Ch. 4 &5: DEFINING AND ESTIMATING THE FUTURE BENEFIT STREAM & CAP/DISCOUNT RATES

Generally speaking, "discretionary" uses are comprised of:

Growth oriented capital expenditures and acquisitions Debt principal reduction Shareholder payments (dividends, stock repurchase)

Two of the most commonly used methods to estimate future benefits based on projected economic income are:

Projected Cash Flows Projected Earnings

Within the context of business valuations, the capitalization or discount rate is the "yield rate" on the business investment. The yield rate is comprised of three main elements:

The real rate of return - what investors expect in exchange for letting someone else use their money on a riskless basis Expected inflation - the expected depreciation in purchasing power while the money is tied up An additional return (premium) that compensates the investor for the relative degree of risk, in excess of the safe rate, inherent in the investment.

The term "earnings" as used in this book is synonymous with the term

"benefit stream." These terms refer to cash flow, net income, or other types of benefit streams.

CAPM, by definition, is an

"equilibrium asset pricing theory that shows that equilibrium rates of expected return on all risky assets are a function of their co-variance with the market portfolio."

ROI, as used to develop beta , is calculated as:

((Ending Stock Price - Beginning Stock Price) + Dividends) / (Beginning Stock Price)

In evaluating company-specific risks, the authors of Practitioners Publishing Company's "Guide to Business Valuation" suggest that the following factors be considered in the specific company risk premium:

1. Company's Financial Risk 2. Diversification of the Company's Operations 3. Other Operational Characteristics, such as key management issues

From a risk adjustment standpoint, there are three main categories of factors that may influence the capitalization or discount rate. Specific factors affecting risk are listed for each category. The three categories (and examples of factors) are:

1. External Factors 2. Internal Factors 3. Investment Factors

Why focus on the long-term period? The Valuation Handbook offers the following observations:

1. Long-term historical returns have shown surprising stability. 2. Short-term observations may lead to illogical forecasts. 3. Every period has dramatic historical events and we do not know what major event lie ahead. 4. Law of large numbers: more observations lead to a more accurate estimate.

The reasons net cash flows are generally preferred are (compared to GAAP earnings):

1. Net cash flows represent the type of earnings most investors are seeking and expect to receive from their investments. 2. Most of the cost of capital derived from the capital markets and other empirical data that is used to derive the discount rate represents net cash flows as the type of earnings to measure economic income. For example, the data used in the Ibbotson Build-up Method to derive the discount rate is based on net cash flows as the measurement of economic income. 3. Net cash flows bring into the income approach the expected future changes in the balance sheet. Net cash flows will take into consideration the future expected working capital needs, capital expenditures, and changes in long-term debt necessary to support the projected earnings of the company.

Two primary criteria exist for the determination of capitalization or discount rates in the context of valuing closely held businesses:

1. The capitalization or discount rate should be essentially the same as the rate of return (yield) that is currently being offered to attract capital or investment to the type, size, and financial condition of business that is being valued. 2. The capitalization or discount rate must be consistent with the "type" of benefit streams to be capitalized or discounted (e.g., pre-tax versus after-tax, cash flow vs. earnings to invested capital or equity).

Discount rate is

A rate of return used to convert a series of monetary sums into present value.

Capitalization rate

Any multiple or divisor used to convert anticipated economic benefits of a single period into value.

CAPITALIZATION RATE =

DISCOUNT RATE LESS LONG-TERM SUSTAINABLE GROWTH RATE

Net cash flow to equity is also referred to as the

Direct Equity Method. It is "direct to equity" because debt has been serviced (in the calculation below, net income is derived after subtracting both interest expense, and future debt repayments). Hence, what remains is net cash flows available to equity owners.

The model for estimating future benefits using projected cash flows is the

Discounted Cash Flow model (DCF)

Net Income Before Tax or Net Income After-tax is usually the type of earnings used with the

Excess Earnings Return on Assets (Treasury Method) as long as the rate of return on assets is based on the same type of earnings.

GROWTH RATE SHOULD EQUAL

INFLATION PLUS REAL GROWTH THAT CAN BE ACHIEVED WITHOUT ADDITIONAL CAPITAL INVESTMENT

Using the Trend Line Projected Method, growth or data is:

Increasing at a declining rate.

Net cash flow to invested capital is also referred to as the

Invested Capital Method. This is the cash flow available to service invested capital (e.g., equity and interest bearing debt).

Net Cash Flows to Equity defined

Net Income (after-tax) + Non-cash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes) - Capital expenditures necessary to support projected operations - Additions (deletions) to net working capital necessary to support projected operations + Changes in long-term debt from borrowings necessary to support projected operations - Changes in long-term debt for repayments necessary to support projected operations = Net cash flow to equity - Dividends paid to preferred shareholders = Net cash flow to common shareholders' equity (after-tax)

Net Cash Flow to Invested Capital defined

Net income (after-tax) + Non-cash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes) - Capital expenditures necessary to support projected operations - Additions (deletions) to net working capital necessary to support projected operations + Interest expense net of the tax benefit resulting from interest as a tax deductible expense = Net cash flow to invested capital (after-tax)

When would using GAAP earnings in a valuation be appropriate?

