Business valuation 101

Business Valuation 101
Presented by:
Dominic Brault
Carleton McKenna

Goal for Today
 Understand the reasons for a business valuation
 Understand the accepted valuation
methodologies
 Understand the levels of value
Be an educated consumer of valuation services

Reasons for a Business Valuation
Buying /
Selling a
Company
Corporate
Lawsuits
Valuation
is Central to
Nearly All Key
Business Issues
Succession /
Estate
Planning
Business
Planning /
Reporting
Financing
Expansion
/ Recap
Owner
Divorce

 Succession and Shareholder Planning
– Estate and gift tax
– Buy-sell agreements
– Stock options
– Stock buybacks
 ESOP and ERISA
– Formation
– Annual valuation
– Follow-on deals
– Exit
Succession
/ Estate
Planning
Business
Planning /
Reporting
Business
Planning /
Reporting
Buying /
Selling a
Company
Financing
Expansion
/ Recap
Succession
/ Estate
Planning

Business
Planning /
Reporting
 Financial and Tax Reporting
– Purchase accounting
– Goodwill impairment testing
– Portfolio company valuations
– Realignment or reorganization of subsidiaries
 Transaction Advisory
– Formation
– Annual valuation
– Follow-on deals
– Exit
Buying /
Selling a
Company
Financing
Expansion
/ Recap
Business
Planning /
Reporting

 Litigation Advisory
– Shareholder dispute
– IP valuation
– Bankruptcy proceedings
– Family law matters
– Shareholder oppression actions
– Expert witness / lost profits / damages calculations
Corporate
Lawsuits
Owner
Divorce

Business Valuation
Art Science

What is stock?
• A share of stock represents partial ownership in a
company
Company is
worth $10
million
Company
has 1 million
shares
Each share is
worth $10

Business Valuation Process
Time frame varies
(client driven), but
typically ranges from
4 to 6 weeks
Proposal and Engagement Letter
Establish Standard of Value , Purpose, and Valuation Date
Data Gathering
Company and Industry Analysis
Analyze & Normalize/Adjust (if applicable) Historical Financials
Financial Statement Analysis (e.g., ratios)
Implement Selected Valuation Methodologies
Draft Narrative Report
Internal Review and QC Process
Issue Final Report

Standards of Value
• Most commonly used standard of value in business valuation
• Defined in the Internal Revenue Code and Ruling 59-60
• The standard applied in federal estate and gift tax proceedings and in matrimonial cases
• The price at which property would exchange between a willing buyer and a willing seller, when the former
is not under any compulsion to buy and the latter is not under any compulsion to sell, both having
reasonable knowledge of the relevant facts
• GAAP accounting ("FASB ASC 820") or oftentimes legal matters (e.g., dissenting shareholders)
• Debate over discounts for lack of marketability and control
• Definition can vary state-to-state in legal matters
• Value to a specifically-defined owner; focused on one side of a market based transaction, that of the seller
• Defined in FASB ASC 820 as "the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date"
• Fair Value should bring about the most advantageous value to the market participant that holds the asset or
owes the liability
Fair Market Value
Fair Value

• The nature and history of the Company;
• The economic outlook in general and the condition and outlook of the Company’s
industry in particular;
• The financial condition of the Company and the book value of its stock;
• The earning capacity of the Company;
• The dividends paid or the dividend-paying capacity of the Company;
• The nature and value of the tangible and intangible assets of the Company;
• Prior sales of stock of companies engaged in the same or similar lines of business,
having their stocks actively traded in a free and open market; and
• Stock restrictions that are binding in nature and impose limitations on transfers of
ownership.
Fair Market Value Standard
Revenue Ruling 59-60

Paths to Value
Equity
Debt
Equity
Enterprise Value, Firm Value, or
Total Invested Capital: Value
available to all stakeholders of a
company
(EV = Total Equity + Debt – Cash +
Minority Interests)
Equity Value or Market
Capitalization: Represents
value attributable to
shareholders only
(Equity Value = EV + Cash –
Debt – Minority Interests)

