Financial valuation Applications and Models phần 2 pot

Appendix 79 Activity Ratios Activity ratios, also known as efficiency ratios, provide an indication as to how effi- ciently the company is using its assets. More efficient asset utilization indicates strong management and generally results in higher value to equity owners of the business. Additionally, activity ratios describe the relationship between the com- pany’s level of operations and the assets needed to sustain the activity. Accounts Receivable Turnover Annual Sales __________________________ Average Accounts Receivable Accounts receivable turnover measures the efficiency with which the company manages the collection side of the cash cycle. Days Outstanding in Accounts Receivables 365 _____________ A/R Turnover The average number of days outstanding of credit sales measures the effective- ness of the company’s credit extension and collection policies. Inventory Turnover Cost of Goods Sold __________________ Average Inventory Inventory turnover measures the efficiency with which the company manages the investment / inventory side of the cash cycle. A higher number of turnovers indi- cates the company is converting inventory into accounts receivable at a faster pace, thereby shortening the cash cycle and increasing the cash flow available for share- holder returns. Sales to Net Working Capital Sales __________________________ Average Net Working Capital Sales to net working capital measures the ability of company management to drive sales with minimal net current asset employment. A higher measure indicates efficient management of the company’s net working capital without sacrificing sales volume to obtain it. Total Asset Turnover Sales __________________ Average Total Assets 80 FINANCIAL STATEMENT AND COMPANY RISK ANALYSIS Total asset turnover measures the ability of company management to efficiently utilize the total asset base of the company to drive sales volume. Fixed Asset Turnover Sales ___________________ Average Fixed Assets Sales to fixed assets measures the ability of company management to generate sales volume from the company’s fixed asset base. Application to Ale’s Four of the five activity ratios for Ale’s have steadily declined during the five-year period analyzed. The only activity ratio to increase during the five-year period was Ale’s fixed asset turnover. Ale’s accounts receivable turnover has declined from 43.2 turns at December 31, 1997, to 18.8 turns at December 31, 2001. This decline in accounts receivable turnover has resulted in an increase in the average collection period of accounts receivable from 8.4 days at December 31, 1997, to 19.4 days at December 31, 2001. Ale’s inventory turnover has declined from 23.5 turns at December 31, 1997, to 12.8 turns at December 31, 2001. The declines in accounts receivable turnover and inventory turnover indicate that Ale’s management of these critical assets has slipped considerably during the period analyzed. The median accounts receivable turnover and inventory turnover for comparable companies within the industry were 86.5 turns and 18.0 turns, respectively. Consequently, Ale’s has clearly fallen below its industry peers in its management of major working capital components. If this trend continues, Ale’s working capital could become significantly strained and become an obstacle to future growth. Ale’s sales to net working capital turnover has declined from 14.3 turns at December 31, 1997, to 7.9 turns at December 31, 2001. The median sales to net working capital turnover for comparable companies within the industry was 37.6 turns. This decline mirrors the problems in accounts receivable and inventory. A review of the Ale’s total asset turnover indicates a decline from 5.8 turns at December 31, 1997, to 4.5 turns at December 31, 2001. The industry-comparable total asset turnover was 3.9 turns. Ale’s fixed asset turnover actually has increased from 12.5 turns at December 31, 1997, to 13.5 turns at December 31, 2001. However, Ale’s fixed asset turnover of 13.5 turns at December 31, 2001, is far below the median fixed asset turnover for comparable companies within the industry of 21.5 turns. These activity ratios suggest an increase in the risk associated with an investment in Ale’s common stock. Additional due diligence is necessary to deter- mine the cause of these potential problems. Leverage Ratios Leverage ratios, which are for the most part balance sheet ratios, assist the ana- lyst in determining the solvency of a company. They provide an indication of a com- pany’s ability to sustain itself in the face of economic downturns. Leverage ratios also measure the exposure of the creditors relative to the share- holders of a given company. Consequently, they provide valuable insight into the rel- ative risk of the company’s stock as an investment. Total Debt to Total Assets Total Debt ___________ Total Assets This ratio measures the total amount of assets funded by all sources of