COPYRIGHT 2008

1. 1 COPYRIGHT 2008 COMPANY VALUATION RUTGERS UNIVERSITY SCHOOL OF BUSINESS CAMDEN by David E. Vance, MBA, CPA, JD NOTHING IN THIS LECTURE SHOULD BE CONSTRUED AS INVESTMENT ADVICE

2. 2 Why Value Companies? Investors will want to know the value of your company before they invest. For example, if your business is worth $100,000 and they invest $25,000 they will want about a quarter of the stock. If it is worth $2,500,000 and they invest $25,000, they will only expect about 1% of the stock. If you are buying or selling a company you are going to want to estimate its value independent of what the seller or buyer thinks its worth to make sure you get a fair price. If you are going public, you want to value your company so you have a reasonable estimate of how to price your stock. Companies are valued for purposes of getting bank loans or paying inheritance tax.

3. 3 What is a Company Worth?

4. 4 Valuation Methods There are many methods of valuing companies, each of which has its strengths and weaknesses. A complete catalog of methods would fill several books. We will explore a few common ways to value companies. A sophisticated individual would also �adjust� the data they used in valuing a company to eliminate one-time gains or losses or other unusual items. A professional would probably value companies using several different methods. Each method would probably arrive at a different value for a company. Some weighted average method would then be used to arrive at a the most likely estimate of value.

5. 5 Book Value Book value is defined as Assets minus Liabilities. Assets less Liabilities is Equity. Many analysts think book value understates the value of a company as a �going concern.� The term �going concern� refers to a company that is making sales, producing a product and or delivering a service. A �going concern� is one expected to produce income into the foreseeable future. Absent any other information, book value may be seen as a company�s minimum value.

6. 6 Market Capitalization Market capitalization (Market Cap) is the price of the stock times the number of shares outstanding. Stocks prices are published in the Wall Street Journal and are available on-line at finance.yahoo.com. The number of shares outstanding (OS shares) should be in a company�s income statement. Outstanding shares are those in the hands of the public. A company can hold its own shares. These would not be included in OS shares. Market Cap = OS Shares x Share Price Example: A company has 10,000,000 OS Shares priced at $27. What is its Market Cap? Market Cap = 10,000,000 x $27 = $270,000,000

7. 7 Price Earnings Ratio Most people don�t by companies; they buy shares of stock in companies. Anyone who watches the stock market knows it is volatile and short term stock price changes are driven by fear and greed. A company�s price earnings ratio is the price of a stock on a given day, divided by one year�s earnings per share (EPS). The EPS is usually the last annual EPS. Some analysts compute a moving 4 quarter EPS. The PE ratio is a dimensionless number. PE ratio = Current Stock Price / EPS Example: A stock has $2 earnings per share. Its price is $32 on the day it is measured. PE = $32 / $2 = 16.

8. 8 How to Use PE Ratio A company�s average PE ratio over a period of years is thought to provide a baseline indicator of value. A PE ratio can be thought of as the cost of buying $1 of earnings. If a company�s PE ratio drops below its average, some say it becomes a bargain. For example, suppose a stock has a three year PE ratio of 16 and the PE drops to 12. That means you can now buy a dollar of earnings in that company for $12 rather than the typical $16. This might signal a buying opportunity. Now suppose you own a stock whose historical PE ratio has been 16 and its PE jumps to 22. This might mean it is overpriced and indicate a selling opportunity. Sophisticated investors think PE analysis is naive. However, sophisticated investors also invested in sub-prime mortgage bonds and Enron.

9. 9 Dividend Model For companies that: (1) pay dividends, (2) are expected to grow at a predictable rate, g, and (3) have a riskiness, Kr, one should be able to predict a stock price. Po = Do x (1 + g) / (Kr �g) Where Po is the price at time zero (the present); Do is the dividend paid at time zero, g is growth rate and Kr is riskiness. Once a company�s stock price is known, if the number of outstanding shares is also known, one can compute value. Stock price times shares outstanding is market capitalization or market cap. It is the company�s value.

10. 10 Stock Dividend Model Example Suppose a company has 2,000,000 shares outstanding. It�s last dividend, Do was $1.50, its growth rate is 15%, its riskiness is 18%, what is its stock price? Po = Do x (1 + g) / (Kr � g) = $1.50 x (1 + 15%) / (18% - 15%) = $1.50 x 1.15 / .03 = $57.50 per share Market Cap = Share price x Outstanding Shares = $57.50 x 2,000,000 = $115,000,000 This model won�t work without dividends or if Kr < or = to g. However, this model has been successfully adapted to a variety of situations.

