Canada: What Is My Business Worth?

Last Updated: September 18 2012
Article by Dennis Leung

When determining the value of a business, an assessment must be made as to whether the premise of value should be based on a going concern approach or a liquidation approach. A going concern approach is generally adopted when the business being valued is deemed to be economically viable. Where a business is forecast to generate minimal or negative operating cash flow for an extended period of time, a liquidation approach may be warranted.

While there are several methodologies to determine value under a going concern approach, the most common methods are the capitalized cash flow methodology, the discounted cash flow methodology and the multiple of EBITDA methodology. Under the liquidation approach, value is determined based on the net realizable value of the business' net assets (assets less liabilities). We discuss each of the approaches below.

CAPITALIZED CASH FLOW METHODOLOGY

Under the capitalized cash flow methodology, an estimated range of maintainable discretionary after tax cash flow is "capitalized" by a rate of return. Adjustments are then made for the present value of existing tax pools, redundant assets, and outstanding interest bearing debt and equivalents to derive the en bloc equity value of the shares of a business. This methodology inherently assumes that the business will generate relatively stable discretionary cash flows into perpetuity. As such, the capitalized cash flow methodology is generally applied to:

  • a mature business with relatively consistent discretionary cash flows;
  • a business where the average discretionary cash flows through business cycles can be reasonably estimated. In situations where the average discretionary cash flows cannot be reasonably estimated into perpetuity, the discounted cash flow approach may be more appropriate to determine the value of a business (discussed below); and
  • a reliable cash flow forecast is not available.

The primary components of the capitalized cash flow methodology are discussed below.

Maintainable Discretionary After-Tax Cash Flow

To determine the maintainable discretionary after-tax cash flow, the estimated range of maintainable cash flow from operations, normally defined as earnings before interest, income taxes, depreciation and amortization ("EBITDA") is determined. The estimate is generally based on an analysis of historical, current, and when available, projected results, as well as the company, industry and economic factors that may impact a business' ability to generated cash flow in the future. Income taxes at the prevailing tax rate are deducted, along with the sustaining capital reinvestment, which represents the annual cash required to purchase fixed assets in order to sustain the maintainable discretionary after tax cash flow.

Rate of Return

The maintainable discretionary after-tax cash flow is "capitalized" by a rate of return or "capitalization rate" to determine the capitalized discretionary cash flow of a business. The capitalization rate reflects anticipated future discretionary cash flow growth and the perceived level of risk of achieving the estimated maintainable discretionary after-tax cash flow. The perceived level of risk is a function of the prevailing and forecast economic conditions, the nature of the industry, and company-specific factors. Company-specific factors may include customer dependency, supply risk, and reliance on key employees.

En Bloc Fair Market Value under the Capitalized Cash Flow Methodology

To determine the en bloc fair market of the shares of a business, adjustments to the capitalized discretionary cash flow are made for:

  • existing income tax pools, which normally include the undepreciated capital cost of assets utilized by the business at the valuation date and available tax losses, and other prospective tax benefits not accounted for as a component of discretionary cash flows;
  • redundant assets (or non-operating assets), which are assets that are not required by a business to generate the prospective discretionary cash flow;
  • other items not reflected in the capitalized discretionary cash flow. These may include one-time costs or benefits that are not included in the determination of the maintainable discretionary cash flow; and
  • outstanding interest bearing debt and interest bearing debt equivalents. As the interest on outstanding debt is not deducted in the determination of the maintainable discretionary after-tax cash flow it is deducted from the capitalized discretionary cash flow.

DISCOUNTED CASH FLOW METHODOLOGY

The discounted cash flow methodology is in essence an extension of the capitalized cash flow methodology. The primary difference is that the capitalized cash flow is based on one annual maintainable discretionary cash flow amount and assumes that the annual discretionary cash flow remains at the same level into perpetuity. The discounted cash flow adopts a forecast of the prospective discretionary cash flow a business is expected to generate over a period of time (generally three to five years). The forecast cash flows are discounted by a rate of return to determine the net present value of the forecast discretionary after-tax cash flow. Beyond the forecast period, an estimate is then made of the value of the annual maintainable discretionary cash flows, which is capitalized to determine the terminal value and then discounted to the valuation date to reflect the net present value. The discounted cash flow methodology is generally applied in situations where a reasonable forecast has been prepared.

The primary components of the discounted cash flow methodology are discussed below.

Present Value of the Annual Discretionary Cash Flow during the Forecast Period

To determine the present value of the annual discretionary cash flow, the annual prospective cash flow from operations (EBITDA) is estimated, generally for a three to five year period (the "Forecast Period"). Income taxes at applicable rates and the capital investment requirements are deducted over the Forecast Period. Adjustments are then made for incremental net trade working capital requirements. The annual prospective cash flow after deducting income taxes and the capital investment requirements and adjusting for incremental net trade working capital requirements result in the forecast annual discretionary cash flow.

The forecast annual discretionary cash flow is discounted to a present value amount using a discount rate. The discount rate reflects the risk of achieving the projected annual discretionary cash flow during the Forecast Period, and takes into consideration the prospective economic conditions, the outlook of the industry that the business operates in and company-specific factors.

Terminal Value

The terminal value is calculated by estimating the annual maintainable discretionary cash flow beyond the Forecast Period, then dividing it by a capitalization rate (similar to the capitalized cash flow methodology). The terminal value is discounted to its present value using the discount rate applied to the annual discretionary cash flow over the Forecast Period

En Bloc Fair Market Value under the Discounted Cash Flow Methodology

The en bloc fair market of the shares of a business under the discounted cash flow methodology is the sum of the present value of the annual discretionary cash flow during the forecast period and the terminal value. This results in the net present value of all prospective discretionary cash flow. Existing income tax pools and redundant assets are added and outstanding interest bearing debt and debt equivalents are deducted from the net present value of all prospective discretionary cash flow to determine the en bloc fair market value of the shares of a business.

MULTIPLE OF EBITDA METHODOGY

Under the multiple of EBITDA methodology, an estimated maintainable EBITDA is multiplied by an EBITDA multiple to derive an enterprise value. Redundant assets are added and outstanding interest bearing debt and debt equivalents are deducted from the enterprise value to determine the en bloc fair market value of the shares of a business.

This methodology does not specifically address the valuation implications of income taxes and capital expenditure requirements, both of which are considered in the capitalized cash flow methodology and the discounted cash flow methodology. As such, while the multiple of EBITDA methodology is frequently utilized, it is fraught with challenges if it is not properly applied.

LIQUIDATION VALUE BASIS

When it is determined that a business is not viable as a going concern, value is typically determined on a liquidation value basis. This methodology may also be appropriate in the infrequent circumstance where the expected liquidation value exceeds the en bloc fair market value of a business. Liquidation value is calculated as the net realizable value of each asset, net of disposition costs (i.e. sales commission), less the fair market value of liabilities and all liquidation related costs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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