$30 $36
$47
$55
$68
Year 1 Year 2 Year 3 Year 4 Year 5
Direct to Equity Cash Flows
Paths to Value
$50 $55
$65
$75
$90
Operating Free Cash Flows
Total Invested Capital Cash Flows
Unlevered Free Cash Flow
EBIT - Taxes + D&A - Capex - Change in
Working Capital
TotalInvestedCapital
orEnterpriseValue
Debt
Value
Equity
Value
Cash Flows to Debt Holders
Total Debt Service
Interest Expense + Principal
Repayment
$20 $19 $18 $20 $22

Accepted Valuation Methods
Traditional
Valuation
Methodologies
Income Method
Discounted Cash
Flow Approach
Capitalization of
Cash Flow
Approach
Market Method
Comparable
Public Company
Approach
Precedent
Transaction
Approach
Asset Method
Net Asset Value
Approach
Leveraged
Buyout
Approach

Accepted Valuation Methods – Income Method
Traditional
Valuation
Methodologies
Income Method
Discounted Cash
Flow Approach
Capitalization of
Cash Flow
Approach
Market Method
Comparable
Public Company
Approach
Precedent
Transaction
Approach
Asset Method
Net Asset Value
Approach
Leveraged
Buyout
Approach

Income
Method
Value of a company is
estimated based on
the earning capacity
of that company
Generally not
applicable in asset
intensive companies
with little intangible
value or in distressed
entities where the
assets are worth
more than their
earning capacity
Discounted Cash Flow Approach
 Develop projections
 Terminal value and cost of capital methodologies
 Good approach for companies with variable rates of
growth and/or multi-year projections
Capitalization of Cash Flow Approach
 Estimate a sustainable level of earnings
 Capitalization rate and cost of capital methodologies
 Good approach for companies in a mature industry with
established market share and modest growth prospects
and stable earnings
Income Method

Income Method
Strengths
Commonly used by bankers, corporations, and
academics
Theoretically based
More insulated from market aberrations
Relies on free cash flow
Flexible (sensitivity)
Weaknesses
Timing and amount of cash flows difficult to estimate
- "garbage in, garbage out"
Incorporates key assumptions that impact value (i.e.,
sensitivity), such as free cash flow forecasts, discount
rates, and perpetuity growth rates

Income Method – DCF Approach
Total Revenue 10,000,000$ 10,750,000$ 11,825,000$ 13,007,500$ 13,657,875$
Annual Growth 5.0% 7.5% 10.0% 10.0% 5.0%
EBITDA 1,000,000 1,182,500 1,419,000 1,560,900 1,638,945
Margin 10.0% 11.0% 12.0% 12.0% 12.0%
Less: D&A (100,000) (107,500) (118,250) (130,075) (136,579)
EBIT 900,000 1,075,000 1,300,750 1,430,825 1,502,366
Margin 9.0% 10.0% 11.0% 11.0% 11.0%
Less: Income Taxes (360,000) (430,000) (520,300) (572,330) (600,947)
Unlevered Net Income 540,000 645,000 780,450 858,495 901,420
Plus: D&A 100,000 107,500 118,250 130,075 136,579
Less: Capital Expenditure (150,000) (161,250) (177,375) (195,113) (204,868)
Less: Increase in Working Capital (50,000) (75,000) (107,500) (118,250) (65,038)
Unlevered Free Cash Flow 440,000 516,250 613,825 675,208 768,093
Discount Period 0.5 1.5 2.5 3.5 4.5
Discount Factor 0.953 0.867 0.788 0.716 0.651
PV of Yearly Cash Flows 419,524$ 447,477$ 483,685$ 483,685$ 500,203$
Present Value of Equity DCF Assumptions
PV of Yearly Cash Flows 2,334,575 WACC 10.0%
PV of Terminal Value 8,141,247
Enterprise Value 10,475,822 Tax Rate 40.0%
Less: Debt (1,000,000) Terminal EBITDA Multiple 8.0x
Add: Cash 500,000
Equity Value (Rounded) 9,980,000$ Terminal Value 13,111,560$
Process
• Project near-term cash
flows until stabilized
• Determine terminal
value
• Determine required
rate of return by
investors
• Discount to present
value (based on
“path” to value)
• Apply the DCF

