FUNDAMENTAL BUSINESS VALUATION NOTES.docx

University of the Cordilleras College of Accountancy 2ND TERM 23-24
MA 104 NOTES ON BUSINESS VALUATION
UC COA MA 104 BUSINESS VALUATION NOTES 2ND TERM 23-24
PREPARED BY: LORENZO DOMINIC M. SALAZAR,CPA,MBA :)
What Is a Business Valuation?
A business valuation, also known as a company valuation, is the process of
determining the economic value of a business. During the valuation process,
all areas of a business are analyzed to determine its worth and the worth of
its departments or units.
A company valuation can be used to determine the fair value of a business for
a variety of reasons, including sale value, establishing partner ownership,
taxation, and even divorce proceedings. Owners will often turn to professional
business evaluators for an objective estimate of the value of the business.
KEY TAKEAWAYS
 Business valuation determines the economic value of a business or
business unit.
 Business valuation can be used to determine the fair value of a business
for a variety of reasons, including sale value, establishing partner
ownership, taxation, and even divorce proceedings.
 Several methods of valuing a business exist, such as looking at its
market cap, earnings multipliers, or book value, among others.

The Basics of Business Valuation
The topic of business valuation is frequently discussed in corporate finance.
Business valuation is typically conducted when a company is looking to sell all
or a portion of its operations or looking to merge with or acquire another
company. The valuation of a business is the process of determining the current
worth of a business, using objective measures, and evaluating all aspects of the
business.
A business valuation might include an analysis of the company's management,
its capital structure, its future earnings prospects or the market value of its
assets. The tools used for valuation can vary among evaluators, businesses, and
industries. Common approaches to business valuation include a review of
financial statements, discounting cash flow models and similar company
comparisons.
Valuation is also important for tax reporting. The Internal Revenue Service
(IRS) requires that a business is valued based on its fair market value. Some
tax-related events such as sale, purchase or gifting of shares of a company will
be taxed depending on valuation.
Important: Estimating the fair value of a business is an art and a science;
there are several formal models that can be used, but choosing the right one
and then the appropriate inputs can be somewhat subjective.
Methods of Valuation
There are numerous ways a company can be valued. You'll learn about several
of these methods below.
1. Market Capitalization
Market capitalization is the simplest method of business valuation. It is
calculated by multiplying the company’s share price by its total number of
shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded
at $86.35 With a total number of shares outstanding of 7.715 billion, the
company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

Market capitalization refers to the total dollar market value of a company's
outstanding shares of stock. The investment community uses this figure to
determine a company's size instead of sales or total asset figures. In an
acquisition, the market cap is used to determine whether a takeover
candidate represents a good value or not to the acquirer.
Understanding Market Capitalization
Understanding what a company is worth is an important task and often
difficult to quickly and accurately ascertain. Market capitalization is a quick
and easy method for estimating a company's value by extrapolating what the
market thinks it is worth for publicly traded companies. In such a case, simply
multiply the share price by the number of available shares.
After a company goes public and starts trading on the exchange, its price is
determined by supply and demand for its shares in the market. If there is a
high demand for its shares due to favorable factors, the price would increase.
If the company's future growth potential doesn't look good, sellers of the
stock could drive down its price. The market cap then becomes a
real-time estimate of the company's value.
Important: One company's share price may be $50. Another company's share
price may be $100. This does not mean the second company is twice as large
as the first company. Always remember to factor in the number of shares
issued (and thereby analyze the company's total market cap) when analyzing
securities.
How to Calculate Market Cap
The formula for market capitalization is:
Market Cap = Current Share Price * Total Number of Shares Outstanding

For example, a company with 20 million shares selling at $100 a share would
have a market cap of $2 billion. A second company with a share price of
$1,000 but only 10,000 shares outstanding, on the other hand, would only
have a market cap of $10 million.
A company's market cap is first established via an initial public offering (IPO).
Before an IPO, the company that wishes to go public enlists an investment
bank to employ valuation techniques to derive a company's value and to
determine how many shares will be offered to the public and at what price.
For example, a company whose IPO value is set at $100 million by its
investment bank may decide to issue 10 million shares at $10 per share or
they may equivalently want to issue 20 million at $5 a share. In either
instance, the initial market cap would be $100 million.
Large-cap (aka big-cap) companies typically have a market capitalization of
$10 billion or more. These companies have usually been around for a long time,
and they are major players in well-established industries. Investing in
large-cap companies does not necessarily bring in huge returns in a short
period of time, but over the long run, these companies generally reward
investors with a consistent increase in share value and dividend payments.
Examples of large-cap companies—and keep in mind that this is an
ever-changing sample—are Apple Inc., Microsoft Corp., and Google parent
Alphabet Inc.2
Mid-cap companies generally have a market capitalization of between $2
billion and $10 billion. Mid-cap companies are established companies that
operate in an industry expected to experience rapid growth. Mid-cap
companies are in the process of expanding. They carry an inherently higher
risk than large-cap companies because they are not as established, but they
are attractive for their growth potential. One example of a mid-cap company
is Eagle Materials Inc. (EXP).3
Companies that have a market capitalization of between $300 million to $2
billion are generally classified as small-cap companies. These small companies
could be younger and/or they could serve niche markets and new industries.
These companies are considered higher-risk investments due to their age, the

