330 PART 2 Important Financial Concepts
In Practice
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 busi-
nesses. 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 semi-
precious stones, a software devel-
oper, 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 isjust 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 ware-
house facility, freezers, and other
equipment.
Because valuing a small busi-
ness is difficult, many owners
make use of reasonably priced val-
uation 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 busi-
ness generate or consume?- 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 pur-
chases have on my venture? - How much ownership in my
business should I give up for a
$2 million equity contribution?
- What will my balance sheet,
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 Valua-
tion,” Bullet Proof Business Plans,down-
loaded from http://www.bulletproofbizplans.com/
BallPark/About_/about_.html;Jill Andresky
Fraser, “Business for Sale: Southeastern
Seafood Distributor,” Inc.(October 1, 2000),
downloaded from http://www.inc.com;VALUware,
http://www.bizbooksoftware.com/VALUWARE.
HTM.FOCUS ONe-FINANCE What’s the Value of the American Dream?
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.
Although dividend valuation models are widely used and accepted, in these situa-
tions it is preferable to use a more general free cash flow valuation model.
Thefree cash flow valuation modelis 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 hori-
zon. However, in the free cash flow valuation model, instead of valuing the
firm’s expected dividends, we value the firm’s expectedfree cash flows,defined
in Equation 3.3 (page 106). They represent the amount of cash flow available to
investors—the providers of debt (creditors) and equity (owners)—after all other
obligations have been met.
The free cash flow valuation model estimates the value of the entire company
by finding the present value of its expected free cash flows discounted at its
weighted average cost of capital,which is its expected average future cost of
funds over the long run (see Chapter 11), as specified in Equation 7.7.VC.. . (7.7)where
VCvalue of the entire company
FCFtfree cash flow expectedat the end of year t
kathe firm’s weighted average cost of capitalFCF∞(1ka)∞FCF 2(1ka)^2FCF 1(1ka)^1