Inputs to Business Valuation

Abstract

We discuss the inputs for enterprise valuation, particularly in a DCF model—the cost of capital, the projected cash flows, and the selection of comparable companies or guideline companies. We first discuss the projection of cashflows. We start by explaining the mid-year convention and the partial-year adjustment, that help align projected cash flow dates to the valuation date. We turn to the construction of proforma income statements and balance sheets, using an example. We discuss how Monte Carlo simulation can be used to model uncertainty in cash flows and parameters. We discuss how to handle multiple-currency cashflows using CIRP. We turn next to the cost of capital. The weighted average cost of capital is built up from the cost of equity and the cost of debt. The cost of equity is usually measured using CAPM (the capital asset pricing model). We discuss how to apply the CAPM to find the cost of equity for a private company by aggregating betas for a set of similar listed guideline companies. We turn to the cost of debt and how to estimate it, for example by constructing a synthetic credit rating. Finally, we discuss how to combine the cost of equity and the cost of debt to arrive at the WACC. For small and/or very specialized enterprises, it may be difficult to find listed similar companies. For such companies, an alternative to using CAPM is to use a build-up model to derive the cost of equity. We briefly discuss this model. We turn next to the choice of guideline companies—listed companies that are similar to the entity being valued. We consider how location, size, industry and strategic positioning are factors in choosing guideline companies.