markets they serve, and their size. Smaller companies with fewer resources
are more sensitive to economic slowdowns.
As a result, small-cap share prices tend to be more volatile and less liquid
than more mature and larger companies. At the same time, small companies
often provide greater growth opportunities than large caps. Even smaller
companies are known as micro-cap, with values between approximately $50
million and $300 million.
Diluted Market Cap
A security's market capitalization may change over time due to the
outstanding number of shares. This is especially prevalent in cryptocurrency
where new tokens or coins are issued or minted frequently.
Because new offerings theoretically thin the value of existing coins, tokens, or
shares, a different market cap formula can be used to calculate what the
potential market cap will be should all authorized shares or tokens be issued
and still be worth the current trading price. This concept is referred to the
diluted market cap, and the formula is:
Diluted Market Cap = Current Share Price * Total Number of
Shares Authorized
For example, consider Bitcoin trading at roughly $24,000 per coin as of
mid-August 2022. At the time of writing, there are also approximately 19.1
million Bitcoin issued. However, the total number of potential Bitcoin that
may eventually be minted is 21 million. Therefore, Bitcoin's market cap
calculations are:
Market Cap = $24,000 * 19.1 million = $458.4 billion
Diluted Market Cap = $24,000 * 21 million = $504 billion
Analysts use diluted market cap to better understand potential changes to a
security, token, or coin's price. For example, imagine if all 21 million Bitcoin
were minted tomorrow. If it were to retain the same market cap of $458.4
billion, the price would have to drop to roughly $21,828 ($458.4 billion / 21
million). Therefore, companies with large inventories of unissued securities or

coins are at greater risk to face price decreases if investors wish to keep its
market cap the same regardless of outstanding tokens.
Misconceptions About Market Caps
Although it is used often to describe a company, the market cap does not
measure the equity value of a company. Only a thorough analysis of a
company's fundamentals can do that. It is inadequate to value a company
because the market price on which it is based does not necessarily reflect how
much a piece of the business is worth. Shares are often over-
or undervalued by the market, meaning the market price determines only
how much the market is willing to pay for its shares.
Although it measures the cost of buying all of a company's shares, the market
cap does not determine the amount the company would cost to acquire in a
merger transaction. A better method of calculating the price of acquiring a
business outright is the enterprise value.
Changes in Market Cap
Two main factors can alter a company's market cap: significant changes in
the price of a stock or when a company issues or repurchases shares. An
investor who exercises a large number of warrants can also increase the
number of shares on the market and negatively affect shareholders in a
process known as dilution.
What Does a High Market Cap Tell You?
A high market cap signifies that the company has a larger presence in the
market. Larger companies may have less growth potential compares to
start-up firms, but larger companies may be able to secure financing for
cheaper, have a more consistent stream of revenue, and capitalize on brand
recognition. Though applicable to every company, companies with higher
market caps are generally less risky than companies with lower market caps.

Is It Better to Have a Large Market
Capitalization?
There are advantages and drawbacks to having a large market capitalization.
On the one hand, larger companies might be able to secure better financing
terms from banks and by selling corporate bonds. Also, these companies might
benefit from competitive advantages related to their sizes, such as economies
of scale or widespread brand recognition.
On the other hand, large companies might have limited opportunities for
continued growth, and may therefore see their growth rates decline over
time.
Does Market Cap Affect Stock Price?
Market cap does not affect stock price; rather, market cap is calculated by
analyzing the stock price and number of shares issued. Although a blue-chip
stock may perform better because of organizational efficiency and greater
market presence, simply having a higher market cap does not directly impact
stock prices.
One could argue that analysts do track market cap to determine which
companies may be undervalued or overvalued. In this lens, market cap can
lead an investor to buy or sell shares based on the company's relative value
compared to the industry or competitors. Still, the stock price of a share is
determined as the fair value determined by the market, not by a company's
market capitalization.
What Is the Importance of Market Cap?
Market cap demonstrates the size of a company. It is an important tool for
analytics, especially when comparing companies. Market cap is often used as a
baseline for analysis as all other financial metrics must be viewed through this
lens. For example, a company could have had twice as much revenue as any
other company in the industry. However, if the company's market cap is four

