Valuation of a business, Part 3
By TOM McCALLUM, FCGA, CBV
This is the last of three articles by Mr. McCallum on Valuation of a business to be carried
on PD Network.
Testing the valuation
conclusion
Testing the valuation conclusion
Cash flow going-concern
methods
The two predominant methods of testing the valuation conclusion, besides the ‘smell test,’
are the dual capitalization approach, and measuring the number of years earnings in
goodwill.
Redundant assets
Dual-capitalization
Revenue valuation model
Conclusion
The dual capitalization method recognizes that a business enjoys a return on both its
tangible assets and its intangible assets. It can be used to test the results for Example Co.
Ltd. Assume that Example Co. Ltd. has a tangible asset backing (TAB) of $400,000.
TAB
Mid-point of maintainable earnings
Desired rate of return on TAB
Desired rate of return on intangibles
$ 400,000
100,000
12%
25%
Mid-point of maintainable earnings
Desired return on TAB @ 12%
Excess earnings associated with intangibles
Capitalized at 25%
Value of intangibles (goodwill)
Add TAB
Fair market value
$ 100,000
48,000
$ 52,000
×4
$ 208,000
400,000
$ 608,000
Fair market value, thus determined, approximates the $600,000 (mid-point) fair market
value determined by the capitalized earnings method, so the valuation appears reasonable.
Also notice that the rate of return required on the intangibles is substantially higher than
that required on the TAB. This is reasonable as there is a higher degree of risk associated
with those earnings.
The 12% and 25% rates, used in the dual capitalization approach, can be restated as a
composite rate and compared to the rate(s) selected in the capitalization of earnings
approach.
Fair market value $608,000 divided by $100,000, (mid-point of the maintainable earnings)
equals 6.1×, or 16.4%, which compares to the rates of 15% to 18% used in the capitalized
earnings approach.
If the results yield by the dual capitalization approach are substantially different from that
concluded by the capitalized earnings approach, then the capitalization rate chosen is
highly suspect.
Number of years earnings in goodwill
The second test commonly employed is to measure the number of years earnings in the
goodwill imputed by the capitalized earnings approach. Returning again to the Example Co.
Ltd. illustration:
Mid-point of fair market value
TAB
Goodwill
Mid-point of maintainable earnings
Number of years earnings ($200/$100)
$ 600,000
400,000
$ 200,000
$ 100,000
2
Given the nature of the business, the industry, the risk, and so on, two years earnings in
goodwill is believed reasonable. If this result yields a high number of years, then in all
likelihood, but not necessarily, the business is over-valued.
Cash flow going-concern methods
There are two methods of cash flow approaches to the valuation of a business. These are the
discounted cash flow and the capitalized cash flow methods. Each is discussed briefly
following.
Discounted cash flow (DCF)
The DCF approach is principally used in valuations where cash flows are expected to vary
widely from year to year or where the business will not have an infinite life, such as an
extractive industry, and where cash flows are reasonably predictable. It is also used in the
valuation of identifiable intangible assets such as patents, and copyrights where the cash
inflows from rents, leases, and royalties are predictable.
The DCF method is seldom employed in commercial, industrial, or service sector business
valuations, but there are exceptions. Most notable exceptions are subscription-based
businesses, such as insurance and cable television companies.
While the DCF approach is conceptually a superior method, the difficulties inherent in
projecting future cash flows, estimating residual values, and selecting an appropriate
capitalization (discount) rate limit its general application. Also, very few closely-held small
businesses prepare forecasts beyond perhaps, at best, one year. Even where the business has
forecasts, those forecasts must be critically evaluated before they can be relied on. This
introduces an element of uncertainty not present in the capitalized earnings approach.
Exhibit 3
Discounted cash flow approach
14% discount rate
Year
After-tax
Income
1
2
3
4
5
$ 100,000
75,000
140,000
200,000
175,000
Sustaining
Non-cash
Capital
Outlays Re-investment Cash Flow
$ 50,000
50,000
50,000
50,000
50,000
$ 15,000
15,000
25,000
30,000
30,000
$ 135,000
110,000
165,000
220,000
195,000
Residual value of business @ end of Year 5
Estimated @ Year 5 earnings capitalized at 14%, $1,250,000
Present
Value
Factor
DCF
.877
.769
.675
.592
.519
$ 118,395
84,590
111,375
130,240
101,205
545,805
.519
648,750
$ 1,194,555
$ 1,200,000
Rounded, say
Valuation of a business, Part 3 • 2
In the foregoing DCF exhibit, sustaining capital re-investment represents the annual
investment in capital assets required to sustain the present operations of the business. The
amount is net of the present value of the income tax (called the “tax shield”) reductions
available by claiming capital cost allowance. Also, no accounting for debt reduction is used.