Income Method – CCF Approach
Sustainable Level of EBITDA 1,000,000$
Less: D&A (120,000)
Less: Taxes (352,000)
Sustainable Level of Unlevered Net Income 528,000$
Add: D&A 120,000
Less: Capital Expenditures (150,000)
Less: Additional Working Capital (50,000)
Sustainable Unlevered Free Cash Flow 448,000$
WACC 10.0%
Less: Long-Term Growth Rate -5.0%
Capitalization Rate 5.0%
Implied Capitalization Factor 21.0
Sustainable Free Cash Flow 448,000$
Multiplied by: Capitalization Factor 21.0
Enterprise Value 9,397,327
Less: Debt (1,000,000)
Add: Cash 500,000
Equity Value (Rounded) 8,900,000$
Process
• Determine sustainable
level of free cash flow
• Determine expected
long-term growth rate
of free cash flow
• Determine required
rate of return by
investors
• Apply the
capitalization of cash
flow model

Income Method – Discount Rates
Venture
Capital
Junk
Bonds
Small Company
Stocks
Large Company
Stocks
High Grade Corporate
Bonds
Certificates of Deposit
Treasury Bonds
Treasury Bills
• In DCF valuations, the discount rate, often an
estimate of the cost of capital for the business,
is used to calculate the net present value of a
series of projected cash flows
• There are several different methods of
determining the appropriate discount rates
• The discount rate is composed of two
elements: (1) the risk-free rate, which is the
return that an investor would expect from a
secure, practically risk-free investment; plus (2)
a risk premium that compensates an investor
for the relative level of risk associated with a
particular investment in excess of the risk-free
rate

Income Method – WACC
Cost of Equity
•Risk Free Rate
•Equity Market Risk
Premium
•Beta
•Small Size Risk
Premium
•Company Specific Risk
Premium
% Equity in
Capital
Structure
Cost of Debt
•After Tax
% Debt in
Capital
Structure
WACC
The rate a company
is expected to pay
on average to all its
security holders to
finance its assets
The Weighted Average Cost of Capital, or WACC, is the most common approach in determining a discount
rate and is composed of three elements: (1) cost of equity; (2) cost of debt; and (3) capital structure

Income Method – WACC
Common WACC
Rates in Business
Valuation
Under 10%
Large, Multi-
National Companies
10% - 30%
Middle market
companies
Over 30%
High risk,
distressed,
venture
companies

Accepted Valuation Methods – Market Method
Traditional
Valuation
Methodologies
Income Method
Discounted Cash
Flow Approach
Capitalization of
Cash Flow
Approach
Market Method
Comparable
Public Company
Approach
Precedent
Transaction
Approach
Asset Method
Net Asset Value
Approach
Leveraged
Buyout
Approach

Market Method
Market
Method
Value of a company
is estimated based
on the prices of
actual transactions
for similar
companies
Generally not
applicable if
comparable
companies or
transactions cannot
be found
Comparable Public Company Approach
 Publicly-traded companies
 Similar operating or industry characteristics
 Apply relevant valuation multiples
Precedent Transaction Approach
 Recent M&A transaction or past transactions of interests
in the subject company
 Similar operating or industry characteristics
 Apply relevant valuation multiples

Process
• Select comparable
companies
• Locate financial
information
• Spread key stats,
ratios, and multiples
• Benchmark your
company versus the
group
• Determine valuation

Strengths
Market based, arms-length indications of value
Easily understandable
Commonly used
Current, valuation based on prevailing market data that can
be updated on a daily basis
Weaknesses
Comps can be hard to find
Subjective adjustments based on differences in risk and
growth profiles of the selected comps and subject company
Market based, multiples may be skewed depending on capital
markets and/or economic environment
Potential disconnect from cash flow, valuation from prevailing
market conditions may have a disconnect from the valuation
based on projected cash flow