times as large, the argument could be made that company is
underperforming.
The Bottom Line
Market cap can be a valuable tool for an investor who is watching stocks and
evaluating potential investments. Market capitalization is a quick and easy
method for estimating a company's value by extrapolating what the market
thinks it is worth for publicly traded companies. The investment community
uses this figure to determine a company's size, as opposed to using sales or
total asset figures. In an acquisition, the market cap is used to determine
whether a takeover candidate represents a good value or not to the acquirer.
2. Times Revenue Method
Under the times revenue business valuation method, a stream of revenues
generated over a certain period of time is applied to a multiplier which
depends on the industry and economic environment. For example, a tech
company may be valued at 3x revenue, while a service firm may be valued at
0.5x revenue.
What Is the Times-Revenue Method?
The times-revenue method determines the maximum value of a company as a
multiple of its revenue for a set period of time. The multiple varies by industry
and other factors but is typically one or two. In some industries, the multiple
might be less than one.
Understanding the Times-Revenue Method
The value of a business might be determined for various reasons, including to
aid financial planning or in preparation for selling the business.
It can be challenging to calculate the value of a business, especially if the value
is largely determined by potential future revenues. Several models can be used
to determine the value, or a range of values, to facilitate business decisions.

The times-revenue method attempts to value a business by valuing its cash
flow.
The times-revenue method is used to determine a range of values for a
business. The figure is based on actual revenues over a certain period of time
(for example, the previous fiscal year). A multiplier provides a range that can
be used as a starting point for negotiations.
The multiplier used in business valuation depends on the industry.
Small business valuation often involves finding the absolute lowest price
someone would pay for the business, known as the "floor." This is often
the liquidation value of the business's assets. Then, a ceiling is set. This is the
maximum amount that a buyer might pay, such as a multiple of current
revenues.
Once the floor and ceiling have been calculated, the business owner can
determine the value, or what someone may be willing to pay to acquire the
business. The value of the multiple used for evaluating the company’s value
using the times-revenue method is influenced by a number of factors
including the macroeconomic environment and industry conditions.
Important: The times-revenue method is also referred to as the multiples of
revenue method.
Who Can Benefit From the Times-Revenue
Method?
The times-revenue method is ideal for young companies with earnings that
are volatile or non-existent. Also, companies that are poised to have a speedy
growth stage, such as software-as-a-service firms, will base their valuations
on the times-revenue method.
The multiple used might be higher if the company or industry is poised for
growth and expansion. Since these companies are expected to have a high

growth phase with a high percentage of recurring revenue and good margins,
they would be valued in the three- to four-times-revenue range.
The multiplier might be one if the business is slow-growing or doesn't show
much growth potential. A company with a low percentage of recurring
revenue or consistently low forecasted revenue, such as a service company,
may be valued at 0.5 times revenue.
Criticism of the Times-Revenue Method
The times-revenue method is not always a reliable indicator of the value of a
firm. This is because revenue does not mean profit. The times-revenue method
fails to consider the expenses of a company or whether the company is
producing positive net income.
Moreover, an increase in revenue does not necessarily translate into an
increase in profits. A company may experience 10% year-over-year growth in
revenue, yet the company may be experiencing 25% year-over-year growth
in expenses.
Valuing a company only on its revenue stream fails to consider what it costs
to generate its revenue.
To get a more accurate picture of the current real value of a company,
earnings must be factored in. Thus, the multiples of earnings, or earnings
multiplier, is preferred to the multiples of revenue method.
FAST FACT: The times-revenue method can be calculated forward or
backward. You can divide the purchase price by annual revenue to
arrive at the multiple, or you can multiple annual revenues by a
desired times-revenue target to arrive at a potential target price.
Example of Times-Revenue Method
In fiscal year 2021, X (formerly Twitter) reported annual revenue of $5.077
billion. Annual revenue for grew from 2020 to 2021 by over $1.3 billion. In
2022, Elon Musk announced his intention to acquire the company for $44

billion. This decision was later reversed and solidified via Securities and
Exchange Commission filings.
The acquisition occurred at a company valuation of approximately 8.7
times-revenue. This means that at an acquisition price of $44 billion, Musk
paid 8.7 times the annual revenue of X ($5.1 billion).
The company's net annual loss for the same period demonstrates a glaring
weakness of the times-revenue model. In 2021, it incurred an annual loss of
$221 million, its second consecutive year of negative profit Although the
times-revenue valuation method indicates a value of 8.7, the method fails to
consider that the company was not a profitable company at the time.
As a postscript, X recorded $4.4 billion in revenue in 2022, an 11% decline.
Its estimated loss for the year was $152 million. That number presumably
reflects some of the severe cost-cutting initiated by Musk after his takeover
but also could include some of the estimated cost of repaying the $13 billion in
loans Musk took out in order to finance the purchase.3
In April 2023, it ceased to exist as a separate corporate entity and was
merged int X Corp., a wholly-owned subsidiary of X Holdings Corp., which is
owned by Musk.
How Do You Calculate Times-Revenue?
Times-revenue is calculated by dividing the selling price of a company by the
prior 12 months revenue of the company. The result indicates how many
times of annual income a buyer was willing to pay for a company.
What Is a Good Times-Revenue Multiple?
Every company, industry, and sector will have different guidelines on what
constitutes a good times-revenue valuation. Companies in higher growth
industries will often sell for higher multiples due to the greater potential of
future revenue. Alternatively, companies of different sizes may be valued
differently due to the inherent risk of a newer business compared to an
established company.

