when assessing future cash flows? Should we use a single discount rate for all future cash flows, or should we use one discount rate in each scenario?

Are there any managerial biases in their own cash flow forecasts?

These are the common questions to ask when trying to estimate cash flows of a private company.

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