When buying or investing in a business you need to evaluate that business carefully. One tool is the Investment Analysis.
The Investment Analysis table gives you discounted cash flow analysis including Net Present Value (NPV) and Internal Rate of Return (IRR). Both of these are important financial analysis tools that will help a business present itself via its plan in the terms used by the more sophisticated investment analysts.
Investment analysis
The estimated cash stream
The Investment Analysis starts with the Cash Flow stated in investment terms. That means that an investment is a negative number, and the return is a positive number. This example is typical of formal investment analysis. Sales, Profits, Expenses, Assets, and Liabilities are not included in the analysis. The analysis even ignores Cash Flow in this case, because Cash Flow is irrelevant unless it becomes a Dividend.
The example treats the company from the investor’s point of view. Namely, there is only one flow into the company that matters, the investment. There are only two flows back out as returns, Dividends and Equity Valuation. Equity Valuation really matters only when the investor cashes out. Until equity is sold, valuation is just paper money only, not real.
The discount rate
The Discount Rate is an important element in Discounted Cash Flow analysis. The discount rate is a mathematical estimate of the time value of money and to some extent the risk in an investment. To understand the discount rate, imagine that somebody offers you the choice between $1,000 delivered today or some greater amount delivered one year from today. Would you prefer $1,000 now to $1,100 a year from now? What about $1,200 next year? People differ in their choices between money now, but just about everybody has some amount of additional money that would make them choose to wait. Investment analysis uses the discount rate to reflect that preference for now over later.
In the example, the Discount Rate is set at 10%. That means $1,000 today worth approximately $1,100 a year from today. A 50% discount rate would make it worth $1,500. Inflation matters to discount rates. The higher the inflation, the higher the discount rate. In an economy with 25% inflation, it takes $1,250 a year from now to equal the value of $1,000 today. Risk matters. The higher the risk, the higher the discount rate.
Net Present Value (NPV)
The NPV of an investment stream is the estimated present value of the future stream, at the specified discount rate. Future cash is discounted to its present value. This analysis depends of course on the length of time and the assumed valuation for the end of that period. The Valuation assumption is a critical assumption, but often must be a rough estimate based on simplistic assumptions. Use it with caution, and understand how much it depends on those questionable assumptions (more on Valuation below).
The Internal Rate of Return (IRR)
The IRR is the Discount Rate at which the NPV of the Investment is $0. You can experiment with the Investment Analysis,setting different Discount Rates to the rate shown as IRR, until NPV becomes $0. Analysts use IRR to compare different investments. They expect higher risk investments to show higher IRRs, and generally if the risk is about the same, then the best investment is the one with the higher IRR.
Valuation estimates
Valuation is what a company is worth, according to stock markets, or buyers and sellers of a business, or tax authorities. Businesses need to determine valuation for tax reasons when ownership changes hands. Ultimately, valuation isn’t a formula at all, it is as simple as any other commercial transaction: the business is worth as much or as little as buyers will pay for it. Take this calculated average as a rough estimate at best, subject to the assumptions. It is what we sometimes call a “talking point” in negotiations. Valuation means what the company is worth, what it should sell for if it is sold. Valuation in real business situations is very much more complex than a simple calculation in a spreadsheet.
There are many valuation formulas:
- The Book Value formula calculates valuation as Assets less Liabilities, just the same as Net Worth. That’s supposedly what a business is worth.
- The Liquidation Value formula says the business is worth the liquidation value of its Assets, less Liabilities.
- The Replacement Value formula says the business is worth what it costs to replace it. This comes up for example when a business is purchased by a larger business for the value of its plant, equipment, product line, brand, etc.
- The Times Sales formula is one of two used in the example, where the business is worth the Sales Multiple shown as the Calculated Sales-based Valuation. The Valuation Sales Multiple is 1, so the Valuation at the end of the period is $770,000, which is 1 times sales of $770,000.
- The Times Earnings formula is another of the two most common. Stocks are often quoted in earnings multiples, called PE for “price times earnings” as in 25 times earnings. Earnings in this context is the same as Net Profits. The stock’s PE ratio is normally quoted as price per share as a multiple of earnings per share. The principal is the same. In the example, the Earnings Multiple is set as 10, so the Valuation in the last year is $520,000.
- Market comparisons (as in real estate) are another very important tool for valuation. Analysts look at actual transactions of similar businesses of similar size.
Percent equity acquired
This gives you a way to confine the investment analysis to some specified portion of equity investment and equity ownership. In this example, the assumption is that the investor ends up with 50% ownership of the business, as shown in the illustration.
The valuation of a business depends not just on simple formulas and multiples, but also general market conditions, specific economics of the business, its location, its branding, its management team, its balance sheet, its customer base, the negotiating skills of the parties, and other factors.
For publicly traded companies, valuation is the same as their market capitalization: the business’ valuation can be determined by multiplying the number of shares outstanding by the value per share. For privately held companies, valuation of a business is theoretical until there is a transaction. When the transaction happens, the business is worth whatever the buyers pay for it. As a buyer and or seller of a business you don’t necessarily get what you deserve; you get what you negotiate; or what you settle for.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