How Is the Times-Revenue Method Used?
Times-revenue is used to set a benchmark purchase price of a company. Using
only the revenue of the business, a buyer can estimate a fair selling price by
imputing what times-revenue they are willing to pay. Alternatively, a seller
may have a purchase price in mind but must check times-revenue for
reasonableness.
Is a Low Times Multiple Bad?
A low times multiple isn't necessarily bad. It simply means the company is
being valued lower than other companies. If a seller is motivated to sell, having
a low times multiple may be a good thing as it may be seen by buyers as a
cheaper, potentially bargain price compared to companies with much higher
multiples.
The Bottom Line
The times-revenue method of valuing a company has the virtue of being
straightforward. It's revenue for a certain period multiplied by a set factor,
usually one or two, to arrive at a figure that reflects the company's value.
It has a big drawback, though. Cash flow does not equal profits, and a
valuation based on the times-revenue method does not reflect the costs of
doing business.
There is another drawback that is shared by every method of valuation: All
are, by necessity, based on past performance and none can accurately predict
future sales.
3. Earnings Multiplier
Instead of the times revenue method, the earnings multiplier may be used to
get a more accurate picture of the real value of a company, since a company’s
profits are a more reliable indicator of its financial success than sales revenue
is. The earnings multiplier adjusts future profits against cash flow that could

be invested at the current interest rate over the same period of time. In other
words, it adjusts the current P/E ratio to account for current interest rates.
What Is the Earnings Multiplier?
The earnings multiplier is a financial metric that frames a company's current
stock price in terms of the company's earnings per share (EPS) of stock, that's
simply computed as price per share/earnings per share. Also known as
the price-to-earnings (P/E) ratio, the earnings multiplier can be used as a
simplified valuation tool with which to compare the relative costliness of the
stocks of similar companies. It can likewise help investors judge current stock
prices against their historical prices on an earnings-relative basis.
Understanding Earnings Multiplier
The earnings multiplier can be a useful tool for determining how expensive the
current price of a stock is relative to the company's earnings per share of that
stock. This is an important relationship because the price of a stock is
theoretically supposed to be a function of the anticipated future value of the
issuing company and future cash flows resulting from ownership of that stock.
If the price of a stock is historically expensive relative to the company's
earnings, it may indicate that it's not an optimal time to purchase this equity
because it's overly expensive. Furthermore, comparing earnings multipliers
across similar companies can help illustrate how expensive various companies'
stock prices are relative to one other.
Example of the Earnings Multiplier
As an example of a practical application of the earnings multiplier, consider
fictitious company ABC. Let's assume this corporation has a current stock
price of $50 per share and earnings per share (EPS) of $5. Under this set of
circumstances, the earnings multiplier would be 50 dollars/5 dollars per year
= 10 years. This means it would take 10 years to make back the stock price of
$50 given the current EPS.
The multiplier can also be verbally expressed by saying, "Company ABC is
trading at 10 times earnings," because the current price of $50 is 10x the $5

EPS. If 10 years ago, company ABC had a market price of $50 and EPS of $7,
the multiplier would have been 7.14 years.
Important: The earnings multiplier should only be used to value investments
on a relative basis and shouldn't be used to gauge an absolute valuation of a
stock.
The current price would be more expensive relative to current earnings than
the price 10 years ago because, at that time, the stock was only trading at
7.14 times earnings instead of 10 times earnings it trades at currently.
Comparing company ABC's earnings multiplier to other similar companies can
also provide a simple gauge for judging how expensive a stock is relative to its
earnings. If company XYZ also has an EPS of $5, but its current stock price is
$65, it has an earnings multiplier of 13 years. Consequently, this stock may
be deemed to be relatively more expensive than the stock of company ABC,
which has a multiplier of only 10 years.
4. Discounted Cash Flow (DCF) Method
The DCF method of business valuation is similar to the earnings multiplier.
This method is based on projections of future cash flows, which are adjusted to
get the current market value of the company. The main difference between
the discounted cash flow method and the profit multiplier method is that it
takes inflation into consideration to calculate the present value.
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) refers to a valuation method that estimates the
value of an investment using its expected future cash flows.
DCF analysis attempts to determine the value of an investment today, based
on projections of how much money that investment will generate in
the future.

