When someone buys a company in Amarillo or an interest in a company in Amarillo, what is that person really buying? Management? Markets? Technological skills? Products? Value? Although each of these factors may be involved in the investment decision, what is actually being bought is a stream of prospective economic income. When addressing the question of how to value a company in Amarillo, business owners should understand what economic income is, so that they may control and enhance it. Understanding these factors will lead to increases in the value of your Amarillo business.
It is also worthwhile to understand that there are many methods, approaches, and techniques utilized to value a company in Amarillo. Many of these techniques require subscriptions to databases and specialized research platforms. There is one method, while not cookie-cutter by any means, that business appraisers generally consider the primary resource when establishing the value of a company. This resource is called the capitalized economic income method, and is just one method under the income approach. This method can be applied without expensive subscriptions and requires business owners to be aware of a few things, such as: economic income and capitalization/ discount rates.
Economic Income
It may be worthwhile to define the term economic income, since we will use it in this discussion of the income approach to valuation. As the term implies, we define income according to the economists’ definition and not the accountants’ definition. In the landmark text Economics, Paul D. Samuelson and William D. Nordhaus define income as: “The flow of wages, interest, payments, dividends, and other receipts accruing to an individual or nation during a period of time (usually a year).” For purposes of this discussion of the income approach, we will use a similarly broad definition of economic income. We define economic income as any inflow into an economic unit in exchange for goods, services, or capital.
When determining the value of a company in Amarillo, most businesses use cash flows (often called net cash flows) as the source of economic income. Without going into the nuances of different ways to define net cash flows, let’s assume the Amarillo business owners wants to determine the value to an unknown 3rd party buyer. The value of the entire invested capital (equity + debt) for an Amarillo company can be expressed in the following formula:
| Net Income (after-tax) | |
| + | Non-cash charges (depreciation, amortization, deferred revenue, deferred taxes) |
| – | Capital expenditures necessary to support projected operations |
| – | Additions to net working capital necessary to support projected operations |
| + | Changes in long-term debt from borrowings necessary to support projected operations |
| – | Changes in long-term debt for repayments necessary to support projected operations |
| = | Net cash flow to equity |
| – | Dividends paid to preferred shareholders |
| = | Net cash flow to invested capital (after-tax) |
It is noteworthy that the capital expenditures, net changes in working capital, and net changes in long-term debt components of net cash flow may be negative. In other words, if there are reductions (sales) of capital assets, decreases in net working capital, or decreases in long-term debt, these components would be represented by negative numbers. And, the subtraction of a negative number (e.g., a decrease in net working capital) would represent an increment—instead of a decrement—to net cash flow.
This formula can be applied to an Amarillo company’s historical financial performance to determine net cash flows to invested capital. Then, the Amarillo business could select a historical year that he or she believes is representative of ongoing operations. As an example, let’s assume that next year’s net cash flow is expected to be $200,000.
Capitalization & Discount Rates
When addressing the topic of how to value a company in Amarillo, business owners should be aware that the value of an asset is the present value of its expected returns. Specifically, business owners in Amarillo expect an asset to provide a stream of returns during the period of time they own it. To convert this estimated stream of returns to a value for the security (such as stock in a privately-held company), you must discount this stream at your required rate of return. This process of valuation requires estimates of (1) the stream of expected returns (cash flows) and (2) the required rate of return on the investment. Value today always equals future cash flow discounted at the opportunity cost of capital.
The capitalization rate used to value the entire invested capital for an Amarillo company can be expressed in the following formula:
C = k – g
Where:
C = Capitalization rate
k = Discount rate
g = Annually compounded rate of growth
So, to value a company in Amarillo using this method, you would first need to develop a discount rate. You could use the 2020 Private Capital Markets Report prepared annually by Pepperdine. The Pepperdine private cost of capital (PCOC) survey was originally launched in and was the first comprehensive and simultaneous investigation of the major private capital market segments. This year’s survey was deployed in January 2020 and specifically examined the behavior of senior lenders, asset-based lenders, mezzanine funds, private equity groups, venture capital firms, angel investors, privately-held businesses, investment bankers, business brokers, limited partners, and business appraisers. The Pepperdine PCOC survey investigates, for each private capital market segment, the important benchmarks that must be met in order to qualify for each particular capital type, how much capital is typically accessible, what the required returns are for extending capital in today’s economic environment, and outlooks on demand for various capital types, interest rates, and the economy in general. As an example, let’s assume that the selected discount rate used to value an Amarillo company is 10%.
C = 10% – g
The annually compounded rate of growth is the long-term growth rate in perpetuity. A general rule of thumb is the Amarillo company cannot grow faster than the economy as a whole (refer to gross domestic product). As an example, let’s assume that the selected long-term growth rate (g) used to value an Amarillo company is 3.0%.
7% = 10% – 3%
Value a Company in Amarillo
In this simple example, the value of the company in Amarillo is used by applying a perpetual growth model for which we have an economic income estimate for the year immediately following the valuation date. Here is how it is applied in this example:
Next year’s expected economic income: $200,000
Discount Rate (k) (required rate of return): 10%
Sustainable income growth rate (g): 3%
In this case, the share of stock would be valued as follows:
$200,000 ÷ (10% – 3%) = $2,857,143
There you have it! This is a quick way to value the invested capital of your Amarillo company. It should be noted that changes in the growth rate projected, sometimes seemingly small, can result in striking changes. In the basic constant growth example used above, assume that the discount rate was 9% instead of 10%. In this case, the share of stock would be valued as follows:
$200,000 ÷ (9% – 3%) = $3,333,333
This resulted in a 16% increase in the value of the Amarillo company. For these reasons, it is always recommended to utilize a professional business valuation located in Amarillo to make sure the value of your company is right. For more information, or to find out the value of your Amarillo company, call Caprock Business Consulting.
