1|Page

FACULTY OF BUSINESS ADMINISTRATION & ECONOMICS DEPARTMENT OF ACCOUNTING, FINANCE AND ECONOMICS BAF 601 Financial Management Assignment I Spring 2013 Name : Date Due :April 09, 2013 Module Title

ID Date Submitted

: :

Managerial Finance Assignment 1 Discuss the limitations of using traditional financial management techniques for valuing dot.coms and why they arise. Do you think that they are so serious to undermine the validity of this approach to the valuation of electronic business? Credit will be given for orderly and appropriate presentation of your report. Credit will also be given for the inclusion of relevant academic and practitioner articles together with a demonstration of detailed knowledge of original sources. Reports should look to incorporate relevant ideas.

Due Date:

April 09, 2013

Word Limited:

2000

Date Submitted:

I declare that this assignment is my own work and that I have clearly referenced any and all material for which I am not solely responsible. Signature Name Date

Basis of Assessment

Weighting

Mark

Presentation & Style of Report (text, tables, figures, etc) Evidence of Reading and Application of Theory

10 30

2|Page Use of applied example (in context) Logical Development / Structure of Argument 15 15

Development of Insight and learning

15

Summery or Conclusion

15

Mark

Please attach this cover sheet to the front of your assignment

3|Page

Table of Contents
Introduction: .................................................................................................................................... 4 Balance sheet methods: ................................................................................................................... 5 Income statement-based methods: .................................................................................................. 5 Goodwill methods: .......................................................................................................................... 6 Discounted cash flow (DCF) method: ............................................................................................ 7 Internet companies valuation: ......................................................................................................... 8 Valuation examples:...................................................................................................................... 10 Conclusion: ................................................................................................................................... 11 Bibliography ................................................................................................................................. 12

4|Page

Introduction:

"Valuation is the process by which forecasts of performance are converted into estimates of price." Many valuation methods are proposed, and each one have its advantages and disadvantages, therefore there is no single method that dominates others (palepu, healy, & bernard, 2004). We can not consider that all businesses are valued in the same way, there is more than twenty different methods to value a company, to know what your business worth you need to apply one of these approachs (Hayes Knight, 2010). This paper discusses the four main methods (or group of methods) used in valuing a company: balance sheet methods, income statement-based methods, goodwill methods and cash flow discounting-based methods (Fernandez, 2007)Then choosing the best one to be applied for internet companies.

Though dot.com companies have been around for more than a decade and many new ones are appearing, most of them barely have historical data which can be relied on to compute their valuations. The ease to search for alternatives (products, services,...) at one click of a mouse increase the number of unpredicted customers for these companies, making their valuation more difficult, unlike customers transacting business in real word with human touch (morison menon, 2010). It also provides some real life examples of different internet companies valuation.

5|Page

Balance sheet methods:

These methods provide the present financial condition of a company and can give a good valuation relying on its total assets, liabilities and shareholders' equity. Owners' equity is equal to the total assets minus total liabilities, and it is not often that a company might be valued under its equity, which gives at least a minimum value for the company (Tracy, august, 2006). Balance sheet could be used for different methods while valuing a company: book value, adjusted book value, liquidation value, substantial value methods (Fernandez, 2007). While reading many articles about balance sheet methods for valuing companies it can be deduced that these methods do not take into consideration any possible future event for the company, for example producing a new product after one year which might increase the wealth of the company or decrease it. It also takes nothing into account of how much a business has in earning power (ANDERS, 2006). Therefore, this approach is most appropriate when a company has little or no intangible assets. Valuing internet companies is much more difficult than a bricks and mortar companies while using this method, because there are almost no tangible assets to consider for these companies.

Income statement-based methods:

Unlike the balance sheet methods, this approach determines the value of a company through its earnings, dividends or sales. Multiplying the company's market per share price by its current earnings would give the company its value, or by multiplying its annual sales by a predetermined multiplier factor (this multiplier is determined in different methods using historical data and projected sales analysis, for example the price/earnings ratio) (Capital corp merchant banking, 2013). Dividends are effectively the earnings paid out to shareholders, so they might determine the value of the company by dividing their net present value on the required rate of return.

6|Page For example it is very common to perform a quick valuation of cement companies by multiplying its annual sales by a multiple (price/sales could be used as a multiple). The most commonly used multiples to value an internet company are: Price/Sales, Prices/Subscriber, Price/Pages visited, Price/Inhabitant (Fernandez, 2007).

