Valuing the firm

A firm has no single objectively correct value. Its estimated worth depends on what is being valued, the purpose and date of the analysis, the method selected and assumptions about assets, cash flow, growth, risk and market comparability. Using several methods creates a reasoned range and reveals which assumptions drive it.

When to use it

• Estimate a defensible price for an acquisition or disposal.

• Assess or defend the value of your company in a potential transaction.

• Decide whether a quoted company appears overvalued or undervalued as an investor.

Origins

Merchants and investors have valued enterprises for as long as ownership interests have been exchanged. Early methods emphasised assets, profitability and cash generation. Present-value methods became more systematic as finance, insurance and actuarial science developed.

R. H. Parker wrote in 1968 that surviving interest-rate tables date to 1340 and are associated with Florentine merchant Francesco Balducci Pegolotti. Flemish mathematician Simon Stevin’s financial-mathematics text of 1582 set out an early form of the present-value rule. Modern valuation combines this discounting tradition with accounting analysis and market comparison.

What it is

Valuation interprets financial statements, forecasts and market evidence to estimate the economic worth of a business or its equity. Absolute methods derive value from the firm’s assets or expected cash flows. Relative methods infer value from prices paid for comparable companies or transactions.

Every result is conditional. Two competent analysts can reach different answers because they choose different forecasts, discount rates, terminal assumptions, comparator sets or adjustments. A useful valuation therefore presents the method, inputs, sensitivities and bridge from enterprise value to equity value.

How to use it

The central investor question is whether the firm’s market price is justified by its economics and risks. Four common approaches are:

1. Asset-based valuation: estimate the fair value of assets less liabilities.

1. Comparable-company or transaction valuation: apply market multiples from a relevant peer set.

1. Discounted cash flow: discount forecast free cash flow and terminal value at a risk-appropriate cost of capital.

1. Dividend discount model: discount the shareholder distributions expected from the company.

The worked example uses Luxury Desserts, a premium New York City dessert producer. Historical results cover 2011 to 2013, followed by a five-year forecast in thousands. Revenue and net income are expected to rise while net margin remains broadly stable. The balance sheet shows growing retained earnings and approximately half a million in cash. A peer set of dessert companies provides market comparisons, although Sunrise Treats is much larger than the others.

Asset-based valuation

This method restates assets and liabilities at an appropriate fair value and subtracts the latter from the former. It is especially informative for asset-intensive businesses, holding companies and liquidation scenarios. Book values may need adjustment for property, inventory, contingent liabilities and other items whose accounting amount differs from economic value.

Luxury Desserts: recent and projected income statements

Luxury Desserts reports total assets of $2,944,000 and liabilities of $505,000, giving net asset value of $2,440,000. Equating that amount with market equity produces a value just below $2.5 million.

The limitation is important: accounting statements often omit internally developed brands, customer relationships, workforce capability and growth options. An asset approach can therefore understate a profitable going concern, although it may overstate value when recorded assets cannot earn an adequate return.

Comparable transaction valuation

Relative valuation asks how the market prices similar businesses. The method resembles estimating a house from nearby sales, but finding truly comparable firms is difficult. Sector, size, growth, margin, geography, capital intensity and risk all affect the appropriate multiple.

Start with the closest operating peers, remove only clearly unsuitable outliers and calculate several relevant multiples. The illustration uses five comparators and an enterprise-value-to-EBITDA measure:

The analysis reports the average with and without the much larger Sunrise Treats. Applying those multiples to Luxury Desserts’ 2013 EBITDA of $713,000 produces the following range:

Depending on the peer set, estimated value is $3,206,000 or $4,275,000. Earnings and sales multiples can supplement EBITDA. The analyst should use the same enterprise or equity definition in numerator and denominator and adjust consistently for debt, cash and unusual items.

Discounted cash flow (DCF)

DCF values the operating business from the present value of the free cash it is expected to generate. Forecast unlevered free cash flow and discount it at the weighted average cost of capital, which reflects required returns for both debt and equity providers.

The example begins with EBITDA, subtracts depreciation and amortisation to obtain operating profit, calculates tax, then adds back the non-cash charge. Capital expenditure and investment in working capital are deducted to obtain unlevered free cash flow. Using a WACC of 17.58 per cent, the forecast-period cash flows have a present value of $1,406,000.

DCF must also capture value after the explicit forecast. Luxury Desserts is expected to continue beyond 2018, so the analysis estimates a terminal value. For cash flow through 2018, it assumes perpetual growth of 4.0 per cent and the same 17.58 per cent WACC. The general relationship uses the next period’s cash flow—current flow multiplied by (1 + growth)—divided by WACC less growth.

At the end of 2018, the calculation is based on 923 × (1 + 4.0 per cent) ÷ (17.58 per cent − 4.0 per cent), producing $7,064,500. Discounting $7,064,500 by 0.44 gives a terminal present value of $3,143,000. The 0.44 factor corresponds to 2018, the fifth-year endpoint. Adding the forecast cash-flow value of $1,406,000 and terminal value of $3,143,000 gives a DCF estimate of $4,548,900.

Because terminal value dominates many DCFs, small changes in growth or discount rate can move the answer substantially. The perpetual growth rate must remain economically plausible and below the discount rate.

Dividend discount model

This method values equity from cash distributions to shareholders. It best suits companies with dividends that reflect sustainable earning capacity and follow a predictable policy. It is less useful for firms that retain cash, repurchase shares irregularly or have unstable growth; a high-growth company such as Workday after its 2012 listing may create investor returns through capital appreciation rather than current dividends.

The Gordon growth form relates the next expected dividend to the cost of equity and perpetual dividend growth:

Value of stock = DPS1 ÷ (required equity return − perpetual growth)

Assume Luxury Desserts will distribute $400,000 annually and that dividends grow at 15 per cent in perpetuity. The example inputs and result are:

| Expected dividend one period from now 400 | |---------------------------------------------------| | Required rate of return for equity holders 26% | | Perpetual annual growth rate for the dividend 15% | | $3,636 |

Using unrounded values, the dividend model estimates $3,636,000.

The four methods therefore yield:

• Asset-based valuation: $2,440,000

• Comparable transaction valuation: $3,206,000 to $4,275,000

• Discounted cash flow: $4,548,900

• Dividend discount model: $3,636,000

The spread—from roughly $2 million to $4 million—is information, not a calculation failure. Reconcile why each method differs and consider intangible capability, customer loyalty, management quality, competitive entry, market volatility, control premiums, buyer synergies and seller motivation. A transaction price may exceed standalone financial value when a particular buyer can create additional benefits, but those synergies should be identified rather than assumed.

Top practical tip

Use several appropriate methods and reconcile the differences. Build sensitivity tables for the assumptions carrying the most weight, and keep enterprise value, equity value, debt, cash and transaction adjustments clearly separated.

Top pitfall

Do not present a model output as the “right” price. Forecasts, comparators, terminal growth and discount rates are judgements. A small plausible input change can move value materially, so show a range, challenge incentives and document the evidence behind each assumption.

Further reading

• Damodaran, A. (twenty twelve). Investment Valuation. Wiley.
• Koller, T., Goedhart, M. and Wessels, D. (twenty twenty). Valuation: Measuring and Managing the Value of Companies. Wiley.