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Understanding Business Valuation Through the Apple Tree Analogy

This guide delves into the various methods of business valuation, illustrated through the metaphor of an apple tree. It covers critical concepts such as salvage value, current and future production, market price, book value, and the time value of money. By comparing cash flow scenarios, such as choosing between receiving $500 today or $800 in three years, we explore how different discount rates affect decision-making. Additional insights include valuation methods like DCF, comparables, and P/E ratios, showcasing practical examples for better comprehension.

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Understanding Business Valuation Through the Apple Tree Analogy

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  1. Business Valuation What’s an apple tree worth?

  2. “Old Man and Apple Tree” Consider the following valuations: • Salvage • Current production • Future production • Market price • Book value Balance Sheet

  3. Time value of money What is the value of $1?

  4. Time value of money Let’s say I offer you either $500 today or $800 in three years. Which is better?

  5. Time value of money $800 in 3 years is better than $500 today (assuming a 10% rate for money)

  6. Time value of money $500 today is better than $800 in 3 years (assuming a 20% rate for money)

  7. Time value of money Mathematically $500 * (1+ .20)3 = $864

  8. Time value of money What if somebody offers you $864 in three years. Or $1000. What is it worth to you?

  9. Time value of money $864 (discounted at 20% rate) = $500

  10. Time value of money $1000 (discounted at 20% rate) = $579

  11. Time value of money Mathematically $1000 / (1+ .20)3 = $578.70

  12. “Old Man and Apple Tree” Value of cash flows? (from Class Notes)

  13. Net income  $390,000 Depreciation $250,000 Bonuses $120,000 Net cash flow $760,000 Adjusted CF $500,000 Discount rate 33% Growth rate 8% Capitalization rate 25% (discount minus growth) Cap multiplier 4 DCF $2,000,000 Precision Tools

  14. Comparables Method Company X Price = $4,000,000 Adj Earnings = $520,000 Precision Tools Price = ?? Adj Earnings = $760,000 4000 PT Price 520 = 760 PT Price = $5,850,000 Use P/E ratio Company X Price = $4,000,000 Adj Earnings = $520,000 P/E = 7.7 Precision Tools Price = P/E * Earnings Adj Earnings = $760,000 7.7*$760,000 = $5,850,000 Precision Tools

  15. Precision Tools Price = $2,000,000 Earnings = $390,000 P/E = 5.13 U.S. stock market (average stock) Price = $36 Earnings = $1.80 P/E = 20 Irrationally exuberant? Price-earnings ratio

  16. Precision Tools

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