M4-S4 - Session notes

M4-S4 - Session audio:

Valuation methods

1. Salvage value
2. Current production
3. Future (undiscounted) production
4. Market price
5. Book value
6. Discounted future earnings

But in practice:

• Gut feel
• Competitive reference
• Growth rate
• Revenue
• Real Options
• Discounted Cash Flow
• Cost of creation of a product
• Cash Flow - Burn Rate

The story of the apple tree A man has an apple tree that delivers him \$100,- per year in selling apples. Now he tries to sell the apple tree:

• The Lumber jack offers \$50,- for cutting it for wood
• The Grocer offered \$100,- for harvesting this year's crop
• The Marketer offers \$1499,- assuming the tree lives another 15 years
• The wealthy physician: ill pay the market price - whatever your last offer
• The young stock broker: capatilized earnings
  • You did have expenses and did not make \$100,- but more like \$50,-
  • I noticed an average of \$45,- earnings per year.
  • I need to compare with other investment alternatives
  • I am willing to pay a price that will give me 20% return.
  • To figure out the price i'll divide \$45 by 0.2, so this is \$225,-
• The young stock broker revisited:
  • Using discounted cash flow to compensate for the risk
  • And using the 'end of life' value of the lumber jack
  • The total offer become \$270,- and was taken for \$250,-

Morals of the story:

1. Methods for valuation:
   1. Asset approach
      1. Salvage value
      2. Book value
   2. Income cash flow
      1. Current production
      2. Future (undiscounted) production
      3. Discounted future earnings
   3. Market (comparable) approach
      1. Price/Earnings ratio
      2. Market price
2. Asset valuation methods and tools are useful but valuation is an art
3. You should listen closely to the experts
   1. Focus on what they don't say (rather than say)

DCF in a decision tree is a good way of visualising risk and opportunity.

Earning multiples

• Suitable for companies with establised financial history
• Price / Earnings ratio represents the value of the business divide by its post tax profits
• It may not be easy which ratio to use
• The P/E ratios used in financial press should be reduced significantly when valuing a small business
• Quite often business advisors use a factor between 5 and 10

Comments during the session:

• Do not agree:
  • Bruno: 97.8 of value is created by imitation: http://hbr.org/2010/04/defend-your-research-imitation-is-more-valuable-than-innovation/ar/1