In general, P/E valuation is a common and reliable method for appraising a company's value, but, as with any method, caution must be exercised.
Discounted cash flow
The discounted-cash-flow method is arguably the most complex valuation model discussed in this paper, but it is often considered reliable because it considers a company's post-sale prospects (Calculating Discounted 2005). In the case of the previously discussed over-valued dot.com, it is easy to see where a potential buyer would eventually develop a cash-flow problem. The company is barely profitable, and it's going to take $5 million to purchase the company, likely creating some debt to be serviced. Perhaps a company with multiple business units would be capable of servicing that debt through the performance of the other units, but clearly the business being acquired could not service such debt through its own cash flow.
The discounted-cash-flow method works well because one of the things it does is help provide a correcting influence on these types of scenarios. The discounted-cash-flows method evaluates what a company's cash flow situation will look like into the future, with the obvious effect of debt service added into the equation (Bizquest No date). That future cash flow is multiplied by a "beta," which is essentially a multiplier that takes the business' level of risk into account (Bizquest No date). A company like Procter & Gamble, which is well established and sells products that people will always need, like soap and toothpaste, may not see its beta devalue the company much, as it is low-risk. On the other hand, when the personal transport vehicle, the Segway, was introduced, the parent company would have been valued as high-risk, because it remained to be seen whether there would be wide consumer acceptance. The risk of that business would create a beta that would have a more negative effect on the company's value.
Let's review a simple example that demonstrates how discounted-cash-flows works in practice. The company being purchased may be generating $10,000 a month in net income and the industry multiplier could be 10. So, the company is worth $120,000 x 10, or $1.2 million (Calculating Discounted 2005). Now, let's imagine that the investors want to cash out in five years. The post-acquisition company is immediately generating just $8,000 a month, primarily because of debt service, but cash flow is expected to increase regularly each year, until it reaches $15,000 a month in Year 5. At that point, the company will be worth $180,000 x 10, or $1.8 million, for a profit for the investor of $600,000 (Calculating Discounted 2005). But how confident is the investor that these Year 5 numbers can be reached, based on factors such as risk and historical performance (Berry 2004)? This is where the beta comes in. If the business is high risk, and that $600,000 is...
Maybe the investor discounts a third, assuming the profit to be $400,000, to play it safe, which obviously hurts how the company's value is perceived.
From the investors' perspective, assuming there is not an overly high rate of risk, the company represents $600,000 in potential profit, based on the value of future cash flow and net income. If the investor's goal is to clear at least $500,000 on the sale of the company, he or she can afford to overpay by $100,000 to purchase the company. If the goal was to clear $1 million, the investor will need to either get a deal on the purchase, find ways to further increase profit after the acquisition, or simply look for a different deal (Brooks, No date).
At any rate, the discounted-cash-flow method works well for investors, because it takes their goals into account, and it also realizes that a company may fundamentally change financially after the acquisition. A company that had cash flow of $10,000 before an acquisition may only have $5,000 after it, and this presents some concerns for the investor. Can that gap be overcome in a period of time that is acceptable to the investor, and what sort of risk does that entail? Discounted cash flow provides a solid approach for beginning to answer those questions.
Berry, T. 2004, "Planning for Purchasing a Business," Bplans.com, viewed 20 May, 2007 at http://www.bplans.com/bb/article.cfm/138.
Bizquest Staff, No date, "Valuation Methodologies," BizQuest.com, viewed 19 May, 2007 at http://www.bizquest.com/resource/valuation_methodologies-18.html.
Brooks Barristers No date, "Key Questions When Purchasing a Business," LexisNexis, viewed 20 May, 2007 at http://business-law.lawyers.com/Key-Questions-When-Purchasing-a-Business.html.
Business Valuation Methods" No date, Second Venture Corp., viewed 20 May, 2007 at http://www.secondventure.com/business-valuation-methods.asp.
Calculating Discounted Cash Flow" 2005, Industry Canada, viewed 20 May, 2007 at http://strategis.ic.gc.ca/sc_mangb/stepstogrowth/engdoc/step3/ssg-3-8.php.
How to Buy an Existing Business" 2007, Small Business Development Centers of Ohio, viewed 20 May, 2007 at http://www.akronsbdc.org/buying_business.php.
Judy, M. No date, "Purchasing an Existing Business," Tuscarawas County Auditor, viewed 19 May, 2007 at http://www.co.tuscarawas.oh.us/Auditors/NewBusinessGuide/PurchasingaBusiness.htm.
Kurtz, H. 2001, "Who Blew the Dot.Com Bubble?" Washington Post, 12 March, viewed 19 May, 2007 at http://www.washingtonpost.com/ac2/wp-dyn/A55045-2001Mar11?language=printer.
Net Asset Value: Unlocks Hidden Potential" 2000, EquityMaster.com, viewed 19 May, 2007 at http://www.equitymaster.com/detail.asp?date=8/11/2000&story=5.
Suits, J. 2004, "Buying a Business," Stonebridge Consulting, viewed 20 May, 2007 at http://www.stonebridgestl.com/articles/buy_business_overview.htm.
Wexler, G. 2003, "Litigation Traps in Purchasing a Business," the Corporate Counselor, viewed 20 May, 2007 at http://www.reish.com/publications/article_detail.cfm?ARTICLEID=411.
Zonis, M. 2001, "P/E Ratios Defined," PBS, viewed 21 May, 2007 at http://www.pbs.org/wnet/moneyshow/mba/042701.html.
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