Normally, this will be the case when the capital expenditures, net working capital requirements and changes in long-term debt to support the company's projected operations are insignificant in relation to the earnings. In addition, even when capital expenditures are significant, this will be the case when depreciation expense approximates capital expenditures.

Large Cap Stocks components of build-up

Real Rate + Inflation Forecast + Equity Risk Premium

Small Cap Stocks components of build-up

Real Rate + Inflation Forecast + Equity Risk Premium + Size Premium

The primary formula for the Build-Up Method is:

Rf + ERP + IRPi + SP + SCR (risk free rate + equity risk premium + industry risk premium reflected for i size + size premium + specific company risk premium)

Expected return =

Risk-free rate + Beta x

The unweighted average method, sometimes referred to as the "average method" of estimating expected future earnings, is based on the simple average or arithmetical mean of the historical economic earnings, which is calculated by taking the sum of a set of values and dividing the sum by the number of values used in deriving the sum. The basic formula is:

Sum of Variables / Number of Variables

Should the projected economic income be in constant real dollars or nominal dollars?

The analyst can prepare the projected economic income in constant real dollars, where the projected economic income is based on the dollars in the first year without regard to inflation, or in nominal dollars, where an estimate of inflation is included in the projected economic income over the projection period. However, whether the analyst chooses constant dollars or inflation-adjusted dollars, they must select the appropriate present value discount rate that corresponds to the economic basis used to project the benefit stream.

Is CAPM a pre-tax or an after-tax method?

The answer: it depends.

When utilizing projected or forecasted financial information, the adequate number of years to be included in the analysis is:

The number of years until it is assumed the benefit stream becomes linear.

Trend-Line Static Method:

The trend-line static method often puts a heavier weighting on the latest year, as does the weighted average method. However, because the trend-line static method is based on least square formulas, it produces a trend line that lessens the impact which any particular year has on the calculation. The trend-line static method assumes a capitalization process of earnings rather than a discounting process.

Using a weighted average method to determine a future benefit stream, a valuation analyst assigns more weight to the most recent years. This indicates:

The valuation analyst determined the most recent year is the most indicative of future years.

True or False: Over long periods of time, returns on investments in smaller firms have consistently and significantly exceeded returns on investment in larger firms.

True

True or False: Projected economic income in constant real dollars is based on real dollars in the first year without regard for inflation.

True

True or False: The combination of the real rate of return and expected inflation is sometimes referred to as the time value of money, which is the same for all investments of the same expected duration, although the expectation may be different for different investors.

True

Bell Landscape Company has the following historical earnings: 1 $75,400 2 65,200 3 87,600 4 90,500 5 53,900 Which method of projecting earnings would appear most appropriate to estimate future benefits?

Unweighted average method. No real trend exists.

Two most commonly used methods to estimate future benefits based on a linear benefit stream are:

Weighted average method and unweighted average method

Start-up Jennings Baker Company provided you the following historical data: 1 ($15,300) 2 32,400 3 89,600 Which method of projecting earnings would appear most appropriate to estimate future benefits?

Weighted average method.

Real Rate =

[(1 + Nominal Rate) ÷ (1+ Inflation Rate)] - 1

Nominal Rate =

[(1 + Real Rate) x (1 + Inflation Rate)] - 1

Variance is

a measure of the squared deviation of the actual return of a security from its expected return.

Co-variance is

a statistical measure of the interrelationship between two securities.

A non-linear benefit stream is a stream of future benefits that is expected to grow or decline at

a variable rate.

External Factors:

a) Expectations of the general economy b) Existing conditions of the general economy c) Expectations of a particular industry d) Existing conditions of a particular industry e) Competitive environment of a particular industry

Internal Factors:

a) General expectations of the business b) Financial position/condition of the business c) Competitive position of the business d) Size of the business e) Nature of the business f) Quality and depth of the organization and staffing of the business g) Reliability or stability of the earnings of the business

The types of earnings to choose from include, but are not limited to, the following (if not using net cash flows):

a) Income from operations b) Income before taxes c) Net income (after-tax)

Generally, estimated future benefits are based on projected economic income when:

a) Projected economic income may be considered more representative of the future whether or not the valuation is for tax or non-tax purposes b) Projections are available and are considered indicative of the expected future benefits c) Lack of reliable historical data d) Emerging businesses e) Start-up development stage enterprises f) Future benefit stream is non-linear

Investment Factors:

a) Risk factors associated with the investment itself b) Amount invested in the particular business-relative to other investments in the portfolio c) Expectations of capital appreciation of the investment d) Expectations of liquidity of the investment e) Level of the expected management burden of the investment

Generally, estimated future benefits are based on historical economic income when:

a) The purpose for the valuation is tax or divorce. Historical economic income is based on fact and thus considered more reliable than projected economic income (the above is a generalization and readers must refer to state case law and the appropriate statute!) b) Historical economic income is indicative of expected future benefits based on the stability and trend of historical earnings c) Company is mature d) Historical operations are a good proxy for the future e) Future benefit stream is linear

Normally, historical economic income is used to estimate a linear benefit stream. Two of the most commonly used methods to estimate future benefits based on historical economic income are:

a) Unweighted Average Method b) Weighted Average Method These methods are used when capitalizing future benefits.