Goodwill methods:

Generally speaking, goodwill represent the value of the company's intangible assets which do not appear in the balance sheet (it is the difference between the true value of a company and its net assets). for example if you own a business where service, location and reputation are important (hairdressing salon) the value of the net assets alone is not sufficient the goodwill value should be added to it, so your business would have a more realistic valuation (commonwealth bank, 2013).

The "Classic" valuation method is one of the goodwill methods which add to the net assets the goodwill value ( it is n times the company's net income or as a certain percentage of the turnover; expressed by the formula: V= A + (n*B) where: A=net asset value; n=coefficient between 1.5 and 3; B=net income ) This formula can be adjusted in many different ways to have a more accurate valuation, by revaluing the net assets or by forecasting a net income instead of using the current one and many other variations (Fernandez, 2007).

7|Page

Discounted cash flow (DCF) method:

DCF is theoretically the most accurate method to value a company, it relies on future expectations of the cash flows rather than historical data which makes it less affected by the accounting figures and assumptions (Macabacus, 2013). The DCF method seek to value a company based on the Net Present Value of its future cash flows discounted at an appropriate discount rate (Steiger, 2008).

This is the used formula for determining NPV:

There is three different cash flows and everyone is related to a different discount rate as shown in the following table CASH FLOWS Free Cash Flow (FCF) Equity Cash Flow Debt Cash Flow APPROPRIATE DISCOUNT RATE Weighted Average Cost Of Capital (WACC) Required Return To Equity Required Return To Debt

The free cash flow is the amount of "cash not required for operations or reinvestment" (Brealey, Myers, & Allen, 2006).

Equity Cash Flow represents funds received from investors, a company could be valued by discounting this cash flow over the required return to equity.

8|Page The Debt Cash Flow is simply the sum of interests to be paid on all debts plus the principle repayments. This cash flow could be discounted on the Required Rate To Debt so it gives a value for the company.

One of the disadvantages of DCF is that it is very dependent on future expectations, which we all know is very difficult to be predicted, so the success of this method depends whether the future cash flows are correctly predicted or not. Another problem arise with this method which is that there are many subjective variables, with a slight change in these variables the whole valuation will change, for example any rate of return used to discount cash flows can vary greatly which affects this valuation (w3businessadvisors, 2012).

Internet companies valuation:

Before starting to apply any rule for internet company valuation, we have to look at the viability of the business in the future. you cannot rely that the business was making profits before, because in the past several years hundreds of internet companies appeared in the business selling same products and competing with one another. Showing your profits and revenue highly positive over the years is a very good indicator about the viability of the business. Any buyer will examine these numbers before making any purchase decision. While trying to value any internet business it is very important to arrive at an accurate profit number which will be very attractive to an investor. but how to calculate this valuation number? one of the best and accurate method is to add the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to the owners benefits and expected expenses in relation with this business; for example the owner's salary, the health insurance and any other personal expenses which are not visible in expense accounts. any non repetitive expense can also be added. in addition if there is any income that is not shown in the profit and loss statement should be added back to this number. The obtained result is a number that is typically very much larger than the company's Net Income or Net Profit shown in reality in its income statement or in the profit and loss statement.

9|Page this result when multiplied by a multiplier which reflect the company, will be the real selling price of this business (Salah, 2011).

Further explanation - If the business is still in early stage of growth and all of its revenues and profits are reinvested in the business to grow it, which will affect the profit and loss statement because it will be shown as an expense leading to a negative or low net income, but in reality this business may be the best investment a buyer can make. A one-time expense spent to grow a business might be considered for example the purchase of an inventory management software. The amount of this expense can be added back with an appropriate explanation (Salah, 2011).

Another point of view in valuing an internet company is the "relative valuation" method, which consist of valuing the company by looking at similiar internet fims and trying to price this firm according to the second one. But the big problem in this method is to find a truly comparable firm that can help you in your valuation (morison menon, 2010).

In case of a company trying to apply the income approach for valuation this is nearly impossible. It is very difficult for internet companies to use this method because it is built on the present value of the projected future income stream, and since the income statement is nearly impossible to predict of such companies which makes this method unused (morison menon, 2010).

