Stock Valuation

FOCUS ON e-FINANCE What’s the Value of the American Dream?
For many people, owning their own
business represents the dream of
a lifetime. But how much should
this dream cost? To get an idea of
how to value a small business,
check out the “Business for Sale”
column in Inc., a magazine that
focuses on smaller emerging businesses.
Each month the column
describes the operations, financial
situation, industry outlook, price
rationale, and pros and cons of a
small business offered for sale. For
example, columns featured in 2000
and 2001 included such diverse
companies as a distributor of semiprecious
stones, a software developer,
a Christmas tree grower, a
small chain of used-book stores,
and a baseball camp, with prices
ranging from $200,000 to $9 million.
Most valuations are based on a
multiple of cash flow or annual
sales, with accepted guidelines for
different industries. That number is
free cash flow valuation model
A model that determines the
value of an entire company as the
present value of its expected free
cash flows discounted at the
firm’s weighted average cost of
capital, which is its expected
average future cost of funds over
the long run.
just a starting point, however, and
must be adjusted for other factors.
For example, food distributors
typically sell for about 30 percent
of annual sales. A Southeastern
seafood distributor was recently
offered for $2.25 million, a discount
from the $3.9 million price you’d
get strictly on the basis of annual
sales. The reason? The new owner
would have to buy or lease a warehouse
facility, freezers, and other
equipment.
Because valuing a small business
is difficult, many owners
make use of reasonably priced valuation
software such as BallPark
Business Valuation and VALUware.
These programs offer buyers and
sellers a quick way to estimate the
business’s value and to answer
such questions as:
• How much cash will my business
generate or consume?
CHAPTER 7 Stock Valuation 283
In Practice
• What will my balance sheet,
income statement, and cash
flow statement look like in 5
years?
• Should I seek debt or equity
to finance growth?
• What impact will capital purchases
have on my venture?
• How much ownership in my
business should I give up for a
$2 million equity contribution?
Once the negotiators decide
to move forward, however, they
usually should hire an experienced
valuation professional to develop a
formal valuation.
Sources: “About Ballpark Business Valuation,”
Bullet Proof Business Plans, downloaded
from www.bulletproofbizplans.com/
BallPark/About_/about_.html; Jill Andresky
Fraser, “Business for Sale: Southeastern
Seafood Distributor,” Inc. (October 1, 2000),
downloaded from www.inc.com; VALUware,
www.bizbooksoftware.com/VALUWARE.
HTM.
pany estimates that its dividend in 2004, D1, will equal $1.50. The required
return, ks, is assumed to be 15%. By substituting these values into Equation 7.4,
we find the value of the stock to be
P0 $
1 8 . 7 5 $1.50 $1.50
per share
0.15 0.07
0.08
Assuming that the values of D1, ks, and g are accurately estimated, Lamar Company’s
stock value is $18.75 per share.
Free Cash Flow Valuation Model
As an alternative to the dividend valuation models presented above, a firm’s value
can be estimated by using its projected free cash flows (FCFs). This approach is
appealing when one is valuing firms that have no dividend history or are startups
or when one is valuing an operating unit or division of a larger public company.
Although dividend valuation models are widely used and accepted, in these situations
it is preferable to use a more general free cash flow valuation model.
The free cash flow valuation model is based on the same basic premise as
dividend valuation models: The value of a share of common stock is the present
value of all future cash flows it is expected to provide over an infinite time horizon.