Raising Entrepreneurial Capital

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