11. 11 Discounted Cash Flow (DCF) Discounted cash flow is most theoretically sound method of valuing a company. On the other hand, there is often a wide gulf between good theory and good practice. A draw back to DCF is that it requires a very large number of assumptions. One must estimate the cash generated by a company far into the future and discount each year�s cash back to the present. This necessarily means estimating sales, and expenses and selecting the appropriate discount rate. To be theoretically correct, free cash flow (FCF) should be estimated and not just cash flow. Free cash flow is the cash available after a company invests in the working capital, plant and equipment, and research and development.

12. 12 Discounted Cash Flow Example One issue is how far in the future can FCF be reliably estimated. Suppose a discount rate of 20% per year is selected for 11 years. Year FCF PVIF PV 1 $10M 0.833 $8.3M 2 $11M 0.694 $7.6M 3 $12M 0.579 $6.9M 4 $14M 0.482 $6.7M 5 $16M 0.402 $6.4M 6 $18M 0.335 $6.0M 7 $20M 0.279 $5.6M 8 $22M 0.234 $5.1M 9 $24M 0.194 $4.7M 10 $26M 0.162 $4.2M 11 $28M 0.135 $3.8M DCF estimated company value $65.3M

13. 13 Market Valuation A company is worth what someone will pay for it. So one indication of what a company is worth is to compare it to the value of similar companies. This done all the time in real estate. Companies are considered similar if they are in the same industry. Every company in America has a four digit Standard Industrial Classification (SIC) code. SIC codes are one indication of whether two companies are in the same industry. Financial statements for all publicly traded companies are posted on the SEC�s website: www.sec.gov. This is an excellent source of information on comparable companies. To compare companies of different size requires some common denominator.

14. 14 EBITDA EBITDA is Earnings Before Interest Taxes Depreciation and Amortization. EBITDA is considered an important measure of a company�s earning ability. Usually, Income Statements have a subtotal line which says something like �Earnings from Operations.� This line will appear above the line where interest expense is subtracted. To get EBITDA you have to add depreciation and amortization to Earnings from Operations. Depreciation and amortization can be found on the Statement of Cash Flows. By computing the average ratio of market cap to EBITDA for an industry, one can estimate the market value of a single company.

15. 15 EBITDA Multiplier Method Company EBITDA OS Shares Price/Shr Market Cap Bob�s Solar $110M 8,000,000 $48.13 $385M Sun Silicon $90M 4,000,000 $85.50 $342M Sun Electric $200M 8,000,000 $100.00 $800M LightPower $20M 1,000,000 $64.00 $64M Threshold $30M 20,000,000 $5.10 $102M PowerCo $50M 10,000,000 $17.00 $170M _____ ______ Subtotals $500M $1,863 EBITA Multiplier = ? Market Cap / ? EBITDA = $1,863 / $500M = 3.726 The EBITDA multiplier is dimensionless.

16. 16 Using the EBITDA Multiplier The EBITDA multiplier is used to estimate the total value of a company with a given EBITDA in a given industry. Company Value = Company EBITDA x EBITDA Multiplier Suppose we have a solar cell company that has an EBITDA of $7M. What would its value be? = $7M x 3.726 = $26.1M Public companies are used to compute the multiplier because private company data is hard to get. The value of private companies is usually around 25% less than their public company counterparts. The reason is that shares in private companies are hard to buy and sell because there is no ready market for them.

17. 17 Sales & Income Multipliers The EBITDA multiplier method cannot be used when EBITDA is negative or close to zero. The companies used to estimate the EBITDA multiplier cannot have a negative or zero EBITDA either. An alternative is to use the Sales multiplier. Sales multiplier = ? Market Cap / ? Sales Some analysts also use an Income multiplier, but like the EBITDA multiplier it cannot be used when income is close to zero or negative and the companies used to estimate the multiplier cannot have negative or zero net income.

18. 18 Sales Multiplier Company Sales OS Shares Price/Shr Market Cap Bob�s Solar $600M 8,000,000 $48.13 $385M Sun Silicon $450M 4,000,000 $85.50 $342M Sun Electric $1,000M 8,000,000 $100.00 $800M LightPower $80M 1,000,000 $64.00 $64M Threshold $120M 20,000,000 $5.10 $102M PowerCo $200M 10,000,000 $17.00 $170M Subtotals $2,450M $1,863M EBITA Multiplier = ? Market Cap / ? Sales = $1,863 / $2,450M = 0.7604 The Sales multiplier is dimensionless.

