the company. This method is limited in its usefulness for most companies but
may be ap plicable to a business that derives most of its value from tangible
assets, such as a natural resource company.
The most common method used in practice is the market multiple ap-
proach. In this method, value is determined by looking at the ratio of price
to sales, earnings, or other value drivers, using similar publicly traded
companies as a benchmark. Differences between the private start-up and
the public companies must be factored into the analysis to adjust for lack of
marketability, age, or other critical factors. It is also important to use several
guideline companies as a basis for comparison to average out the effects of
company-specific information on firm value.
Earnings capitalization is a method similar to the market multiple ap-
proach, used primarily in the real estate industry. In this method an income
stream is discounted, in perpetuity, to establish firm value. It is important to
understand the implicit assumptions being made about growth when this
method is used.
The excess earnings approach was originally developed to value the good-
will in a business. In this method an imputed return is calculated based on the
tangible assets of the business. Earnings above this amount are attributed to
goodwill and valued separately and added to the value generated by the
tangible assets. The sum of the two is the total firm value.
Finally, discounted cash flow (DCF) analysis was considered. In this
method the free cash flows of the business are discounted at the company’s
cost of capital. While this is theoretically the most sound and rigorous
method, as with any model, ‘‘garbage in equals garbage out.’’ If the qua lity
of the forecasts is questionable, it diminishes the usefulness of this method in
establishing value. On the other hand, the exercise of generating the free cash
flows causes the entrepreneur to think long and hard about how the business
will progress.
Calculation of the appropriate discount rate to be used in the DCF
analysis was also discussed with special emphasis on the weighted average
cost of capital. It is best to think of the firm’s cost of capital in an oppor-
tunity cost sense, rather than resulting from a particular model, since the
inputs to the model are problematic for a private company.
Valuation is one of the most important and contentious aspects of entre-
preneurial finance. The more ways you can attack the problem, the stronger
the resulting valuation will be .
DISCUSSION QUESTIONS
1. Testing Your Understanding of Free Cash Flow Valuation
Valuation—Survey of Methods 175

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