It can help those considering whether to acquire a company or buy securities.
Discounted cash flow analysis can also assist business owners and managers in
making capital budgeting or operating expenditures decisions.
How Does Discounted Cash Flow (DCF) Work?
The purpose of DCF analysis is to estimate the money an investor would
receive from an investment, adjusted for the time value of money.
The time value of money assumes that a dollar that you have today is worth
more than a dollar that you receive tomorrow because it can be invested. As
such, a DCF analysis is useful in any situation where a person is paying money
in the present with expectations of receiving more money in the future.
For example, assuming a 5% annual interest rate, $1 in a savings account will
be worth $1.05 in a year. Similarly, if a $1 payment is delayed for a year, its
present value is 95 cents because you cannot transfer it to your savings
account to earn interest.
Discounted cash flow analysis finds the present value of expected future cash
flows using a discount rate. Investors can use the concept of the present value
of money to determine whether the future cash flows of an investment or
project are greater than the value of the initial investment.
If the DCF value calculated is higher than the current cost of the investment,
the opportunity should be considered. If the calculated value is lower than the
cost, then it may not be a good opportunity, or more research and analysis
may be needed before moving forward with it.
To conduct a DCF analysis, an investor must make estimates about future cash
flows and the ending value of the investment, equipment, or other assets.
The investor must also determine an appropriate discount rate for the DCF
model, which will vary depending on the project or investment under
consideration. Factors such as the company or investor's risk profile and the
conditions of the capital markets can affect the discount rate chosen.

If the investor cannot estimate future cash flows or the project is very complex,
DCF will not have much value and alternative models should be employed.
FAST FACT: For DCF analysis to be of value, estimates used in the
calculation must be as solid as possible. Badly estimated future cash
flows that are too high can result in an investment that might not
pay off enough in the future. Likewise, if future cash flows are too
low due to rough estimates, they can make an investment appear
too costly, which could result in missed opportunities.
Discounted Cash Flow Formula
The formula for DCF is:
Example of DCF
When a company analyzes whether it should invest in a certain project or
purchase new equipment, it usually uses its weighted average cost of
capital (WACC) as the discount rate to evaluate the DCF.
The WACC incorporates the average rate of return that shareholders in the
firm are expecting for the given year.

For example, say that your company wants to launch a project. The
company's WACC is 5%. That means that you will use 5% as your discount
rate.
The initial investment is $11 million, and the project will last for five years,
with the following estimated cash flows per year.
Adding up all of the discounted cash flows results in a value of $13,306,727.
By subtracting the initial investment of $11 million from that value, we get
a net present value (NPV) of $2,306,727.

The positive number of $2,306,727 indicates that the project could generate
a return higher than the initial cost—a positive return on the investment.
Therefore, the project may be worth making.
If the project had cost $14 million, the NPV would have been -$693,272.
That would indicate that the project cost would be more than the projected
return. Thus, it might not be worth making.
Important: Dividend discount models, such as the Gordon Growth
Model (GGM) for valuing stocks, are other analysis examples that use
discounted cash flows.
Advantages and Disadvantages of DCF
Advantages
Discounted cash flow analysis can provide investors and companies with an
idea of whether a proposed investment is worthwhile.
It is an analysis that can be applied to a variety of investments and capital
projects where future cash flows can be reasonably estimated.
Its projections can be tweaked to provide different results for various what-if
scenarios. This can help users account for different projections that might be
possible.
Disadvantages
The major limitation of discounted cash flow analysis is that it involves
estimates, not actual figures. So the result of DCF is also an estimate. That
means that for DCF to be useful, individual investors and companies must
estimate a discount rate and cash flows correctly.
Furthermore, future cash flows rely on a variety of factors, such as
market demand, the status of the economy, technology, competition, and
unforeseen threats or opportunities. These can't be quantified exactly.
Investors must understand this inherent drawback for their decision-making.

DCF shouldn't necessarily be relied on exclusively even if solid estimates can be
made. Companies and investors should consider other, known factors as well
when sizing up an investment opportunity. In addition, comparable company
analysis and precedent transactions are two other, common valuation
methods that might be used.
How Do You Calculate DCF?
Calculating the DCF involves three basic steps. One, forecast the expected cash
flows from the investment. Two, select a discount rate, typically based on the
cost of financing the investment or the opportunity cost presented by
alternative investments. Three, discount the forecasted cash flows back to the
present day, using a financial calculator, a spreadsheet, or a manual
calculation.
What Is an Example of a DCF Calculation?
You have a discount rate of 10% and an investment opportunity that would
produce $100 per year for the following three years. Your goal is to calculate
the value today—the present value—of this stream of future cash flows.
Since money in the future is worth less than money today, you reduce the
present value of each of these cash flows by your 10% discount rate.
Specifically, the first year’s cash flow is worth $90.91 today, the second year’s
cash flow is worth $82.64 today, and the third year’s cash flow is worth
$75.13 today. Adding up these three cash flows, you conclude that the DCF of
the investment is $248.68.
Is Discounted Cash Flow the Same As Net
Present Value (NPV)?
No, it's not, although the two concepts are closely related. NPV adds a fourth
step to the DCF calculation process. After forecasting the expected cash flows,
selecting a discount rate, discounting those cash flows, and totaling them,
NPV then deducts the upfront cost of the investment from the DCF. For
instance, if the cost of purchasing the investment in our above example were