debt capital. Total Equity to Total Assets Total Equity ____________ Total Assets This ratio measures the total amount of assets funded by all sources of equity capital. It can also be computed as one minus the total debt to total assets ratio. Long-term Debt to Equity Long term Debt ______________ Total Equity This ratio expresses the relationship between long-term, interest-bearing debt and equity. Since interest-bearing debt is a claim on future cash flow that would oth- erwise be available for distribution to shareholders, this ratio measures the risk that future dividends or distributions will or will not occur. Total Debt to Equity Total Debt ___________ Total Equity This ratio measures the degree to which the company has balanced the funding of its operations and asset base between debt and equity sources. In attempting to lower the cost of capital, a company generally may increase its debt burden and hence its risk. Application to Ale’s The leverage ratios for Ale’s have remained fairly steady during the five-year period analyzed. Ale’s total debt to total asset ratio has remained at 0.5 for all five years. Ale’s total equity to total asset ratio has also remained stable at 0.5 for all five years. The median total debt to total asset ratio for comparable companies within the industry was 0.6. Ale’s total debt to equity ratio has been 0.9 to 0.8 historically, Appendix 81 well below the industry average of 1.5. This indicates that the company tends to finance growth with more equity than debt. Profitability Ratios Profitability ratios measure the ability of a company to generate returns for its shareholders. Profitability ratios also measure financial performance and manage- ment strength. Gross Profit Margin Gross Profit ___________ Net Sales This ratio measures the ability of the company to generate an acceptable markup on its product in the face of competition. It is most useful when compared to a similarly computed ratio for comparable companies or to an industry standard. Operating Profit Margin Operating Profit _______________ Net Sales This ratio measures the ability of the company to generate profits to cover and to exceed the cost of operations. It is also most useful when compared to compara- ble companies or to an industry standard. Application to Ale’s The profitability ratios for Ale’s have declined during the five-year period ana- lyzed. Ale’s gross profit margin has declined from 26.1 percent at December 31, 1997, to 25.6 percent at December 31, 2001. The median gross profit margin for comparable companies within the industry was 24.0 percent. Thus, although Ale’s gross profit margin has declined during the five-year period analyzed, the com- pany has been able to maintain higher margins on its products than that of its industry peers. Ale’s operating profit margin has declined from 4.5 percent at December 31, 1997, to 3.7 percent at December 31, 2001. The median operating profit margin for comparable companies within the industry was 3.7 percent, indicating that the com- pany’s competitive advantage may be adversely affected by a less focused manage- ment team or by some external forces affecting the company. Rate of Return Ratios Since the capital structure of most companies includes both debt capital and equity capital, it is important to measure the return to each of the capital providers. 82 FINANCIAL STATEMENT AND COMPANY RISK ANALYSIS Appendix 83 Return on Equity Net Income __________________________________ Average Common Stockholder’s Equity This ratio measures the after-tax return on investment to the equity capital providers of the company. Return on Investment Net Income ϩ Interest (1 Ϫ Tax Rate) ___________________________________________ Average (Stockholder’s Equity ϩ Long-term Debt) This ratio measures the return to all capital providers of the company. Interest (net of tax) is added back since it also involves a return to debt capital providers. Return on Total Assets Net Income ϩ Interest (1 Ϫ Tax Rate) ________________________________ Average Total Assets This ratio measures the return on the assets employed in the business. In effect, it measures management’s performance in the utilization of the company’s asset base. Application to Ale’s Since RMA only reports pretax returns, that is how Ale’s ratios were computed for this exhibit only. Ale’s rate of return ratios have fluctuated significantly over the five- year period analyzed. Its return on equity and return on total assets have been very inconsistent in spite of fairly steady sales activity. However, Ale’s most recent return on total assets of 16.0 percent is above the industry average of 10.3 percent. Ale’s recent return on equity of 29.5 percent is dramatically below the industry average of 35.7 percent. This may have to do with Ale’s leverage being so much lower than its peer groups, since optimal use of leverage can magnify equity returns. Again, this is cause for further analysis. Growth Ratios Growth ratios measure a company’s percentage increase or decrease for a partic- ular line item on the financial statements. These ratios can be calculated as a straight annual average or as a compounded annual growth rate (CAGR) meas- uring growth on a compounded basis over a specific time period. Although it is possible to calculate growth rates on every line item on the financial statements, growth rates typically are calculated on such key financial statement items as sales, gross margin, and operating income, and are calculated through use of the following formulas. 