That approach will be ‘foreign’ to most accountants, but there is an assumption in the DCF
method that debt will be replaced by debt.
Capitalized cash flow approach
Many investors consider cash flows as a major measure of a prospective investment’s
suitability rather than net income determined through application of Canadian GAAP. Also,
for some industries, cash flow — particularly where high rates (relative to accounting
amortization rates) of capital cost allowance are allowed for income tax purposes — is the
more relevant approach.
The professional valuator frequently uses both the capitalized earnings and the capitalized
cash flow approaches in estimating fair market value. Although each method offers
advantages and disadvantages, the distinct advantage of the cash flow approach is its
recognition of capital reinvestment, capital cost allowance, and the related income tax
consequences, versus amortization (depreciation) accounting. Additionally, the problem of
deferred taxes is virtually eliminated.
The concepts and procedures are similar to those of capitalization of earnings and are best
demonstrated by example.
ABC LIMITED
Fair market value
(Capitalized cash flow approach)
(,000s)
Adjusted income before income taxes
Add amortization (depreciation)
Cash flow before income taxes
Less income taxes at 20%
Less sustaining capital reinvestment
Less tax shield
Discretionary cash flow after-tax
Multiplier (capitalization rate 14.3%, 16.7%)
$ 20
7
Add tax shield on existing undepreciated
capital cost
Fair market value
Rounded, say
Low
High
$ 100
50
$ 150
30
$ 120
$ 135
50
$ 185
37
$ 148
13
$ 107
×7
$ 749
$ 25
9
16
$ 132
×6
$ 792
50
$ 799
50
$ 842
$ 800
$ 850
Redundant assets
Where a business has assets which are surplus to the operating needs of the business, these
assets are considered redundant assets, and their value is additional to the capitalized earnings
or cash flows value otherwise determined. Examples include items such as works of art,
investment portfolios, excess cash or working capital, and retired equipment.
Valuation of a business, Part 3 • 3
Assume, for example, that Private Co. Ltd. has not been distributing its earnings to its
shareholders. This is often the case in a small closely-held business where the tax costs of the
distribution outweigh the advantage, albeit a temporary one, of retaining profits. Private Co.
Ltd. has a working capital ratio of 4:1, whereas the industry norm is 1.5:1, and the excess is
mostly invested in a term deposit or GIC. Let us assume the excess working capital,
represented in cash, is $150,000. The issue is how to account for this in determining value.
First, the earnings, if any, on the redundant asset need to be removed from the measure of
maintainable earnings (or cash flows). Second, the gross value of the asset needs to be
removed from TAB.
Adjusted earnings before considering non-operating income
Less interest income
Maintainable earnings
$ 200,000
10,000
$ 190,000
TAB before considering redundant assets
Less redundant assets
TAB
$ 450,000
150,000
$ 300,000
Without considering the existence of redundant assets we might have, based on the level of
TAB, assigned a value of 6 × $200,000, or $1,200,000 to Private Co. Ltd. Now though,
having reduced TAB to a lesser figure, we can assume there is more risk in the company and
therefore a greater capitalization rate (lower multiple) is appropriate. Assume that to be 5×,
which gives a value of $950,000 ($190,000 × 5). Note that in the first instance, interest
income on the redundant asset was erroneously included in maintainable earnings.
While the capitalized value of Private Co. Ltd.’s earnings is $950,000, this is not the fair
market value of the company. The redundant asset — cash — is additional as it can be
withdrawn from the company (by definition, without affecting the operations). The realizable
value of the redundant asset is added to the capitalized earnings value. Realizable value is the
amount net of any tax or sale costs that represents cash to the shareholder. If we assume some
tax planning, an estimate of the tax costs might range from zero to 40%.
Private Co. Ltd.
Fair market value
High
Low
Capitalized earnings
Add realizable value of redundant assets
Fair market value
$ 950,000
90,000
$ 1,040,000
$
950,000
150,000
$ 1,100,000
Failure to recognize the redundant asset and the associated income caused the initial valuation
of $1,200,000 to be an overstatement. In any given set of circumstances, a failure to recognize
redundant assets can also result in an understatement of value.