Now going back to the traditional methods the best one to value an internet company is the DCF method. Most Dot-com companies have a major lack in historical data. This problem is easily solved by this method, because it only takes into consideration future cash flows. But its only difficulty is in forecasting these future cash flows. Main advantages of this method are that it avoids misinterpretations resulting from the accounting numbers and principles, it is independent from the current market evaluation and it also take into consideration future investment needs (Dariusz Zarzecki, 2011)

10 | P a g e

Valuation examples:

Valuation is very important and should be carefully done by only expertise people, because a wrong valuation may cause big problems for the company. For example in February,12, 2008 yahoo rejected a $44.6 billion bid from Microsoft claiming it was undervalued by this last one (but today this was consider one of yahoo's top ten mistakes, and now it is valued for $19 billion) (Robles, 2013).

Another example - In 2005 News Corp. decided after valuing "MySpace" to buy this last one for $580 million (this valuation used a multiple of 12 times turnover). In 2008 "MySpace" generated $1.2 billion which over doubles its value three years ago, so News corp. made a good choice by buying MySpace until 2008 (Whitwell, 2008). As we all know "MySpace" is an internet companies and as known internet companies are unpredictable, the can enjoy very high success and then a quick drop in their value. The newest and best technology is always one click away (Whitwell, 2008). In 2011 this quick drop caused News corp. to sell back "MySpace" for $35 million which is $545 million less than what it was bought six years ago. "MySpace" was one the best websites in the world, however "Facebook" has eclipsed "MySpace" in power which caused a huge decline in the popularity of this last one. This scenario became a lesson to whomever want to buy an internet company, to know how to value this company before making any step.

11 | P a g e

Conclusion:

To understand the true value of any company first of all requires to determine which valuation method is the best to be applied. For any business there should be a maximum of two methods to be applied, and they should be chosen after real understanding of the business and its underlying characteristics. Failing in determining the right valuation method can cause a highly inaccurate value of the business (Yahoo and MySpace) (Hayes Knight, 2010).

Finally I think valuing bricks and mortar companies is very possible leading to some real and accurate results, but I also think that it is nearly impossible or very difficult to value an internet company because we saw what happened to Yahoo and MySpace which are two enough examples that shows the difficulty of valuing internet companies.

12 | P a g e

Bibliography
1. ANDERS, M. (2006, october 19 thursday). Corporate finance forum, balance sheet method. 2. Brealey, R., Myers, S. C., & Allen, F. (2006). Principles of corporate finance. 3. Capital corp merchant banking. (2013). Retrieved april friday, 2013, from Capital corp merchant banking web site: http://infofunding.capitalcorpmerchantbanking.com/104web-news-Corporate-Tax-Forms.html 4. commonwealth bank. (2013). Retrieved april friday, 2013, from commbank.com.au: http://www.commbank.com.au/business/betterbusiness/leaving-a-business/how-much-isit-worth.html#topofpage 5. Dariusz Zarzecki. (2011, august 16). VALUING INTERNET COMPANIES. SELECTED ISSUES. poland. 6. Fernandez, P. (2007, february). company valuation methods. the most comon errors in valuation. barcelona. 7. Hayes Knight. (2010). Retrieved april friday, 2013, from Hayesknight.com.au: http://www.hayesknight.com.au/archives/277 8. Macabacus. (2013). Retrieved april sunday, 2013, from macabacus.com: http://www.macabacus.com/valuation/DCF/terminal-value.html 9. morison menon. (2010). Retrieved april 14, 2013, from morison menon/valuation of internet companies: http://www.morisonmenon.com/valuation_of_interent_companies.php 10. palepu, k. G., healy, p. M., & bernard, v. L. (2004). Business Analysis & Valuation. United States Of America. 11. Robles, P. (2013). econsultancy. Retrieved april 14, 2013, from econsultancy.com: http://econsultancy.com/lb/blog/9909-yahoo-s-ten-biggest-mistakes 12. Salah, M. (2011, may 24). Partical ecommerce. Retrieved april 14, 2013, from particalecommerce.com: http://www.practicalecommerce.com/blogs/post/840eCommerce-Business-Valuation

13 | P a g e 13. Steiger, F. (2008). The validity of company valuation using discounted cash flow methods. United States Of America. 14. Tracy, J. A. (august, 2006). Accounting Workbook For Dummies. united states. 15. Valuation of internet companies. (n.d.). global. 16. w3businessadvisors. (2012). Retrieved april 14, 2013, from w3businessadvisors: http://www.w3businessadvisors.com/internet-business-valuation-methods.php 17. Whitwell, S. (2008, march 3). Accounting web. Retrieved april 14, 2013, from intangiblebusines.com: http://www.intangiblebusiness.com/Brand-Services/Financialservices/Press-coverage/How-to-value-internet-companies~1063.html