84 FINANCIAL STATEMENT AND COMPANY RISK ANALYSIS Average Annual Sales Growth {Sum of all Periods[(Current Year Sales / Prior Year Sales) Ϫ 1] / # of Periods Analyzed} ϫ 100 Compound Annual Sales Growth {[(Current Year Sales / Base Year Sales) (1 / # of Periods Analyzed) ] Ϫ 1} ϫ 100 Average and compounded annual growth measures for gross margin and oper- ating income are computed in the same manner. Note: Analysts often spread five years of financial statements. When calculat- ing growth rates on financial statements spread over five years, the analyst should be careful to obtain growth rates over the four growth periods analyzed. In other words, periods =number of years –1. Application to Ale’s Ale’s sales growth on a compounded basis is slightly above the rate of inflation (3 percent), suggesting that the company’s unit volume (on a case-equivalent basis) is relatively flat. The operating profit of Ale’s decreased over the period, further evi- dence of a flattening in operating performance. However, Ale’s showed a dramatic increase in operating profit within the past year, possibly indicating a rebound. Income Approach P erhaps the most widely recognized approach to valuing an interest in a privately held enterprise is the income approach. As with both the market and asset approaches, several valuation methodologies exist within the income approach to develop an indication of value. This chapter explores the fundamental theory behind the approach and its numerous applications. Valuation professionals use a number of terms, such as “economic benefits,” “economic income,” and “net income.” These terms are used interchangeably throughout this chapter. However, since most empirical data is based on some vari- ation of cash flow, that term is typically used herein to represent the company’s eco- nomic benefit stream. FUNDAMENTAL THEORY Equity Interests Are Investments An equity interest in a privately held enterprise is an investment that can be evalu- ated in the same basic manner as any other investment that the investor might choose to make. An investment is: the current commitment of dollars for a period of time to derive future payments that will compensate the investor for • the time the funds are committed, • the expected rate of inflation, and • the uncertainty of the future payments. 1 Investments and Business Valuations Involve the “Forward-Looking” Premise An investment requires a commitment of dollars that the investor currently holds in exchange for an expectation that the investor will receive some greater amount of dollars at some point in the future. This “forward-looking” premise is basic to all investment decisions and business valuations. “Value today always equals future cash flow discounted at the opportunity cost of capital.” 2 85 CHAPTER 4 1 Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management, 5th ed. (The Dryden Press, Harcourt Brace College Publishers), p. 5. 2 Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 5th ed. (New York: McGraw-Hill, Inc., 1996), p. 434. The income approach to business valuation embraces this forward-looking premise by calculating value based on the assumption that the value of an owner- ship interest is equal to the sum of the present values of the expected future benefits of owning that interest. No other valuation approach so directly incorporates this fundamental premise in its calculation of value. INCOME APPROACH INVOLVES A NUMERATOR One of the two elements of any income approach method is a numerator, repre- senting the future economic benefit accruing to the holder of the equity interest. This future economic benefit can take many forms. It can represent cash flow or net income. Net income may be on a pretax or after-tax basis. It also can repre- sent a single payment or a series or stream of payments. Again, although we con- tinue to use the term “economic benefit,” this chapter focuses mainly on cash flow. INCOME APPROACH INVOLVES A DENOMINATOR The second element, the denominator, is the rate of return required for the particu- lar interest represented by the cash flow in the numerator. The denominator reflects opportunity cost, or the “cost of capital.” In other words, it is the rate of return that investors require to draw them to a particular investment rather than an alternative investment. This rate of return incorporates certain investor expectations relating to the future economic benefit stream: • The “real” rate of return investors expect to obtain in exchange for letting some- one else use their money on a riskless basis; • Expected inflation is the expected depreciation in purchasing power during the period when the money is tied up; • Risk is the uncertainty as to when and how much cash flow or other economic income will be received. 