DILEMMAS OF DYNAMIC METHODS OF BUSINESS VALUATION

1. DILEMMAS OF DYNAMIC METHODS OF BUSINESS VALUATION Mirjana Radman-Funarić, PhD

2. Dilemmas of dynamic methods of business valuation 1. Different terms for valuation • Business Valuation Methods (Business Value), • Company Valuation Methods (Company Value, Firm Value) 2. Different divisions of enterprises to small (micro), medium and large 3. Different divisions of (business) valuation methods 4. Different expectations in terms of valuation results

3. (Business) Valuation methods(Orsag, 1997)

4. (Business) Valuation methods (Hermoza, 2017)

5. (Business) Valuation methods (Vidučić et al., 2015) • Valuation methods based on assets = STATIC METHODS • Valuation methods based on profitability = DYNAMIC METHODS • COMBINED METHODS

6. 1. Preparation 2. Size does matter 3. Valuation using valuation multiples  - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate Preparation of documents; Preparation of indicators on which the valuation result depends. Can subjectivity and different calculations of coefficients result in different valuations of a business? How much is an enterprise worth?

7. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuation multiples  - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate • Large • Small • Medium • Between 2013 and 2017, the share of small and medium enterprises in Croatia was 99.7% (the share was lowest in 2001, 99%). (GEM, 2018)

8. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuationmultiples - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate Net profit x Multiplier = Enterprise value Does not take into account future earnings of enterprise and/or variables that may affect the multiplier

9. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuation multiples - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate • Constant free cash flow (profit); • Large number of previous reports; • Elimination of extraordinary items; • Subjectivity.

10. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuation multiples  - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate Valuation multiples method for small and medium enterprises Costs (expenses) – overstated/understated • Personal income; • Costs of lease of real property and cars; • Travel and entertainment expenses; • Costsofcompany-ownedfacilities; • Costs of legal and accounting services; • Donations and other one-off costs.

11. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuationmultiples - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate Valuation multiples method for small and medium enterprises • Removal of essential value of owner • Is there a strong management team? Can the company survive the owner’s departure? • ADJUSTED NET INCOME (ANI)

12. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuation multiples - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate Variables that can affect the multiplier: • Company sector; • Finance; • Profitability/margin; • Balance sheet; • Contracts; • Customers/suppliers.

13. How much is an enterprise worth? 1. Preparation 2. Size does matter 3. Valuation using valuation multiples - traditional valuation method 4. Calculating actual income 5. Calculation of multiplier 6. Calculation of discount rate • Approximate rules • Multipliers for enterprises that are not listed on the stock exchange can range between 1x ANI and 10x ANI; • Companies that are in the process of resolving ownership issues at the time of valuation – 2.5x ANI at most • Company with ANI < ?????? EUR multiplier ??-?? • Company with ANI > ?????? EUR multiplier ??-??

14. 5.1. Constant cash flow • Depends on the manner of assessing the discount rate appropriate for the risk involved in cash flow realization • For small and medium enterprises = gross free cash flow (before tax) • For large enterprises – listed on the stock exchange = net free cash flow (after tax)

15. 5.2. Capitalization rate – multiplier • Risk identification For large, stable enterprises, the following multipliers are appropriate: • For small and medium enterprises = ?????? – a series of factors on which valuation depends

16. 5.2. Capitalization rate – multiplier Orsag, 1997

17. 5.2. Capitalization rate – multiplier

18. 5.2. Capitalization rate – multiplier

19. 6. Calculating the discount rate, WACC Discounted cash flow methods • For large enterprises – listed on the stock exchange = weighted average cost of capital – WACC • Discount rate – “expected rate of return” • Cost of equity (ke)

20. Discounted cash flow methods “The methods encompassed within this group are currently the most commonly used methods and are also the most accepted methods in both the academic and business community.” (Hermoza et al. 2017) • Based on the net present value method

21. Discounted cash flow methods 𝑊𝐴𝐶𝐶 = 𝑘𝑒 ∗ 𝐸⁄(𝐸 + 𝐷) + 𝑘𝑑 ∗ (1 − 0,2) ∗ 𝐷⁄(𝐷 + 𝐸) 𝑘𝑒 = 𝑘𝑓 + 𝛽(𝑘𝑚 − 𝑘𝑓) 𝑘𝑒 – cost of equity 𝑘𝑑 – cost of debt E – market value of equity D – market value of debt 𝑘𝑒 – cost of ordinary equity 𝑘𝑓 – risk-free rate 𝛽 – beta, measure of systemic or market risk 𝑘𝑚 – expected market return