In Millions of U.S. Dollars Target Fundamentals Indicated Multiples
Closed
Announced Target Acquirer
Enterpris
e Value
[a]
LTM Net
Revenue
LTM
EBITDA
LTM
EBITDA
Margin
EV / LTM
Revenue
EV / LTM
EBITDA
1 Pending American Healthcare Holdings, Inc. CompuGroup Medical AG 65.0$ 28.0$ 6.2$ 22.2% 2.32x 10.4x
8/31/2010 Offers practice management softw are to
manage demographics, scheduling,
insurance, and billing.
Offers softw are and communications
solutions for the healthcare industry.
2 Pending A.D.A.M., Inc. Ebix, Inc. 72.5 27.9 6.3 22.5% 2.60x 11.6x
8/29/2010 Provides online information and technology
solutions, including an agency
management system.
Provides softw are and e-commerce
solutions to the insurance industry.
3 8/24/2010 Eclipsys Corporation Allscripts-Misys Healthcare 1,049.3 517.4 54.2 10.5% 2.03x 19.4x
6/9/2010 Provides integrated clinical, revenue cycle,
and performance management softw are;
and professional services that assist
healthcare organizations and physicians.
Offers softw are, and connectivity
solutions that enable physicians and other
healthcare providers to deliver patient
safety and clinical outcomes.
4 4/23/2010 AMICAS, Inc. Merge Healthcare Incorporated 174.7 89.1 6.6 7.4% 1.96x 26.5x
2/28/2010 Provides radiology and medical image, and
information management solutions.
Develops healthcare information softw are
solutions that automate healthcare data
and diagnostic w orkflow , as w ell as
delivers related services.
5 4/20/2010 Chordiant Software, Inc. Pegasystems Inc. 104.2 76.3 (1.6) nmf 1.37x nmf
3/14/2010 Operates as an enterprise softw are
vendor.
Develops, markets, licenses, and supports
softw are to automate various business
processes.
Mean 293.1 147.7 14.3 15.6% 2.05x 17.0x
Median 104.2 76.3 6.3 16.3% 2.03x 15.5x
High 1,049.3 517.4 54.2 22.5% 2.60x 26.5x
Low 65.0 27.9 (1.6) 7.4% 1.37x 10.4x
Source: Capital IQ, Inc.
Enterprise Value is presented on a "net of cash" basis.
Process
• Select comparable
transactions
• Locate deal and
financial information
• Spread key stats,
ratios, and multiples
• Benchmark your
company versus the
transactions

Strengths
Market based, arms-length indications of value
Commonly used
Current, recent transactions reflect prevailing M&A, capital markets and general
economic conditions
Objectivity, precedent based and, therefore, avoids making assumptions about
future performance
Weaknesses
Comps can be hard to find
Subjective adjustments based on differences in risk and growth profiles of the
selected comps and subject company
Market based, multiples may be skewed depending on capital markets and/or
economic environment
Availability of information
Acquirer’s basis for valuation (e.g. synergies, type of consideration)
Time lag, transactions occurred in the past and may not be indicative of current
market conditions

Accepted Valuation Methods – Asset Method
Leveraged
Buyout
Approach
Traditional
Valuation
Methodologies
Income Method
Discounted Cash
Flow Approach
Capitalization of
Cash Flow
Approach
Market Method
Comparable
Public Company
Approach
Precedent
Transaction
Approach
Asset Method
Net Asset Value
Approach

Accepted Valuation Methods
Asset
Method
Value of a
company is
estimated by
developing a Fair
Market Value or
current value
balance sheet
Good for asset-
intensive
businesses or
distressed
companies but
difficult to employ
in companies with
high intangible
value
Net Asset Value Approach
 Discretely value of assets and liabilities, including
intangible assets or contingent assets or liabilities
 Performed on either a going-concern or liquidation
basis
 Good approach to value asset intensive companies,
such as holding companies, or companies where the
value of the underlying assets in liquidation exceeds
the value of the business as a going concern
 Hard to employ if the company is producing a return
on its assets that indicates value exits over-and-above
the value of the underlying tangible assets, since
intangible assets must be identified and valued

