Should I buy it?

What’s it worth?
Should I sell it?
 Example
Hardware World:
The seller wants UGX 20b
for this business.

You think you could get your

brother to manage the
business and you have
UGX 1b set aside to start Question:
a passive-income
generating business. What’s your valuation
of the business?
 If Positive,
+ Revenue then
Earnings=
NET PROFIT

Remainder =
Earnings
If Negative,
then
Earnings=
A NET LOSS

- Operating simplified - Taxes

look at a
Costs business
• When dealing with a real business, however,
those categories (revenue, operating costs, taxes)
get a bit more complicated.

• R&D costs?
• Depreciated assets?
• Competition? Patent Expiration?
• Product viability?
• Tax laws? Perhaps tax credits expiring?
• Prior to the instant gratification age of the
internet...
• Three methods of particular interest were:
– Multiple of Sales
– Net Present Value
– DCFROR (Discounted Cash Flow Rate of Return),
which is also known as the Internal Rate of Return
• This is by far the easiest method, and hence it’s
probably the most overused and abused one.

In essence, this method correlates the sales

(revenue) of a company to takeover prices, and
lumps them into sectors. Then, after enough data
is generated from takeovers, the multiple tends to
converge within the sector.

Downside????
• Annual cash flows for a business vary year to
year. Use of Net Present Value (NPV) makes it
possible to account for such fluctuations in
terms of the Present Values of these cash
flows.

• NPV = (sum of PV’s of cash inflow)-(sum of PV’s

of cash outflow)
• The NPV method focuses on the Time Value
of Money, which is the premise that a shilling
today is worth more than a shilling a year
from today.

• Some abbreviations we’ll need:

– PV = Present Value
– FV= Future Value
– i= Interest Rate
– n = number of interest compounding period
• Future Value (FV) of your money can be
mathematically determined as:

FV = PV * (1+i)n

For example, if you have UGX 1000 and you

put it in an account that pays 5% annually, in
three years, your money would be worth:

FV = 1000 * (1+0.05)3 = UGX 1157.63

• Present Value (PV) of your money can be
conversely determined as:

PV = FV / (1+i)n

You loan your buddy some money at an 11%

[inflation adjusted] interest rate. At the end of
three years, he is to pay you UGX 8000. What is
the present value of the loan?

PV = 8000 / (1+0.11)3 = UGX 5849.53

Example:
You deposit UGX 5000 into an account that
will pay you UGX 10,000 at the end of 5
years from now. Assuming a discount rate
of 10% (the interest your money COULD be
earning elsewhere), the

NPV = -5000 (cash outflow today) + 10000 /

(1+0.10)5 = -5000 +6209.21 = $1209.21
NPV gives you a baseline for the present value of
a company. If the PV of a company is equal to
$1 M, and the owners want to sell for $800k,
then should you buy it, the NPV of the
acquisition would be $200k.

Positive NPV is good because it projects positive

cash flow (sort of like passive income)
The Discounted Cash Flow Rate of Return is
Warren Buffet’s method of choice.

• Also known as Internal Rate of Return (IRR)

• While NPV is good as a starting point, DCFROR

allows potential buyers to determine the rate
of return that they can expect from the
acquisition.
Think of the IRR as the rate of growth
(profitability) that a project or acquisition is
expected to generate.

The larger the IRR, the better it is for the buyer.

Calculating the IRR is done by setting the NPV

equal to zero.
In other words, the IRR of an acquisition is
the discount rate at which the NPV of costs
(negative cash flows) of the acquisition equals
the NPV of the benefits (positive cash flows) of
the acquisition. That is why the NPV = 0.

It is the break-even rate. Mathematically:

Compare the following two investment options:

Project A Project B

Year Cash Flow Cash Flow Which one is

0 $-1000 $-1000 the better
1 500 100 investment?
2 400 200
3 200 200
4 200 400
5 100 700
Using IRR:
Option A
Project A Project B

Year Cash Flow Cash Flow

0 $-1000 $-1000 Option B

1 500 100
2 400 200
3 200 200
4 200 400
5 100 700
Valuation is a complicated matter. Because
valuation takes into consideration projected
worth, there is no single system that is
infallible.

Knowing good valuation

techniques will help you
avoid being swindled
Generally:
 The higher the IRR, the more desirable it would be
for a business acquisiton.

However:
 Use of IRR alone to determine profitability may be
misleading:
 Scenarios:
1. Low IRR, high NPV
2. IRR = , < or > cost of capital