BVX® Valuation Approach
BVX® uses Income Approach and Discounted Cash Flow (DCF) method. However, there are significant differences between BVX® and the traditional methods. They are :
- BVX® discounts actual cash flow to the investor,
- BVX® satisfies "willing seller" requirement of highest value,
- BVX® satisfies buyer objectives of return on investment, debt service-ability and debt-availability,
- BVX® valuation depends on deal structure, organization form and debt repayments schedule,
- BVX® does not use WACC (weighted average cost of capital), and
- BVX® does not use the capitalization formula (aka Gordon growth Model) to calculate the Terminal Value.
The theory of DCF requires that the DCF method be applied to the actual investor cash flow. In practice, traditional methods substitute earnings or free cash flow as a proxy for actual cash flow. And, even then, such earnings or free cash flow are determined using seller's capital structure or an assumed capital structure for the buyer, rather than using buyer's actual capital structure.
Determination of actual investor cash flow requires knowing buyer's post-acquisition capital structure, but buyer's post-acquisition capital structure cannot be known until one knows the value; and one does not know the value until one knows the actual investor cash flow. This is a circular problem that can only be solved through iterations as done by BVX® using Iterative DCF method (Iterative Discounted Cash Flow). In addition, BVX® simultaneously satisfies the "willing seller" objective of maximum value and "willing buyer" objective of achieving the targeted Return On Equity (ROE).
The Iterative DCF method starts by assuming an Enterprise Value (V) and buyer equity (E) for the transaction. These values when combined with all other user inputs, allow BVX® to calculate investor's actual cash flow from financial statements prepared using standard accounting methods. It then changes V and E until it converges on a combination of V and E that satisfies the seller objective of maximum price and the buyer objectives of ROE, debt-service and debt-availability. Investor's actual cash flow is the cash flow distributed to the investor, not the cash flow available to the investor. It is calculated after servicing debt principal and is distributed only if lending covenants permit. Investor's actual cash flow is discounted using buyer's expected ROE. This step is similar to Net Cash Flow to Equity method (NCFe); the difference between BVX® and NCFe is the calculation of cash flow and how Terminal Value is calculated.
BVX® calculates investor's actual cash flow based on actual post-acquisition capital structure, not based on seller's capital structure or industry capital structure. Cash flow is Net Income plus non-cash expenses minus principal amount of debt service, minus working capital change (net of new borrowing), and minus capital expenditure (net of new borrowing). Net Income is calculated after deducting interest on actual debt, goodwill amortization, personal goodwill amortization, depreciation on price allocated to the fixed assets and the chosen depreciation method, non-compete amortization, interest on new borrowings and depreciation on new capital assets. Cash flow calculation is adjusted for Asset vs. Stock purchase. Such cash flow, which is the cash flow after fulfilling all obligations, is distributed to the equity holder only if financial covenants allow dividend distribution. Otherwise, such cash flow is used to pre-pay debt obligations..
BVX® calculates Terminal Value at the end of the 5th year without using the capitalization formula (aka Gordon growth Model). There are three different ways to calculate the Terminal Value in BVX,
1) User supplies the exit EBITDA multiple. BVX multiplies this user-given exit multiple with the 5th year EBITDA to calculate the Terminal Value.
2) User can enter "PM" for exit EBITDA multiple. "PM" stands for Purchase Multiple, which is the Enterprise Value, divided by last year's EBITDA. This is a circular problem. But, BVX is able to handle it because BVX uses the iterative approach. Terminal Value is the 5th year EBITDA times the exit multiple, which in this case is equal to the Purchase Multiple.
3) BVX automatically determines the Terminal Value from the user-given perpetuity parameters. The perpetuity parameters are perpetual growth, perpetual return on equity (ROE) and perpetual EBITDA margin. Terminal Value is the PV of the equity cash flows starting in year-6. BVX calculates this PV, the Terminal Value, by a) using the perpetuity parameters, b) by leveraging the fact that price multiples are constant in perpetuity, and c) by assuming that all other parameters are the same as the one for year-1 through year-5. This approach eliminates the need to use WACC and the use of the Gordon Growth model.
BVX® does not discount the Terminal Value as calculated above. BVX discounts Net Proceeds to the equity holder, not the Terminal Value. Net Proceeds equal Terminal Value less outstanding debt, corporate taxes (if any), and closing expenses, plus an adjustment for basis change for single-tax entities.
As described earlier, BVX® does not use WACC, nor the capitalization formula.
Using WACC as a discount rate is theoretically wrong. It ignores debt repayment and overvalues businesses (see Limitations of the Traditional Methods). BVX® does not use the capitalization formula for many reasons; one of them being that it is not possible to satisfy the implicit assumption in the capitalization formula that the numerator will grow at a uniform rate if there are debt repayments, or if there are tax incentives like depreciation.
BVX® does not use any other formula or any market data. There are no inputs for industry codes or the type of the business. Even then, day after day users are reporting that BVX® results are exactly where the market clears a deal. BVX® indirectly captures the industry and the business type by capturing its balance sheet and the corresponding financing market. Value differential between industries and types of businesses arises due to their different balance sheet and its borrowing capacity.