3 The first item is essentially rent. Any investor forgoing current consumption and allowing another party to use his or her funds would require a rental payment. The second item is required due to the time value of money and the decreased purchas- ing power associated with invested funds being spent later rather than sooner. The third item captures investor expectations about the risks inherent in the specific equity instrument. Generally, this risk assessment is developed through analysis of the future economic benefit and the uncertainty related to the timing and quantity of that benefit. See Chapter 5 for additional detail on rates of return. 86 INCOME APPROACH 3 Shannon P. Pratt, Cost of Capital: Estimation and Application (New York: John Wiley & Sons, Inc.), p. 5. (Used with permission.) INCOME APPROACH METHODOLOGIES The business valuation profession commonly uses three primary methods within the income approach to value privately held business interests. These include: 1. Discounted cash flow (DCF) method 2. Capitalized cash flow (CCF) method 3. Excess cash flow (ECF) method Each of these methods depends on the present value of an enterprise’s future cash flows, often based on historical financial data. The ECF method is really a hybrid method combining elements of both the asset approach and the income approach. Preferably, the financial data is in compliance with generally accepted accounting prin- ciples (GAAP). Valuation analysts, including CPA-analysts, are not responsible for attesting or verifying financial information or certifying GAAP statements when pro- viding valuations. Often they are given non-GAAP financial information as a starting point to derive income or cash flow; this information is often acceptable. However, analysts still should do their best to make appropriate adjustments to income state- ments and/or balance sheets within the scope of their engagement. The development of these adjustments is referred to as the normalization process. NORMALIZATION PROCESS If the value of any investment is equal to the present value of its future benefits, determining the appropriate future benefit stream (cash flow) is of primary impor- tance. Therefore, items that are not representative of the appropriate future cash flow must be either eliminated or adjusted in some manner. The process begins with the collection of historical financial data and includes a detailed review of that data to determine what, if any, adjustments are required. “Big Five” The normalization process involves the restatement of the historical financial state- ments to “value” financial statements, i.e., statements that can be used in the valu- ation process. Normalization generally involves five categories of adjustments: 1. For ownership characteristics (control versus minority) 2. For GAAP departures, extraordinary, nonrecurring and/or unusual items 3. For nonoperating assets and liabilities and related income and expenses 4. For taxes 5. For synergies from mergers and acquisitions, if applicable Normalization Process 87 Failure to develop the appropriate normalizing adjustments may result in a significant overstatement or understatement of value. ValTip Generally, the second, third, and fourth categories of normalization adjust- ments are made in all valuations, whether the ownership interest being valued is a minority or a control interest. The first category of normalization adjustments is not always necessary if the ownership interest being valued is a minority interest. The fifth category is most often used to derive investment value. ADJUSTMENTS FOR OWNERSHIP CHARACTERISTICS Controlling interest holders are able to extract personal financial benefits beyond fair market amounts in a number of ways. For instance, in a privately held enter- prise, it is not unusual for the controlling shareholder to take compensation in excess of going market rates that might be paid for the same services. Since the “willing buyer” of a control ownership interest could reduce compensation to mar- ket levels, often it is appropriate to add back excess compensation to cash flow to reflect the additional economic benefits that would be available to the “willing buyer.” Other examples of control adjustments include: • Excess fringe benefits including healthcare and retirement • Excess employee perquisites • Excess rental payments to shareholders • Excess intercompany fees and payments to a commonly controlled sister company • Payroll-related taxes • Reimbursed expenses • Nonbusiness travel and entertainment of shareholders and/or key individuals • Related party transactions (i.e., leases between shareholder and entity) • Sales/purchases to/from related entities 88 INCOME APPROACH By choosing to make certain adjustments to the future economic bene- fit (i.e., the numerator), the analyst can develop a control or noncon- trol value. ValTip Normalization adjustments affect the pretax income of the entity being valued. Consequently, the control adjustments will result in a corre- sponding modification in the income tax of the entity, if applicable. ValTip [...]