Asset-based valuation

This technique looks at the fair-market value of the company’s equity, which is calculated by deducting total liabilities from total assets. The focus is on the fair-market value of its total assets minus total liabilities. According to basic accounting principles, a firm’s income statement provides a measure of its true earnings potential, while the balance sheet gives a reliable estimate of the value of the assets and equity in the firm.

Luxury Desserts: recent and projected income statements

Luxury Desserts: balance sheets

Luxury Desserts: comparable firms

In Luxury Desserts’ case, total assets are $2,944,000 and total liabilities are $505,000, leaving net asset value, or equity, of $2,440,000. If we assume the market value of equity is the same as the net asset value, then Luxury Desserts is worth just under $2.5 million. This is one way of valuing a firm, but – as we will see – it is typically an underestimate of value because there are some assets (such as loyal customers or the power of a brand) that are not put on the balance sheet.

Comparable transaction valuation

The second valuation method looks for comparable firms to see how much they are trading for on the stock market. When you want to sell your home, you estimate its value by looking at how much a similar house down the street sold for, and this is the same principle.

The challenge here is identifying the right comparison firms. Ideally, a comparable firm is one that is quite similar – a direct competitor in the same industry – but of course it is very difficult to find firms that are so well matched. In practice, most analysts start by comparing the firm being valued to four or five of the closest competitors in its industry sector. If there are more than a handful of candidates, the analyst can focus on firms of similar size and growth potential. For example, in the smartphone industry, an analyst might compare Apple Inc. to Samsung as both are market leaders, but exclude Sony’s entry, assuming financials can be broken out for the latter unit.

We have five comparators for this valuation exercise. Dividing the target price by EBITDA, we arrive at what multiple of EBITDA each firm is worth:

Notice that the average is computed both with and without Sunrise Treats. Because Sunrise Treats is significantly larger than the rest of the firms, one can argue for an exclusion of Sunrise Treats in the analysis. Given that Luxury Desserts had 2015 EBITDA of $713,000, we can estimate the value of Luxury Desserts based on the comparable transactions analysis (000s):

Depending on the comparator set used, Luxury Desserts is estimated to be worth $3,206,000 or $4,275,000. We have used a multiple of EBITDA in our comparable transactions analysis. Other multiples may be used in combination or in place of a multiple of EBITDA. These include earnings multiples and sales multiples, to cite two examples.

Discounted cash flow (DCF)

The DCF analysis is based on the observation that the value of the firm is linked to how much free cash flow it can generate. These cash flows are discounted back to present value using the firm’s discount rate. The firm’s discount rate is its cost of capital, which includes what its shareholders expected to earn on equity and what its debt-holders are owed on its debt.

The typical DCF calculation discounts a firm’s ‘unlevered free cash flow’ (UFCF) by a discount rate to get to the present value of the projected results. UFCF simply means the firm’s cash flows before it makes interest payments – hence the use of the term ‘unlevered’ in the metric.

Let’s look at Luxury Dessert’s example:

Note that the calculation starts with EBITDA, removes amortisation (the ‘DA’), then calculates the tax on EBIT (remember that this is a firm’s ‘unlevered’ cash flow calculation). The result is EBIAT, or earnings before interest but after tax. Then amortisation, which is a non-cash expense, is added back, and cash expenses for capital expenditures and any investments in working capital are deducted. The result is UFCF.

Let’s assume the weighted average cost of capital (WACC) for our discount rate is 18 per cent. Using the assumed WACC, we find that the present value of Luxury Desserts’ UFCF is $1,406,000 (see table below).

Don’t miss out on an important step in this exercise: determining the terminal value of the firm. The tricky thing is that Luxury Desserts is expected to continue operating after the fifth year (2020). In calculating a terminal value for the UFCFs before 2020, we can assume a perpetual growth rate (g) of 4.0 per cent, and the same WACC of 18 per cent. The formula for terminal value is:

Thus, the terminal value for Luxury Desserts at the end of 2020 is*:

We find the present value of this terminal value by multiplying $6,856,571 by 0.44 (it’s 0.4371 before rounding) to get $2,997,007. In the previous example, 0.44 is the discount factor for 2020, or the end of the fifth year. Note that the present value of the terminal value is much higher than the present value of the five years of cash flows. This is why it is important to remember to estimate a terminal value in the first place.

We add the present value of the UFCFs ($1,387,458) to the present value of the terminal value ($2,997,007) to get Luxury Desserts’ DCF value of $4,384,465.

Dividend discount model

This method simply looks at the cash to be received by shareholders. Investors look either for capital gains (think high-tech ‘Unicorns’ or startups worth more than $1 billion, many of which have never turned a profit), or for dividends (for example, telecommunications and utilities).

This model works best when dividends are known, are steady and are expected to grow at a predictable rate. The simplest version of the dividend discount model, the ‘Gordon growth model’, can be used to value a firm that is in ‘steady state’ with dividends growing at a rate that can be sustained forever. The Gordon growth model relates the value of a stock to its expected dividends in the next time period, the cost of equity and the expected growth rate in dividends.

Where:

1. DPS₁ = the expected dividend one period from now.
2. k_e = the required rate of return for equity holders.
3. g = the perpetual annual growth rate for the dividend.

Using Luxury Desserts’ example, let’s assume investors can expect dividends of $400,000 per year, growing at rate of 15 per cent a year in perpetuity:

In this case, Luxury Desserts is worth $3,636,000.

In summary, the various valuation methods yield different results due to the different inputs used in the calculations:

• Asset-based valuation: $2,440,000.
• Comparable transaction valuation: $3,206,000 to $4,275,000.
• Discounted cash flow: $4,384,465.
• Dividend discount model: $3,636,000.

Clearly there is no single right answer to the question, ‘What is Luxury Desserts worth?’. This analysis provides a range of estimates (from $2.4m to $4.4m), and as an analyst or potential investor you would now be expected to consider various subjective factors to come to an opinion on what number is most realistic. Some of these factors are about the intangible strengths and weaknesses of the firm – for example, how loyal its customers are, or how skilled you consider the firm’s managers to be. Equally important are external factors, such as how volatile the market is or whether new competitors are emerging.

Finally, you also have to consider how strongly the current owners of the firm want to sell, and whether other buyers are out there. Such factors often result in a much higher price being paid than would be expected using these valuation methods.