22. Discounted cash flow methods • CAPM – model for determining the appropriate balance in terms of existence of a positive linear relationship between the expected rate of return for a security/portfolio and the corresponding risk in the context of the portfolio. • Expected rate of return is the sum between the calculation of the risk-free rate of return and the risk premium which reflects diversification. • William Sharpe (1964) and John Litner (1965).

23. Discounted cash flow methods • CAPM cannot be acceptable as long as the portfolio used is inefficient. Even minor deviations from efficiency can produce an insignificant relationship between the risk and the expected return. • Bias in perception of data used for testing the validity of the CAPM model specifications. • Beta (β) has been declared unreliable. (Choudhary & Choudhary, 2010)

24. Discounted cash flow methods Requirements • Used mainly for larger enterprises; • Solid input documents; • Relatively predictable future. • Two problems connected to the use of this method: • Projections are speculative; - Agreement or dispute - Possibility of arguing • Subjective determination of the discount rate.

25. Discounted cash flow methods • As expert witnesses, pay attention to the following: • Minimum five years of future operations; • Including residual value of enterprise at the end of a period – upon expiry of the calculation period, the enterprise has value (assets intendedfor sale or for continued operation); • If future cash flows can only be realized after new investments are made – current value of such investments decreases the current enterprise value.

26. Discounted cash flow methods

27. Discounted cash flow methods • The price of the share calculated using the P/E multiplier deviates the least in regard to the market price (4.55%) • It also deviates the least in regard to the average market price (2.41%) • The price of the share calculated using the book value method deviates the most in regard to the market (32.16%) and average market price (33.70%)

28. Discounted cash flow methods

29. Discounted cash flow methods Enterprise value increases in accordance with the higher long-term growth rate, as well as with the lower WACC rate.

30. (Business) Valuation methods (Buble et al., 2010) • “The principle of focusing on the future requires valuing an enterprise not on the basis of achieved results, but on the basis of expected results.” • CONCLUSION

31. References • Buble, M., Kulović, Dž., Kuzman, S. (2010) Due diligence i procjena vrijednosti poduzeća, Sarajevo: Kemigrafika • CEPOR – SMEs and Entrepreneurship Policy Center (2018) Small and Medium Enterprises Report Croatia – 2018, GEM – Global Entrepreneurship Monitor research for Croatia for 2017, http://www.cepor.hr/wp-content/uploads/2015/04/EN-SME-Report-2018-za-web.pdf • Choudhary, K., Choudhary, S. (2010) Testing Capital Asset Pricing Model: Empirical Evidences from Indian Equity Market, Eurasian Journal of Business and Economics Vol. 3., No. 6., 2010. • Damodaran, A. (2010) Valuation: Part I Discounted Cash Flow Valuation, New York: Wiley Finance • FINA (2019) Pregled neizvršenih osnova blokiranih pravnih i fizičkih osoba koje obavljaju registriranu djelatnost, promatrano po županijama i po djelatnostima - stanje 31. 12. 2018. https://www.fina.hr/-/pregled-neizvrsenih-osnova-za-placanje-poslovnih-subjekata-promatrano-po-zupanijama-i-djelatnostima-na-dan-31-12-2018- • Hermoza, R., Molina, J.C., Enrique, J. (2017), Brief Considerations On Business Valuation Methods, Tendencias, Vol.18, No.2,  July/Dec. 2017, http://www.scielo.org.co/scielo.php?script=sci_arttext&pid=S0124-86932017000200011 • Kolačević, S., Hreljac, B. (2009) Vrednovanje poduzeća-novi pristupi i upravljanje temeljeno na vrijednosti, Zagreb: TEB-poslovno savjetovanje • Orsag, S. (1997) Vrednovanje poduzeća, Zagreb:Infoinvest • Peterson, C.D. (1989) How to Sell Your Business, New York: McGraw-Hill • Vidučić, Lj., Pepur, S., Šimić Šarić, M. (2015) Financijski menadžment, Zagreb: RRIF plus