19. 19 Using the Sales Multiplier Suppose a company has $30M in sales. The Sales multiplier method (SMM) would be: Company Valuation = Sales x Sales multiplier = $30M x 0.7604 = $22.8 Notice the valuation based on EBITDA multiplier method (EMM) is $26.1M. There is no reason why the two methods should converge to exactly the same result. Never the less, a sophisticated analyst would probably consider estimates from several methods plus additional information in arriving at an estimate of company value.

20. 20 Integrating Different Company Values Suppose the Income multiplier estimate (IMM) of value was $28M. An analyst might average the EBIDTA, Sales and Net Income Method valuations, but double weight of the EBITDA method value. Composite Estimate of Value = SMM + 2 x EMM + IMM 4 = 22.8M + 2 x 26.1M + $28.0M 4 = $25.8M

21. 21 Company Valuation Refinement There are many ways to improve on the estimate of company value. For example, one might want to eliminate one time items that affect EBITDA, Revenue or Net Income. Another way to refine the estimate of company value is to take debt into consideration. When company is purchased, the purchaser assumes responsibility for the company�s debt. The question is: How does a company�s debt affect its value? Consider companies A & B with the following characteristics: A B Revenue $50M $50M EBITDA $10M $10M Net Income $4M $4M Debt $10M $30M

22. 22 The Revenue, EBITDA and Net Income values are the same for both companies, but would you pay the same? The EBITDA, Revenue and Net Income multipliers discussed previously assume companies have an average amount of debt. Assuming average debt masks a lot of detail. One of the reasons that the Revenue Multiplier (Market Value/Revenue) EBITDA Multiplier (Market Value/EBITDA) and Net Income Value (Market Value/Net Income) varies from company to company is the difference in debt load. Suppose companies A & B were publicly traded with market capitalizations of $40M and $20M respectively. The revenue multipliers for A & B would be .8 ($40M/$50M) and .4 ($20M/$50M) respectively. The industry revenue multiplier would be .6 (($40M +$20M)/($50M +$50M)).

23. 23 Assume the Total Value (TV) is the value of a company if it were debt free. All of that value would be allocated to the shareholders (owners.) For publicly traded companies the owner�s value is the market value. If we assume that the every dollar of debt reduces a dollar allocated to the shareholders, we can write the equation: TV = Market Value + Debt We can use this to generate a new set of multipliers that should, be more accurate than the commonly used multipliers we have been using so far. TV Revenue Multiplier = TV / Revenue TV EBITDA Multiplier = TV / EBITDA TV Net Income Multiplier = TV / Net Income

24. 24 Consider the following Total Value (TV) Analysis: A B Industry Market Value $40M $20M $60M Debt $10M $30M $40M Total Value (TV) $50M $50M $100M Revenue $50M $50M $100M TV Revenue Multiplier 1.0 1.0 1.0 EBITDA $10M $10M $20M TV EBITDA Multiplier 5.0 5.0 5.0 Net Income $4M $4M $8M TV Net Income Multiplier 12.5 12.5 12.5

25. 25 After the total value is calculated, the debt load of each individual target company can be subtracted to compute a more refined estimate of company value. For example suppose we were valuing companies C & D with revenues of $20M and $25M and debt of $5M and $12M. C D Revenue $20M $25M x TV Revenue Multiplier x 1.0 x 1.0 _____ _____ TV $20M $25M Less Debt -5M -12M _____ ____ TV Revenue Market Value $15M $13M

26. 26 Compare this to the company valuations using the Revenue Multiplier unadjusted for debt. C D Revenue $20M $25M x Revenue Multiplier x 0.6 x 0.6 _____ _____ Revenue Value $12M $15M In this example, there is a $3M swing in the value of companies C & D when debt load is explicitly taken into account rather than assuming each company has an average debt load.

27. 27 Going Public One cannot sell stock to the public until it is registered with the SEC. Registration is complex and expensive so �going public� is a big deal. So, why go public? For one thing, it is easier to raise money if a company is publicly traded. Small blocks of stock can be sold to people who can resell to anyone then want, when they want, to cash out. A person who buys stock in a non-publicly traded company can usually only sell it back to the company or to other stockholders. With such a limited market, the resale price is likely to be low; and the company or other shareholders might not want to buy when the stockholder wants to sell. Hence the lower value for privately held stock.

28. 28 Investment Bankers & Underwriters When a company goes public, a process called an initial public offering (IPO), it usually issues a large number of new shares. If the company isn�t publicly traded, there is no market price to look at. The question is: What is a fair value for those shares? When a company issues new stock, an investment banker called an underwriter buys all the new stock and then resells it, taking a commission on the sale. Obviously, if the stock price is low, it is easy to sell. So, underwriters want to set the price low. The lower the price, the less money a company gets from the IPO to invest in new products, sales and marketing and expansion. So, if this your company, you will want to do your own calculation just to make sure they are aren�t selling you short.

