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.
2. Comparable-company or transaction valuation: apply market multiples from a relevant peer set.
3. Discounted cash flow: discount forecast free cash flow and terminal value at a risk-appropriate cost of capital.
4. 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