Process
In U.S. Dollars Book Value Fair Market
As of Value as of
12/31/2009 12/31/2009
1 Cash 1,000,000$ 1,000,000$
2 Accounts Receivable - Trade 100,000 100,000
3 Inventories 100,000 100,000
4 Total Current Assets 1,200,000 1,200,000
5 Machinery and Equipment 5,000,000 3,500,000
6 Automotive Equipment 1,000,000 n/a
7 Real Property 500,000 1,250,000
8 Rental Home 200,000 300,000
9 Less: Depreciation and Amortization (2,000,000) n/a
10 Net Property and Equipment 4,700,000 5,050,000
11 Total Assets 5,900,000$ 6,250,000$
12 Accounts Payable 100,000 100,000
13 Accrued Expenses - Salaries and Wages 100,000 100,000
14 Total Current Liabilities 200,000 200,000
15 Built-In Gains Tax 0 119,000
16 Total Other Liabilities 0 119,000
17 Notes Payable - Shareholders 3,000,000 3,000,000
18 Total Long-Term Liabilities 3,000,000 3,000,000
19 Total Liabilities 3,200,000 3,319,000
20 Common Stock 50,000 n/a
21 Retained Earnings 2,650,000 n/a
22 Total Stockholders' Equity 2,700,000$ 2,931,000$
23 Marketable, Controlling-Interest Value of Equity 2,931,000$
24 Less: Discount for Lack of Control 15.0% (439,650)
25 Marketable, Noncontrolling-Interest Value of Equity 2,491,350
26 Less: Discount for Lack of Marketability 30.0% (747,405)
27 Fair Market Value of Equity (Rounded) 1,740,000$
Process
• Input balance sheet as of
valuation date
• Discretely value each asset,
including intangibles (if
applicable), on going concern
or liquidation basis
• Determine all liabilities,
including contingent or off-
balance sheet

Strengths
Good for asset intensive or distressed
companies
Weaknesses
Difficult to discretely value intangible
assets and goodwill
Difficult to estimate liquidation
values of tangible assets

Levels of Value
If 100% of a private
company is worth $100
million, a 10% interest
may be worth
significantly less than
$10 million
Why?
• Control
• Marketability
Strategic Control Premium
Financial Control Premium Lack of Control Discount
Lack of Marketability Discount
Strategic Control Value
Financial Control Value
Marketable Minority
Nonmarketable Minority

Why is Control Valuable?
• Control is not valuable in and
of itself; rather it’s the
controlling owner’s ability
(perceived or actual) to
generate higher cash flows
• Control premium reflects a
belief that exerting control will
generate higher cash flows
and can be segmented into
financial and strategic control
Marketable Minority
• Control premiums can be observed in acquisitions of
publicly traded companies; minority discounts can be
inferred from the control premiums observed above
or from researching NAV discounts in closed-end
funds

Strategic Versus Financial Control
Strategic Control Benefits
Reduction in competition
Revenue or profit enhancement
through synergies
Cost savings or economies of
scale
Financial Control Benefits
Ability to change management or
compensation
Ability to sell or acquire assets
Ability to change capital structure
Ability to make distributions
Ability to control capex decisions

Marketable Minority
Public Equivalent
Value
Strategic Versus Financial Control
• Strategic control unlocked only by a strategic buyer
• Financial buyer of a well-run, efficient public company may be unable to make
significant changes from a financial control perspective to increase its cash
flows relative to the status quo cash flows

Marketability
• A discount for lack of
marketability is widely
recognized and accepted
by courts, valuation
experts, and the IRS
• A discount is the “cost” of
the lack of liquidity
inherent in the stock of
companies for which
there is no ready market
for the shares (e.g.,
private companies)
Marketable Minority

Marketability
Marketable Minority
• Factors affecting
marketability include:
dividends/distributions,
control, transferability
restrictions, industry and
company characteristics
(M&A environment, financial
performance), expected
holding period, put options
• Various methods are used to
quantify a discount for lack
of marketability, including
the restricted stock method,
IPO method, and option
pricing method, among
others

Thank you
Paul H. Carleton MANAGING PARTNER
phc@carletonmckenna.com
Christopher J. McKenna MANAGING DIRECTOR
cjm@carletonmckenna.com
Dominic M. Brault MANAGING DIRECTOR
dmb@carletonmckenna.com
For more
information please
contact:
1801 East Ninth Street, Suite 1425
Cleveland, OH 44114
Phone: 216.523.1962 Fax:216.523.1322
www.carletonmckenna.com

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