The example used here also illustrates a valuation practice principle. Where there are known
redundant assets, including hidden redundancies, as discussed in the next section, a valuator
can attempt to account for these via a decrease in the capitalization rate (higher multiple), but
generally the isolation of the redundant assets, along with the selection of a more appropriate
capitalization rate based on the ‘true’ TAB, is the superior approach.
Valuation of a business, Part 3 • 4
Hidden redundancies
The foregoing section on redundant assets also provides a hint of another valuation concept
used in the capitalization of earnings/cash flow approach. The business is assumed to have an
optimal balance sheet, that is, an appropriate level of financing.
Where the balance sheet is not optimal, and the business is overcapitalized, a hidden
redundancy may exist. Note that while the excess working capital example in the above
redundant asset section does present an overcapitalized balance sheet, the redundancy was not
hidden.
Generally, a hidden redundancy exists where long-term debt is disproportionately small when
compared to capital assets and/or equity. Consider the following balance sheet:
Current assets
Capital assets
$ 1,000,000
1,500,000
$ 2,500,000
Current liabilities
Shareholder equity
$
800,000
1,700,000
$ 2,500,000
A review of industry norms, publicly available from a number of sources (e.g., Dun &
Bradstreet’s Key Business Ratios, Industry Canada, Statistics Canada), indicates that this
company could have additional debt of $700,000 and still be at the debt to equity level
considered normal for its industry. How then to account for this overcapitalization in valuing
the company?
As the overcapitalization is a redundant asset, its value is excess to the going-concern value
based on a capitalization of its earnings/cash flows. However, unlike the working capital
overcapitalization example used in the redundant asset section, this overcapitalization cannot
be realized without borrowing.
TAB before considering redundancy
Less additional borrowing (hidden redundancy)
TAB
$ 1,700,000
700,000
$ 1,000,000
Adjusted earnings before considering hidden redundancy
Less interest on new debt, $700,000 × 8%, net of 20% tax
Maintainable earnings
Capitalized at 12.5%
$ 200,000
44,800
$ 155,200
×8
$ 1,241,600
600,000
$ 1,841,600
Add realizable value of redundant asset, say
Fair market value, rounded
$ 1,850,000
Without considering the hidden redundancy, the fair market value of the business might have
been determined as $1,600,000, based on 8 × $200,000 — a serious undervaluation.
Where a business is undercapitalized, that is, it is carrying too much debt, there will be a
negative redundancy. The valuation approach is essentially just the opposite of that just
presented. The required capital infusion will be applied to reduce debt. Consequently,
maintainable earnings will increase and the capital infusion will be deducted from the
resulting capitalized earnings/cash flows.
Valuation of a business, Part 3 • 5
Revenue valuation models
For some businesses, such as professional practices, a gross revenue valuation approach can
be used. This approach requires a careful analysis of, among other things, the practice
revenues, services performed, and the clientele or patients. The revenue model is based on the
assumption that a professional practice is fairly standard and revenues of ‘x’ dollars should
produce earnings of ‘y’ dollars.
While the model is appealing because of its apparent simplicity, the reality is that it is very
complex. This is because of the numerous judgements involved, and that the model varies
depending on, among other things, whether the practice is urban or rural, its geographical site
(which, and what part of a, province/territory), and whether there is a shortage or abundance
of practitioners.
Valuations based on revenue models should always be reconciled to values determined using
the other generally accepted methods. In short, revenue models are extremely dangerous in
the hands of the inexperienced. For example, accounting practices are generally said to have a
goodwill value of one year’s revenue. In truth, that value can range anywhere from about zero
to 150% of revenues.
Conclusion
As noted in Part 1 of this series, valuation is part science, part art, but mostly the latter. This
is an introduction to the basics and many of the concepts, methods, and approaches have not
been examined in depth. Items such as the capitalization rates, discount rates, tax rates,
management salaries, liquidation costs, and assumptions used in these documents are for
illustration purposes only and are not intended to represent actual appropriate selections.
Additionally, matters such as special-interest purchasers, minority discounts, valuation of
special or preferred shares, unusual liquidity issues, economic value-added determinations,
and non-voting shares have not been addressed and are left to the reader to further research.
J. Thomas McCallum, FCGA, CBV, began his tax career in 1967. He is currently based in
Ontario and restricts his practice to business valuation and income tax consulting. He has
conducted hundreds of seminars throughout Canada, Barbados, and the United States. Active
in the Certified General Accountants Association, Tom is a past president of CGA Ontario.
Valuation of a business, Part 3 • 6