29. 29 Estimating Stock Price An entrepreneur should independently estimate the fair price of the stock in his or her company rather than just relying on an underwriter. The pre-IPO value of the company (CV) plus the amount of cash generated by the IPO (Amt) must be spread over the old outstanding stock (OS) plus the new stock (NS) to get the estimated stock price (P) as shown in equation (1). P = CV + Amt (1) OS + NS The amount raised (Amt) is based on P and NS, see equation (2) Amt = P x NS (2)

30. 30 So the stock price in (1) is determined by the amount raised, but the amount raised is based on the stock price (2). What? Re-write equation (2) as equation (3). P = Amt / NS (3) Since equations (1) and (3) both equal price, set them equal to each other. CV + Amt = Amt (OS + NS) NS Cross multiply both sides to eliminate the denominators. CV x NS + Amt x NS = Amt x OS + Amt x NS

31. 31 Subtract Amt x NS from both sides which gives: CV x NS = Amt x OS Dividing both sides by CV gives: NS = Amt x OS / CV If we have the number of new shares, and know the amount raised, we can find the estimated share price using equation (3). P = Amt / NS

32. 32 Estimating Share Price Example A company valued at $25M has 5M shares outstanding. It wants to raise an additional $6M when it goes public by selling new shares. How many shares should it issue and what should be their price? NS = Amt x OS CV = $6M x 5M $25M = 1.2M new shares P = Amt / NS = $6M / 1.2M = $5 / share

33. 33 What You Should Have Learned in this Lecture 1. Reasons for valuing companies 2. How to compute the PE ratio and use it for valuation. Interpreting what higher or lower than average PE might signal. How to use the Stock Dividend Model to value stock and a company. How to value a company using a DCF valuation model. 6. How to estimate market valuation based on EBITDA. 7. How to estimate market valuation based on Sales. 8. How to estimate market valuation based on Net Income. 9. How to integrate company valuations. 10. When can stock be sold to the public, what is registration and what is an IPO. 11. How to estimate the number of shares to issue to raise a given amount and how to estimate the stock price for an IPO.

34. 34 Assignment: Your company is thinking about buying an electronics firm in Denver. They have asked you to estimate a fair value for the firm before they make their initial offer. The Denver electronics firm has sales of $40 million, EBITDA of $12 million, Net Income of $4 million. After doing some research you find there are five similar firms in the industry. Company Revenue EBITDA Net Inc. OS Shares Price/Shr Ajax Solar $100M $30M $10M 9,000,000 $11.00 Baker Inc. $90M $25M $7M 2,000,000 $45.00 Cynx Semi $80M $22M $8M 5,000,000 $16.00 Deltex $60M $14M $5M 8,000,000 $7.00 ElectronA $50M $14M $6M 3,000,000 $16.00

35. 35 Compute the EBITDA Multiplier for this industry. 2. Estimate the value of the Denver firm using the EBITDA Multiplier method. 3. Compute the Revenue Multiplier for this industry. 4. Estimate the value of the Denver firm using the Revenue Multiplier method. 5. Compute the Net Income Multiplier for this industry. 6. Estimate the Denver firm using the Net Income Multiplier method. 7. Given your estimates of the value of the Denver firm using the EBITDA, Revenue and Net Income methods, what is the weighted average estimate of the value of the firm if you weight the EBITDA value twice as much as the Revenue and Net Income values?

36. 36 Assignment: continued Your firm wants to sell a division and wants you to estimate a fair price for the sale. Accounting has estimated the cash flow that will be generated over a number of years. Yr. Cash Flow Yr. Cash Flow Yr. Cash Flow Yr. Cash Flow 1 $10.0M 3 $12.5M 5 $15.4M 7 $19.0M $11.0M 4 $14.0M 6 $17.0M 8 $21.0M 8. Assume that in the division�s industry, companies are valued using the Discounted Cash Flow (DCF) method using a discount rate of 20%. Estimate the value of this company. 9. Assume that in the division�s industry, companies are valued using the DCF method using a discount rate of 15%. Estimate the value of this company. 10. How much of a difference is there in the estimated value of the division under the DCF valuation method if the discount rate is 15% or 20%. Answer should be in millions of dollars.

37. 37 THE END COMPANY VALUATION by David E. Vance, MBA, CPA, JD