Use of business valuation on projected cash flows
In 2020, I wrote an article on business valuation. I explained that companies are popular for dealing with situations such as acquisitions, mergers, share ownership, divorce, admitting new partners, administering estates, and other purposes.
In said article, I also explained that common valuation methods include the market approach used for listed or publicly traded stocks, the earnings approach which includes the discounted cash flow method (“DCM Also known as the net present value (“NPV”) method and the capitalization of past income.
Another method is the Price Earnings (PE) method which basically consists of calculating the ratio of the price per share (price) to (divided by) the earnings per share (EPS) of a comparable, usually listed company.
The average annual profit (AAE), past or future, of the evaluated company is then multiplied by the PE ratio of the comparable company to estimate the value of the evaluated company.
This article focuses on the DCM or NPV method.
DCM or NPV method
This method is very popular with business valuers and in management appraisals of capital investments.
It bases the valuation of a business on the present or present value of expected future net cash flows.
It is based on future cash flow, not profit. The main aspects of the method are explained below.
An evaluation period or a number of future years to be used must be defined. For example, an appraiser might use projections for the standard 5-year appraisal period.
Other reviewers may consider shorter or longer review periods.
For companies with finite (exhaustible) resources such as mining, it is common practice to estimate value based on the quantified resource, e.g. gold ore, and the rate at which the resource will be mined. or extracted until exhaustion.
In the case of mines, this information is estimated by mining professionals and generally documented in geological reports.
Estimated volumes are essential for determining revenues and therefore revenues, and for estimating costs and therefore payments. Volumes are factors influenced by the projected installed capacity and its use.
Other considerations include market share, availability of foreign currency in the case of imports, etc.
For mines, for example a gold mine, estimates are made of the recovery rate of ingots from the gold ore, for example in grams per tonne of ore.
Entrances and exits
This amounts to formulating a cash budget, excluding borrowing costs. It is about estimating cash flows such as revenue, operating expenses and investments etc. Entries and exits are calculated for each year.
Capital expenditures are treated as cash outflows. The disposal of assets for cash consideration is treated as inflows.
Pay attention to necessary acquisitions and disposals of assets.
Discount rate to calculate NPV
A discount rate is usually obtained by using an estimate of the opportunity cost of receiving money in the future rather than now.
Alternatively, the rate at which future money is expected to lose value relative to current or present money is used. It is common for appraisers to calculate and use the Weighted Average Cost of Capital, or WACC, or simply use borrowing interest rates.
A discount factor applicable to each valuation year is estimated by entering the discount rate and the number of years into the standard formulas used to estimate the discount factor.
For example, assuming a discount rate of 10% per year, the discount factors for years 1, 2, 3, 4 and 5 will be 0.91, 0.83, 0.75, 0, respectively. 68 and 0.62.
In other words, against the current dollar, future dollars in years 1, 2, 3, 4, and 5 are worth $ 0.91, $ 0.83, $ 0.75, $ 0.68, and 0.62. $.
Calculation of NPV
The estimated future net cash flows for each year are then multiplied by the discount factor calculated for that year.
For example, hypothetical net cash flows for Year 1 ($ 2,000,000), Year 2 ($ 2,500,000), Year 3 ($ 3,000,000), Year 4 ($ 3,500,000), and Year 5 ($ 4,000,000)) totaling $ 15,000,000 will be multiplied by the discount factor for each year.
Still assuming 10% per year, the NPV for each year will be Year 1 ($ 1,818,182), Year 2 ($ 2,066,116), Year 3 ($ 2,253,944), Year 4 ($ 2,390,547) and Year 5 ($ 2,483,685) to give a total NPV of $ 11,012,474.
As the evaluation period increases, the risk of performing below expectations also increases.
It is because of so many uncertainties inherent in business.
These may be due to external factors such as political, economic, social, technological, environmental or legal (“PESTEL”) or to those summarized in Porter’s 5 forces model or to factors specific to the company such than the age of machines.
The risk is usually taken into account by lowering the revenue forecast.
Alternatively, progressively decreasing probabilities of occurrence can be assigned to each future year and multiplied by the annual NPV.
The hypothetical probabilities of Year 1 (90%), Year 2 (80%), Year 3 (70%), Year 4 (60%), and Year 5 (50 %) will result in an NPV of $ 7,543,188.
The net present value, excluding borrowing costs, calculated before accounting for the capital structure of the business is called enterprise value or EV.
Debt such as loans must be deducted from EV to arrive at shareholder value.
Calculating the value of a share
The value per share is calculated by dividing the value of the company (NPV) by the number of shares issued by the company (number of shares).
Assessment of a mine
The value of an operating mine can be calculated by estimating the NPV of future cash flows.
Future flows are estimated, for example, by multiplying the quantity or volume of ore processed, for example gold or bullion, by the estimated world price of the ore (for example the London Bullion Market Association price).
Outputs such as the cost of mining, general processing and administration, taxes and the like are estimated and deducted. Capital expenditures are treated as outflows.
This simplified article is for general information purposes only and does not constitute professional advice from the writer.
Godknows Hofisi, LLB (UNISA), B.Acc (UZ), CA (Z), MBA (EBS, UK) is a lawyer / courier at a local law firm, Chartered Accountant, Insolvency Specialist, Tax Accountant registered, consultant in transaction structuring, business management and taxation and is an experienced director, including as chairman. He writes in a personal capacity. He can be contacted on +263772246900 or [email protected]