$200, then the NPV of that investment would be $248.68 minus $200, or
$48.68.
The Bottom Line
Discounted cash flow is a valuation method that estimates the value of an
investment based on its expected future cash flows. By using a DFC calculation,
investors can estimate the profit they could make with an investment
(adjusted for the time value of money). The value of expected future cash flows
is first calculated by using a projected discount rate. If the discounted cash
flow is higher than the current cost of the investment, the investment
opportunity could be worthwhile.
What Is Weighted Average Cost of Capital
(WACC)?
Weighted average cost of capital (WACC) represents a company's average
after-tax cost of capital from all sources, including common stock, preferred
stock, bonds, and other forms of debt. As such, WACC is the average rate that
a company expects to pay to finance its business.
WACC is a common way to determine required rate of return (RRR) because
it expresses, in a single number, the return that bondholders and shareholders
demand to provide the company with capital. A company's WACC is likely to
be higher if its stock is relatively volatile or if its debt is seen as risky, because
investors will want greater returns to compensate them.
Understanding WACC
Calculating a company's WACC is useful for investors and stock analysts, as
well company management, although they may use it for different purposes.
In corporate finance, determining a company's cost of capital can be
important for a couple of reasons. For instance, WACC can be used as
the discount rate for estimating the net present value of a project or
acquisition.

If the company believes that a merger, for example, will generate a return
higher than its cost of capital, then it's likely a good choice for the company.
However, if it anticipates a return lower than its investors are expecting, then
it might want to put its capital to better use.
To investors, WACC is an important tool in assessing a company's potential for
profitability. In most cases, a lower WACC indicates a healthy business that's
able to attract money from investors at a lower cost. By contrast, a higher
WACC usually coincides with businesses that are seen as riskier and need to
compensate investors with higher returns.
If a company only obtains financing through one source—say, common
stock—then calculating its cost of capital would be relatively simple. If
investors expected a rate of return (RoR) of 10% on their shares, the
company's cost of capital would be the same as its cost of equity: 10%.
The same would be true if the company only used debt financing. For example,
if the company paid an average yield of 5% on its bonds, its cost of debt would
be 5%. This is also its cost of capital.
However many companies use both debt and equity financing in various
proportions, which is where WACC comes in.

Explaining the Formula Elements
Cost of equity (Re in the formula) can be a bit tricky to calculate because share
capital does not technically have an explicit value. When companies reimburse
bondholders, the amount they pay has a predetermined interest rate. On the

other hand, equity has no concrete price that the company must pay. As a
result, companies have to estimate the cost of equity—in other words, the
rate of return that investors demand based on the expected volatility of the
stock.
Because shareholders will expect to receive a certain return on their
investment in a company, the equity holders' required rate of return is a cost
from the company's perspective; if the company fails to deliver this expected
return, shareholders may simply sell their shares, which can lead to a decrease
in both share price and the company's value. The cost of equity, then, is
essentially the total return that a company must generate to maintain a
share price that will satisfy its investors.
Companies typically use the capital asset pricing model (CAPM) to arrive at
the cost of equity (in CAPM, it's called the expected return of investment).
Again, this is not an exact calculation because companies have to lean on
historical data, which can never accurately predict future growth.2
Determining cost of debt (Rd in the formula), on the other hand, is a more
straightforward process. This is often done by averaging the yield to
maturity for a company's outstanding debts. This method is easier if you're
looking at a publicly traded company that has to report its debt obligations.
For privately owned companies, one can look at the company's credit
rating from firms such as Moody's and S&P Global and then add a relevant
spread over risk-free assets (for example, Treasury bonds of the same
maturity) to approximate the return that investors would demand.
Businesses are able to deduct interest expenses from their taxes.3 Because of
this, the net cost of a company's debt is the amount of interest it is paying
minus the amount it was able to deduct on its taxes. This is why Rd x (1 - the
corporate tax rate) is used to calculate the after-tax cost of debt.
WACC vs. Required Rate of Return (RRR)
The required rate of return is the minimum rate that an investor will accept.
If they expect a smaller return than they require, they'll put their money
elsewhere.

