Company Valuation Methods

Pablo Fernandez

University of Navarra – IESE Business School

Abstract:

In this paper, I describe the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods. The methods that are conceptually correct are those based on cash flow discounting. I briefly comment on other methods since – even though they are conceptually incorrect – they continue to be used frequently.

I also present a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value.

I finish the paper showing the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or teacher.

Company Valuation Methods: Introduction

For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite. This is not only because of the importance of valuation in acquisitions and mergers but also because the process of valuing the company and its business units helps identify sources of economic value creation and destruction within the company.

The methods for valuing companies can be classified in six groups:

Company Valuation Methods

In this chapter, we will briefly describe the four main groups comprising the most widely used company valuation methods. Each of these groups is discussed in a separate section: balance sheet-based methods (Section 2), income statement-based methods (Section 3), mixed methods (Section 4), and cash flow discounting-based methods (Section 5).1

Section 7 uses a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. Section 8 shows the methods most widely used by analysts for different types of industry.

The methods that are becoming increasingly popular (and are conceptually “correct”) are those based on cash flow discounting. These methods view the company as a cash flow generator and, therefore, assessable as a financial asset. I will briefly comment on other methods since -even though they are conceptually “incorrect”- they continue to be used frequently.

Section 12 contains the most common errors in valuations: a list that contains the most common errors that the author has detected in the more than one thousand valuations he has had access to in his capacity as business consultant or teacher.

1. Value and price. What purpose does a valuation serve?

Generally speaking, a company’s value is different for different buyers and it may also be different for the buyer and the seller.

Value should not be confused with price, which is the quantity agreed between the seller and the buyer in the sale of a company. This difference in a specific company’s value may be due to a multitude of reasons. For example, a large and technologically highly advanced foreign company wishes to buy a well-known national company in order to gain entry into the local market, using the reputation of the local brand. In this case, the foreign buyer will only value the brand but not the plant, machinery, etc. as it has more advanced assets of its own. However, the seller will give a very high value to its material resources, as they are able to continue producing. From the buyer’s viewpoint, the basic aim is to determine the maximum value it should be prepared to pay for what the company it wishes to buy is able to contribute. From the seller’s viewpoint, the aim is to ascertain what should be the minimum value at which it should accept the operation. These are the two figures that face each other across the table in a negotiation until a price is finally agreed on, which is usually somewhere between the two extremes2. A company may also have different values for different buyers due to economies of scale, economies of scope, or different perceptions about the industry and the company.

A valuation may be used for a wide range of purposes:

1. In company buying and selling operations. For the buyer, the valuation will tell him the highest price he should pay. Another valuation will tell the seller the lowest price at which he should sell.

2. Valuations of listed companies are used to compare the value obtained with the share’s price on the stock market and to decide whether to sell, buy or hold the shares. The valuations of several companies are used to decide the securities that the portfolio should concentrate on: those that seem to it to be undervalued by the market. They are also used to make comparisons between companies. For example, if an investor thinks that the future course of GE’s share price will be better than that of Amazon, he may buy GE shares and short-sell Amazon shares. With this position, he will gain provided that GE’s share price does better (rises more or falls less) than that of Amazon.

3. Public offerings. The valuation is used to justify the price at which the shares are offered to the public.

4. Inheritances and wills. The valuation is used to compare the shares’ value with that of the other assets.

5. Compensation schemes based on value creation. The valuation of a company or business unit is fundamental for quantifying the value creation attributable to the executives being assessed.

6. Identification of value drivers. The valuation of a company or business unit is fundamental for identifying and stratifying the main value drivers

7. Strategic decisions on the company’s continued existence. The valuation of a company or business unit is a prior step in the decision to continue in the business, sell, merge, milk, grow or buy other companies.

8. Strategic planning. The valuation of the company and the different business units is fundamental for deciding what products/business lines/countries/customers … to maintain grow or abandon. The valuation also provides a means for measuring the impact of the company’s possible policies and strategies on value creation and destruction.

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