Use of business valuation on projected cashflow
In 2020 I wrote an article on how businesses are valued. I explained that businesses are valued to address situations such as acquisitions, mergers, shareholding, divorce, admission of new partners, estate administration and other purposes.
In the said article I also explained that the common valuation methods include the market approach used for publicly traded or listed shares, the earnings approach which includes the Discounted Cashflow Method (“DCM”) also called the Net Present Value (“NPV”) method, and the capitalisation of past earnings.
Another one is the Price Earnings (PE) method which essentially involves computing the ratio of Price per Share (Price) over (divided by) Earnings per Share (EPS) of a comparable, usually listed company.
The average annual earnings (AAE), past or future, of the company being valued are then multiplied by the PE ratio of the comparable company to estimate the value of the company being valued.
This article focusses on the DCM or NPV method.
DCM or NPV method
This method is very popular with business valuers and in capital investment appraisals by management.
It basis the valuation of a business on the current or present value of expected future net cashflows.
It is based on future cashflows, not profit. The key aspects of the method are explained below.
A valuation period or number of future years to be used, has to be defined. For example a valuer may use projections for the standard valuation period of 5 years.
Other valuers may consider shorter or longer valuation periods.
For businesses with finite (exhaustible) resources such as mines it is standard practice to estimate the value based on the quantified resource, for example gold ore, and the rate at which the resource will be mined or extracted until it is exhausted.
In the case of mines such information is estimated by mining professionals and usually documented in geological reports.
Estimated volumes are critical in determining revenue and therefore receipts, and in estimating costs and therefore payments. Volumes are influenced factors projected installed capacity and its utilisation.
Other considerations include market share, availability of foreign currency in the case of imports, etc.
For mines, for example a gold mine, estimates are made of the rate of recovering bullion from gold ore, eg grams per tonne of ore.
Inflows and outflows
This is similar to formulating a cash budget, excluding borrowing costs. It involves estimating cashflows such as revenue receipts, operating expenses and capital expenditure, etc. The inflows and outflows are worked out for each year.
Treatment of assets
Capital expenditure is treated as cash outflows. Disposal of assets for cash consideration is treated as inflows.
Pay attention to necessary asset acquisition and disposals.
Rate of discount to compute NPV
A rate of discount is arrived at usually by using an estimate of the opportunity cost of receiving money in the future instead of now.
Alternatively the rate at which future money is expected to lose value when compared to current or present money is used. It is common for valuers to compute and use Weighted Average Cost of Capital or WACC, or simply use borrowing interest rates.
A discount factor applicable to each valuation year is estimated by inputting the rate of discount and number of year into standard formulas used to estimate the discounting factor.
For example assuming a discount rate of 10 percent per annum the discount factors for year 1, 2, 3, 4 and 5 will be 0,91, 0,83, 0,75, 0,68 and 0,62 respectively.
In other words compared to the present dollar, future dollars in years 1, 2, 3, 4 and 5 will be worth $0,91, $0,83, $0,75, $0,68 and $0,62.
Computation of NPV
The estimated future net cashflows for each year are then multiplied by the discounting factor calculated for that year.
For example, hypothetical net cashflows for Year 1 ($ 2 000 000), Year 2 ($ 2 500 000), Year 3 ($ 3 000 000), Year 4 ($ 3 500 000) and Year 5 ($ 4 000 000) totalling $ 15 000 000 will be multiplied by the discounting factor for each year.
Still assuming 10 percent per annum, the NPV for each year will be Year 1 ( $ 1 818 182), Year 2 ( $ 2 066 116), Year 3 ($ 2 253 944), Year 4 ($ 2 390 547) and Year 5 ($2 483 685) to give a total NPV of $ 11 012 474.
As the valuation period increases so does the risk of getting results lower than expected.
This is because of so many uncertainties inherent in business.
These can be due external factors such as political, economic, social, technological, environmental or legal (“PESTEL”) or those summarised in Porter’s 5 Forces model or those peculiar to the company such as age of machinery.
Risk is usually factored in by lowering revenue projections.
Alternatively, progressively decreasing probabilities of occurrence can be assigned to each future year and multiplied by the annual NPV.
Hypothetical probabilities in Year 1 (90 percent), Year 2 (80 percent), Year 3 (70 percent), Year 4 (60 percent), Year 5 (50 percent) will result in NPV of $ 7 543 188.
Accounting for debt
The Net Present Value, excluding borrowing costs, computed before accounting for the capital structure of the business is referred to as Enterprise Value or EV.
Debt such as loans should be deducted from the EV to arrive at the value attributable to shareholders.
Computing value of a share
The value per share is computing by dividing the value of the business (NPV) by the number of the business’ issued shares (Number of shares).
Valuation of a mine
The value of a mine as a going concern can be computed by estimating the NPV of future cashflows.
The future inflows are estimated, for example, by multiplying the quantity or volume of the processed mineral, for example gold or bullion, by the estimated world mineral price (eg London Bullion Market Association price).
Outflows such as the cost of mining, processing and administration overheads, taxes and others are estimated and deducted. Capital expenditure is treated as outflows.
This simplified article is for general information purposes only and does not constitute the writer’s professional advice.
Godknows Hofisi, LLB(UNISA), B.Acc(UZ), CA(Z), MBA(EBS,UK) is a legal practitioner / conveyancer with a local law firm, chartered accountant, insolvency practitioner, registered tax accountant, consultant in deal structuring, business management and tax and is an experienced director including as chairperson. He writes in his personal capacity. He can be contacted on +263 772 246 900 or [email protected]