A business unit must conduct its valuation as a stand-alone entity. The primary reason is that business value is the most critical performance parameter, which the business unit manager must own, empower, and maximize. In addition, a transparent valuation as a stand-alone business facilitates alignment with the corporation’s CEO. Finally, a stand-alone valuation offers the ability to protect the business against activist shareholders and respond quickly.
STAND-ALONE VALUATION
The discounted cash flow (DCF) method is the standard framework for valuing a business. Because the business unit is deeply interlaced with the corporation, valuing the entity as a stand-alone requires adjustments to separate the business from the corporation before conducting the DCF calculation.
- Corporate overhead allocation. Corporate overhead comprises the costs incurred by the corporate center to provide administrative services to the businesses, including payroll, accounting, auditing, legal, compliance, and human resources. These overhead costs should be allocated by activity. Corporate overhead costs also include the compensation of the corporate C-level executives and support staff. These costs should not be allocated to the business and valued separately as corporate cost.
- Invested capital. Invested capital comprises the operating assets of the business. They include total assets minus current liabilities, including cash, accounts payable, short-term debt, notes payable, and income taxes owed. The business’s total assets are a known quantity available at the business level. For companies that hold current liabilities at the corporate level, allocate current liabilities by revenue or total assets.
- Discount rate. Estimating the weighted average cost of capital for the business is essential because the systematic risk is specific to the business segment, not the corporation. Estimating the cost of capital requires three steps. The first is to denature the corporation’s capital structure from the business so as not to impose overburdened debt. This is done by using the median capital structure of its peers. The second step is to calculate the un-levered beta of the business. This is done by using the average un-levered beta of the peer group. The third step is to re-lever the beta with the new D/E ratio and calculate the discount rate.
- Other. Companies with inter-business transactions, pension obligations, operating leases, restructuring charges, and other non-operating items need more advanced adjustment methods.
With these adjustments in place, the valuation of the business becomes a straightforward DCF calculation.
CONCLUSION
The stand-alone value of the business represents how much it is worth if it were a separate entity from the corporation. For a company with many businesses, stand-alone valuation is instrumental. At a minimum, it allows comparing the corporate value to the sum of its parts and tracking corporate performance vs. business performance. Beyond that, it provides the analytical basis for insights into where and how the business and the corporation generate value together and apart for potential strategic action and value improvement.
