Valuation AOs come up on CPA Canada module exams all the time, starting with Core 1 and all the way to the CFE. Here’s a summary of the common valuation methods with examples.
Introduction
Valuation is required in situations where there may be:
- Proposed sale of business (both sale of shares or direct sale of net assets)
- Company wishes to go public and must set an issue price
- Division of assets needs to be determined
- Company needs to evaluate impairment or reorganization for tax purposes etc.
There are various valuation approaches, they are categorized to: Income-based, asset-based, and market-based.
Income-based approaches:
- Capitalized cash flow (CCF)
- Discounted cash flow (DCF)
- Capitalized earnings
- Discounted earnings
Asset-based approaches:
- Liquidation
- Adjusted net asset
- Replacement cost
Market-based approaches:
- Assets with an active market
- Comparable transaction (ie, earnings multiple approach)
In this blog, I’ll discuss the DCF and CCF (income-based), adjusted net asset (asset-based) and earning multiple (market-based) approaches.
Discounted Cash Flow (DCF)
When an entity is a start up and they don’t have positive cash flows, it would not be appropriate to use potential cash flows for valuation. Thus, a discounted cash flow (DCF) technique is used. To calculate the DCF valuation, write out the annual cash flows in Excel and discount them to the present dollars.
Example:
Let’s assume the business will earn $100,000 in the current year and each year it will grow by 5%. We’re given the rate of return (ie, the WACC) at 15% per year. We will apply this discount rate to all future cash flows.
The equation would be:
As you can see, even if the actual cash flows will keep growing, the discounted versions of those cash flows will shrink over time, because the discount rate is higher than the growth rate. Therefore, the value of the company will be the total of all discounted cash flows.
Capitalized Cash Flow (CCF)
If an entity has consistent cash flows that are reflective of the future operations, an approach such as the capitalized cash flow (CCF) approach, based on historical cash flow, is appropriate. In this approach, the cash flows expected to occur consistently in the future are determined and a capitalization rate is applied to the expected future annual cash flow to obtain a value for the entity.
There are 2 steps to the CCF valuation process:
- Compute expected cash flows for a single period
- Divide cash flow from a single period by a capitalization rate
What’s really important here is the long term sustainable growth rate, where the Gordon Growth model is used. Hence we have to find the enterprise value and then deduct the interest bearing debt to arrive at the value of equity.
Here’s an example:
Notes:
- FCFF – Free cash flows
- WACC: Weighted Average Cost of Capital
- Gordon’s Growth Model —> P = D1/ (R-G)
- P = Stock’s price based off its dividends
- D1 = Stock’s expected dividend over the next year
- R = Required rate of return
- G = Expected dividend growth rate
Remember to reduce the interest bearing debt amount from the enterprise value above to come to the equity value.
Gordon Growth model is not tested at Core 1 or CFE Day 3 levels, but it is tested at Finance elective and CFE Day 2 Finance role levels. In Core 1 and CFE Day 3, you will be given the capitalization rate and you would need to apply it to the cash flows.
Adjusted net assets
Where the entity does not maintain active operations, or it has active operations but does not have excess earnings, the adjusted net asset approach is appropriate. Under the adjusted net asset approach, all assets are valued at their FMVs net of disposition costs. Liabilities are deducted and the tax consequences of selling the assets and settling the liabilities are adjusted for.
So this is a simple valuation technique. Simply write the total assets (at FMV), then deduct the liabilities, and the result is the value of the business.
Points to remember:
- Inventory adjustments should be based on FIFO
- PPE values may differ
- Intangible assets are often written off to zero
- Consider whether the payables will be fully paid and receivables fully collected
- Don’t forget to consider unrecorded liabilities or potential settlements
Earnings multiple
This is an approach based on historical earnings of the company. Earnings are multiplied by a multiplier to determine the company’s value. The earnings multiplier calculates the return an investor will get against the invested amount.
Example:
The share price of a company is now trading at $100 and its per share earnings is $10. The earnings multiplier will be 10. ($100/$10) It implies for $1 dollar earned by the company, an investor will give $10. This means the investor is paying 10 times the company’s present value. If the company’s earning multiplier is higher than that of industry average, the share price of the company is high.
In CPA Canada cases, you’re often given the multiplier, so you don’t have to calculate it. Instead, you should normalize the earnings (add/remove unusual transactions and amounts, such as one-time bonus, high manager salary, lawsuit, government grants, etc.) and multiply the adjusted earnings by the multiplier. This will give you the value of the business.
Hope this article was helpful and added “value” 😉
Happy Studying!
Leela
Author: Leela Pai, ICAI and successful CFE writer from Sep 2021