One way to determine the RRR is by using the CAPM, which looks at a stock's
volatility relative to the broader market (its beta) to estimate the return that
stockholders will require.
Another method for identifying the RRR is by calculating WACC. The
advantage of using WACC is that it takes the company's capital structure into
account—that is, how much it leans on debt financing vs. equity.4
Limitations of WACC
The WACC formula seems easier to calculate than it really is. Because certain
elements of the formula, such as the cost of equity, are not consistent values,
various parties may report them differently for different reasons. As such,
although WACC can often offer valuable insight into a company, one should
always use it along with other metrics in deciding whether to invest.
More complex balance sheets, such as for companies using multiple types of
debt with various interest rates, make it more difficult to calculate WACC. In
addition, there are many inputs to calculating WACC—such as interest rates
and tax rates—all of which can be affected by market and economic
conditions.
Example of How to Use WACC
Consider a hypothetical manufacturer called XYZ Brands. Suppose
the market value of the company's debt is $1 million, and its market
capitalization (or the market value of its equity) is $4 million.
Let's further assume that XYZ's cost of equity—the minimum return that
shareholders demand—is 10%. Here, E/V would equal 0.8 ($4,000,000 of
equity value divided by $5,000,000 of total financing). Therefore, the
weighted cost of equity would be 0.08 (0.8 × 0.10). This is the first half of the
WACC equation.
Now we have to figure out XYZ's weighted cost of debt. To do this, we need to
determine D/V; in this case, that's 0.2 ($1,000,000 in debt divided by
$5,000,000 in total capital). Next, we would multiply that figure by the
company's cost of debt, which we'll say is 5%. Last, we multiply the product of

those two numbers by 1 minus the tax rate. So if the tax rate is 0.25, then "1
minus Tc" is equal to 0.75.
In the end, we arrive at a weighted cost of debt of 0.0075 (0.2 × 0.05 ×
0.75). When that's added to the weighted cost of equity (0.08), we get a
WACC of 0.0875, or 8.75% (0.08 weighted cost of equity + 0.0075 weighted
cost of debt).
That represents XYZ's average cost to attract investors and the return that
they're going to expect, given the company's financial strength and risk
compared with other investment opportunities.
What Is a Good Weighted Average Cost of
Capital (WACC)?
What represents a "good" weighted average cost of capital will vary from
company to company, depending on such factors as whether it is an
established business or a startup, its capital structure, and the industry in
which it operates. One way to judge a company's WACC is to compare it to
the average for its industry or sector. For example, according to Kroll research,
the WACC for companies in the consumer staples sector was 8.4%, on average,
in June 2023, while it was 11.4% in the information technology sector.5
What Is Capital Structure?
Companies use various means to obtain the capital they need, which can
include issuing bonds (debt) and shares of stock (equity). Capital
structure refers to how they mix the two.
What Is a Debt-to-Equity Ratio?
A debt-to-equity ratio is another way of looking at the risk that investing in
a particular company may hold. It compares a company's liabilities to the
value of its shareholder equity. The higher the debt-to-equity ratio, the riskier
a company is often considered to be.6

The Bottom Line
Weighted average cost of capital (WACC) is a useful measure for both investors
and company executives. However, it can be difficult to compute with
accuracy and usually should not be relied on all by itself.
5. Book Value
This is the value of shareholders’ equity of a business as shown on the balance
sheet statement. The book value is derived by subtracting the total liabilities of
a company from its total assets.
6. Liquidation Value
Liquidation value is the net cash that a business will receive if its assets were
liquidated and liabilities were paid off today.
This is by no means an exhaustive list of the business valuation methods in use
today. Other methods include replacement value, breakup value, asset-based
valuation, and still many more.
Terminal Value (TV) Definition
and How to Find The Value (With
Formula)
What Is Terminal Value (TV)?
Terminal value (TV) is the value of an asset, business, or project beyond the
forecasted period when future cash flows can be estimated. Terminal value
assumes a business will grow at a set growth rate forever after the forecast
period. Terminal value often comprises a large percentage of the total assessed
value.

Understanding Terminal Value
Forecasting gets murkier as the time horizon grows longer. This holds true in
finance as well, especially when it comes to estimating a company's cash flows
well into the future. At the same time, businesses need to be valued. To "solve"
this, analysts use financial models, such as discounted cash flow (DCF), along
with certain assumptions to derive the total value of a business or project.
Discounted cash flow (DCF) is a popular method used in feasibility
studies, corporate acquisitions, and stock market valuation. This method is
based on the theory that an asset's value equals all future cash flows derived
from that asset. These cash flows must be discounted to the present value at a
discount rate representing the cost of capital, such as the interest rate.
DCF has two major components: forecast period and terminal
value.1 Analysts use a forecast period of about three to five years—anything
longer than that and the accuracy of the projections suffer. This is where
calculating terminal value becomes important. However, this period is often
longer for certain industries, like those involved in natural resource extraction.
Two commonly used methods to calculate terminal value are perpetual
growth (Gordon Growth Model) and exit multiple. The former assumes that a
business will continue to generate cash flows at a constant rate forever, while
the latter assumes that a business will be sold for a multiple of some market
metric. Investment professionals prefer the exit multiple approach, while
academics favor the perpetual growth model.
How Is Terminal Value Estimated?
There are several terminal value formulas. Like discounted cash flow (DCF)
analysis, most terminal value formulas project future cash flows to return the
present value of a future asset. The liquidation value model (or exit method)
requires figuring out the asset's earning power with an appropriate discount
rate and then adjusting for the estimated value of outstanding debt.
The stable (perpetuity) growth model does not assume the company will be
liquidated after the terminal year. Instead, it assumes that cash flows
are reinvested and that the firm can grow at a constant rate into perpetuity.