An unweighted average method is typically used when the analyst concludes

all of the past earnings are representative of the expected future benefits and no existing pattern or trend would suggest that any one year or years results are any more indicative than the rest of the historical data.

There are several methods of estimating terminal value, including price/earnings and other multiples. The most frequently used method is to

capitalize terminal year earnings using an appropriate capitalization rate and then discount the results back to a present value.

This rate represents the return available in the market on an investment free of

default risk.

type of earnings used in Discounted Economic Income Method (aka DCF)

either Net Cash Flows to Equity or Net Cash Flows to Invested Capital

Weighted Average Method basic forumla:

ew1 + ew2 + ewn / w1 + w2 + wn (e = earnings, w = weight factor)

In the event the analyst places a disproportionate weight on any particular year or years, the analyst should

explain in the report the rationale for the weighting.

Generally, valuation analysts prefer to use this number of years:

five to seven years worth of historical data to adequately cover the effects of internal and external factors that would be expected to continue in the future.

Analysts commonly make mistakes when the components of cash flows are determined based on

historical data. The analyst must base the non-cash charges, capital expenditures, net working capital and long-term debt borrowings and repayments on the cash flow necessary to support the projected operations.

However, in cases where the capital structure of the company is significantly different from the capital structures of the comparable industry or capital markets used to derive the discount/capitalization rate, the analyst should consider using the net cash flow to

invested capital as a measurement of economic income.

Historical economic income is used when estimated future benefits are expected to be

linear.

Projected economic income, however, is used for both tax or non-tax valuations including

litigation matters, ESOPs, and transactional valuations because the projected income may be more representative of the expected future results.

A weighted average method is typically used when

n the analyst concludes certain past earnings are more representative of the expected future results or the historical earnings demonstrate a trend that is expected to continue in the future.

A pre-tax rate should not be applied to ________ because ________ is assumed to be stated on an after-tax basis.

net income

In most cases the discount rate (cost of capital) is stated as a ________ rate.

nominal

Projected economic income is used when estimated future benefits are expected to be

non-linear (subject to any restrictions based on the purpose of the engagement).

Many valuation analysts prefer to use income from

operations because they believe this type of earnings is the most stable and reliable level of earnings of the company. In any case, the discount/capitalization rate must be consistent with the type of earnings.

Based on this analysis, it can be seen that the expected rate of return for a company should be _________ related to its beta.

positively

If the analyst uses RMA's ROE, it is _____-tax.

pre

A linear benefit stream is a stream of future benefits that is expected to

remain constant or grow/decline at a constant rate.

Historical economic income is generally used to estimate future benefits for

tax, buy-sell, and divorce valuations because the historical data is based on fact and hence considered more reliable.

The "nominal return" includes

the "real" rate of return and the effects of inflation. It is important to note that the conversion of the nominal and real rates is not a process of addition; it is a geometric calculation.

rather than using the expected return on a market portfolio as the ERm, it is represented by

the average pre-tax ROE of the specific companies or the industry in which the subject company operates.

Generally, the economic income will be projected over as many years as necessary until

the benefit stream stabilizes and becomes linear (increasing or decreasing at a constant rate into perpetuity).

FCF provides a measure of

the cash available to the company for discretionary uses after deducting the funds needed to continue operating at a planned level.

when using net income as your measure of economic income, the valuator may convert the discount/capitalization rate derived from net cash flow data by

the cash to earnings factor, if material.

When discounting net cash flow to equity, the appropriate discount rate is

the cost of equity.

The "Real return" represents

the exchange rate between current and future purchasing power (inflation).

The risk-free rate (Rf) is represented by

the intermediate term (five to 10 year) Treasury bond yield rate.

Beta (B) is modified so that it represents the co-variance of

the pre-tax return on equity (ROE) of the subject company, with the ROE of other specific companies or industry averages divided by the variance of the ROE of the industry.

Three basic components of the cost of capital, as stated at the beginning of this chapter, are

the real rate of return, expected inflation, and risk.

A distinction between the capitalization process and the discounting process is

the utilization of a terminal value.

Net cash flow to equity will result in

the value of the equity

Net cash flow to invested capital will result in

the value of the invested capital

The discount rate and the capitalization rate are interchangeable only when

there is no projected growth in the benefit stream.

Many valuators believe the long-term sustainable growth rate for mature companies should be in the range of

three to four percent.

When discounting net cash flow to invested capital, the appropriate discount rate is the

weighted average cost of capital (WACC).

If earnings are used, the analyst needs to explain in the report

why he/she expects the future earnings will approximate the future cash flows of the company.