Alternatives to the Discount Rate Method for Business Valuation
Other methods to utilize in valuing companies include
Capitalization of Earnings
Multiply base year earnings/cash flow by a capitalization rate ( typically 15% to 40%). Assumes future earnings will be stable. If expect company to grow at a stable rate can modify formula to capture this growth by subtracting the growth rate from the capitalization rate (i.e. if want to use a 25% capitalization rate and you expect company’s earnings to grow by 6% per year use a capitalization rate of 25%-6%= 19%). If company is expected to be flat or grow at stable rate can arrive at the same value using the capitalization rate as you would using the discount rate without all the work of putting together pro forma financial statements. Ideal for quickly trying to access effect of changes in growth rates or discount rate on value. It would be beneficial to learn how to convert the discount rate into the capitalization rate.
Net Asset Value
Is useful when the balance sheet is likely to be more important in establishing value than the income statement. Typical types of companies that this method may be appropriate include:
- Machine Shops
- Investment Companies
- Start up Companies
- No earnings history
Characteristics to look for in deciding to us this method include:
- Have significant tangible assets and insignificant intangible assets
- Company adds little value to the product.
- It is relatively easy to enter the company’s industry
- The business depends heavily on competitive bids, and their is no significant consistent, predictable customer base
- start up company
- No earnings history
- Company assets and operations are primarily investment oriented
May be appropriate in the following situations:
- Doubt about ability to continue as going concern
- Current and projected cash flows are low compared to asset-base
- Company may be worth more dead than alive
May be helpful when company has a significant level of assets to back up the value. This method allows “you to establish two different rates of return. A lower rate on portion of value that is backed up by tangible assets, A higher rate for that portion of the value that reflects goodwill.
Rules of Thumb
Rules of thumb are important to know but they should not be relied on. A rule of thumb makes one generalized statement about the value of companies in an industry without any consideration given to the company’s position within the industry or the endless other factors that are important in considering value.
Consider the source of the rule of thumb and the timeliness of the rule of thumbs. Many rules of thumbs , are tossed around based on some experts comments that may have been made a decade ago.
Probing the client on this area may prove insightful as clients often have heard the rules of thumb for their industry which are often higher than our opinion of value. Many are based on a percentage or multiple of revenue. It can be very helpful to discuss shortcomings of rules of thumbs that rely on one variable with client.