The multiples approach uses the approximate sales revenues of a company
during the last year of a discounted cash flow model, then uses a multiple of
that figure to arrive at the terminal value without further discounting
applied.
FAST FACT: The Gordon Growth Model is named after Myron
Gordon, an economist at the University of Toronto, who worked out
the basic formula in the late 1950s.
Types of Terminal Value
Perpetuity Method
Discounting is necessary because the time value of money creates a
discrepancy between the current and future values of a given sum of money.
In business valuation, free cash flow or dividends can be forecast for a discrete
period, but the performance of ongoing concerns becomes more challenging to
estimate as the projections stretch further into the future. Moreover, it is
difficult to determine when a company may cease operations.
To overcome these limitations, investors can assume that cash flows will grow
at a stable rate forever, starting at some point in the future. This represents
the terminal value.

Exit Multiple Method
If investors assume a finite window of operations, there is no need to use the
perpetuity growth model. Instead, the terminal value must reflect the net
realizable value of a company's assets at that time.1 This often implies that
the equity will be acquired by a larger firm, and the value of acquisitions are
often calculated with exit multiples.
Exit multiples estimate a fair price by multiplying financial statistics, such as
sales, profits, or earnings before interest, taxes, depreciation, and
amortization (EBITDA), by a factor that is common for recently acquired and
similar firms. The terminal value formula using the exit multiple method is the
most recent metric (i.e., sales, EBITDA, etc.) multiplied by the decided-upon
multiple (usually an average of recent exit multiples for other
transactions). Investment banks often employ this valuation method, but
some detractors hesitate to use intrinsic and relative valuation techniques
simultaneously.

IMPORTANT: Terminal value accounts for a significant portion of the total
value of a business in a DCF model, as it represents the value of all future cash
flows beyond the projection period. This means that the assumptions made
about terminal value can significantly impact the overall valuation of a
business.
Terminal Value vs. Net Present Value
Terminal value is not the same as net present value (NPV). Terminal value is a
financial concept used in discounted cash flow (DCF) analysis and depreciation
to account for the value of an asset at the end of its useful life or of a business
past some projection period.
Net present value (NPV) measures the profitability of an investment or
project. It is calculated by discounting all future cash flows of the investment
or project to the present value using a discount rate and then subtracting the
initial investment. NPV is used to determine whether an investment or
project is expected to generate positive returns or losses. It is a commonly used
tool in financial decision-making, as it helps to evaluate the attractiveness of
an investment or project by considering the time value of money.
Why Do We Need to Know the Terminal Value
of a Business or Asset?
Most companies do not assume they will stop operations after a few years.
They expect business to continue forever (or at least for a very long time).
Terminal value is an attempt to anticipate a company's future value and
apply it to present prices through discounting.
When Evaluating Terminal Value, Should I
Use the Perpetuity Growth Model or the Exit
Approach?
In DCF analysis, neither the perpetuity growth model nor the exit multiple
approach is likely to render a perfectly accurate estimate of terminal value.

The choice of which method of calculating terminal value to use depends
partly on whether an investor wishes to obtain a relatively more optimistic
estimate or a relatively more conservative estimate.
Generally speaking, using the perpetuity growth model to estimate terminal
value renders a higher value. Investors can benefit from using both terminal
value calculations and then using an average of the two values arrived at for a
final estimate of NPV.
What Does a Negative Terminal Value Mean?
A negative terminal value would be estimated if the cost of future capital
exceeded the assumed growth rate. In practice, however, negative terminal
valuations cannot exist for very long. A company's equity value can only
realistically fall to zero at a minimum, and any remaining liabilities would be
sorted out in a bankruptcy proceeding. Whenever an investor comes across a
firm with negative net earnings relative to its cost of capital, it's probably best
to rely on other fundamental tools outside of terminal valuation.
The Bottom Line
Terminal value is the estimated value of an asset at the end of its useful life. It
is used for computing depreciation and is also a crucial part of DCF analysis,
as it accounts for a significant portion of the total value of a business.
Terminal value can be calculated using the perpetual growth method or the
exit multiple method. Terminal value is a crucial part of DCF analysis as it
accounts for a significant portion of the total value of a business. It is
important to carefully consider the assumptions made when calculating
terminal value, as they can significantly impact a business's overall valuation.

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