... 2nd Explicit Period 3rd Explicit Period Year Cash Flow To Equity _ Average Growth Rates _ Equity Discount Rate End of Year PV Factor 1 2 3 4 $ 10,000 16,000 22 ,400 29 , 120 N/A 60% 40% 30% 26 % 26 % 26 % 26 % 0.794 0.630 0.500 0.397 5 6 7 8 9 34,944 41,933 50,319 60,383 72, 460 20 % 20 % 20 % 20 % 20 % 26 % 26 % 26 % 26 % 26 % 0.315 0 .25 0 0.198 0.157 0. 125 11,010 10,480 9,960 9,480 9,060 10 11 12. .. view for year 20 02 Exhibit 4.11 presents another view Exhibit 4.10 Schematic View for Year 20 02 1st Forecast Period (4/ 12 ths of 20 02) Partial Period Factor = 3333 8/12ths of $100,000 or $66,667 4/12ths of $100,000 or $33,333 0.33333 Fiscal Year Begins on January 1, 20 02 Partial Year Discount Valuation Date August 31, 20 02 Company's Fiscal Year End December 31, 20 02 2nd Forecast Period (20 03) $107,000... Period 2 NCF2 (1 ϩ k )2 NCF3 (1 ϩ k)3 ϭ NCF4 (1 ϩ k)4 ϭ NCF5 (1 ϩ k)5 ϭ (1 ϩ 26 )2 $16,359 ϫ (1 ϩ 16%) (1 ϩ 26 )3 $18,976 ϫ (1 ϩ 12% ) (1 ϩ 26 )4 ϭ Terminal Value _ NCF5 ϫ (1 ϩ g) ϭ _ (k Ϫ g) _ $21 ,25 4 ϫ (1 ϩ 8%) (1 ϩ 26 )5 ϭ ϩ ϭ $10,556 $16,359 _ ϩ ϭ $10,304 1.5876 ϩ ϭ $18,976 _ ϩ ϭ $ 9,486 2. 0004 ϩ ϭ $21 ,25 4 _ ϩ ϭ $ 8,4 32 2. 520 5 ϩ... 114,017 12% 12% 12% 12% 26 % 26 % 26 % 26 % 0.099 0.079 0.063 0.050 8,030 7,180 6,410 5,700 120 ,858 6% 26 % 0.050 30 ,21 0 Terminal Value Total Value of Common “Equity” Present Value of Cash Flows $ 7,940 10,080 11 ,20 0 11,560 $148,300 109 Terminal Value Exhibit 4.13 Formula for Mulitistage Models n1 PV = ⌺ i=1 ϩ NCF0 (1 g1)i (1 ϩ k)i ϩ n2 ⌺ i ϭ n1ϩ1 ϩ NCFn1 (1 g2)i (1 ϩ k)i ϩ ϩ NCFn2... $1 ,20 0 (1 ϩ 06)1 /2 Month Amount 1 2 3 4 5 6 7 8 9 10 11 12 100 100 100 100 100 100 100 100 100 100 100 100 1 ,20 0 1 ,20 0 ϭ $1 ,20 0 1. 029 563 6.00% Discount Factor Half-Year 1. 029 563 Monthly ϭ $1,165.54 Present Value 1.005 1.010 1.015 1. 020 1. 025 1.030 1.036 1.041 1.046 1.051 1.056 1.0 62 99.50 99.01 98.51 98. 02 97.54 97.05 96.57 96.09 95.61 95.13 94.66 94.19 1,161.88 1. 029 563... ϩ ϭ $ 8,4 32 2. 520 5 ϩ ϩ (1 ϩ k)5 $13,300 ϫ (1 ϩ 23 %) $13,300 _ Final _ 1 .26 ϩ ϩ Period 5 ϭ ϩ ϩ Period 4 (1 ϩ 26 )1 ϩ ϩ Period 3 $10,000 ϫ (1 ϩ 33%) Further Reduces To ϩ ϭ $22 ,954 _ ϩ ϭ $ 7 ,22 8 3.1758 ϩ ϩ Terminal Value $22 ,954 ϫ (1 ϩ 6%) ( .26 Ϫ 06) (1 ϩ 26 )5 Terminal Value $24 ,331 ϭ 0 .20 ϩ ϭ $38,307 3.1758 The Sum of the Present... over fiscal year 20 02 g ϭ 7% ke ϭ 20 % In the scenario shown in Exhibit 4.9, the valuation date is August 31, 20 02, with projections for the first projection year ending in four months, at December 31, 20 02 Assuming equal distribution of earnings over the months, then 8/12ths has already been taken into consideration with the August 31, 20 02, period Assuming that the DCF model is the proper valuation tool... Year n2 = 1.333 Fiscal Year Begins on January 1, 20 03 Company's Fiscal Year End December 31, 20 03 108 INCOME APPROACH Exhibit 4.11 Another View Fiscal Year Ending December 31st 20 02 2003 _ NCF Times: Partial Period Factor Times: Present Value Factor 100,000 0.3333 0.9410 _ $ 31,364 ke ϭ 20 % 107,000 N/A 0.78 42 $ 83,909 ϩ 83,909 _ Total Present Value at August 31, 20 02 $115 ,27 3 ... determined b ϭ [5 ( $2, 340,000)] Ϫ [15 ($700,000)] _ 5 (55) Ϫ (15 )2 b ϭ $11,700,000 Ϫ $10,500,000 _ 27 5 Ϫ 22 5 b ϭ $1 ,20 0,000 50 b ϭ $24 ,000 Solving further for variable a, a ϭ $700,000 Ϫ [ $24 ,000 (15)] 5 a ϭ $340,000 5 a ϭ $68,000 100 INCOME APPROACH Finally, solving the original least square formula, y ϭ a ϩ bx y ϭ $68,000 ϩ ( $24 ,000 ϫ 5) y ϭ $188,000... greater detail and examples on financial statement adjustments ADJUSTMENTS FOR NONOPERATING ASSETS AND LIABILITIES AND RELATED INCOME AND EXPENSES The application of most commonly accepted income approach methodologies results in a valuation of the company’s operating assets, both tangible and intangible Therefore, it is often necessary to remove all nonoperating items from the com- 92 INCOME APPROACH . at December 31, 20 01. Ale’s inventory turnover has declined from 23 .5 turns at December 31, 1997, to 12. 8 turns at December 31, 20 01. The declines in accounts receivable turnover and inventory. decisions and business valuations. “Value today always equals future cash flow discounted at the opportunity cost of capital.” 2 85 CHAPTER 4 1 Frank K. Reilly and Keith C. Brown, Investment Analysis and. characteristics (control versus minority) 2. For GAAP departures, extraordinary, nonrecurring and/ or unusual items 3. For nonoperating assets and liabilities and related income and expenses 4. For taxes 5.