Introduction
A company valuation is defined as a process of determining the economic value of a business or a company unit. The motivation behind the need to value a company might stem from the intention to sell it or from the desire to understand where it stands on the market. The latter enables a better insight into a business’s success and performance as well as its worth. On the other hand, the market value of a business is a critical piece of knowledge that should be informing investors’ decisions. For the last few decades, the approaches to company valuation have been evolving and improving in terms of precision and efficiency. This paper reviews the most commonly used methods toward company valuation as well as their advantages and disadvantages.
The logical question might arise as to exactly why company valuation is seen as a challenging process that has motivated the emergence of multiple methods and frameworks. Firstly, intangible assets can complicate the process of business valuation. Intangible assets such as intellectual property ranging from patents to trademarks and copyrights are notoriously difficult to assess (Massari, Gianfrate & Zanetti 2016). On top of that, there are valuation difficulties that come down to particular characteristics of a company being analyzed. For example, as explained by Hennessy (2017), cash-rich companies with a negligible amount of debt are harder to value than companies with fewer assets and higher borrowings. Hennessy (2017) opines that it is not exactly easy to predict how a company in the first case is intending to handle the cash. For large tech companies, it is typical to invest in challenger startups, which often results in a negative net rate of return (Hennesy, 2017). Lastly, there is always non-business-related risk such as adverse political and social events that affect markets.
Net Asset Value
At present, there are numerous established methods of a company valuation. This subsection focuses on four of them: net asset value, cash flow methods, price earning ratio, and Gordon (dividend growth) model. Net asset value (NAV) is a part of the asset-based approach to business valuation. The intuition behind this method lies in the difference between a company’s assets (example: buildings, vehicles, and equipment) and liabilities (example: debt). Therefore, for a fair assessment of a company’s market value, one needs to subtract later from the former.
The term NAV has gained traction with regard to the fund valuation and pricing, which is achieved through the division of the difference between assets and liabilities by the number of shares in the ownership of investors. This idea is expressed in the following formula: NAV = (Assets – Liabilities) / Total number of outstanding shares. By this logic, the fund’s NAV is reflective of the value of the fund on a per-share basis, which facilitates its use in valuation and transactions in the fund shares (Arjaliès et al. 2017). NAV is a powerful tool for identifying good investment opportunities within mutual funds and analyzing one’s investment portfolio.
For all its advantages, the NAV valuation method is not without certain drawbacks. It is not uncommon that upon valuation, NAV is going to be equal or close to the book value, taking depreciation into account. In this case, the book value might not be the same as the market or replacement value. Companies that have a lot of growth potential are likely to be undervalued by NAV (Rak-Młynarska & Skobelska, 2018). In the event of high inflation, previously bought stock might turn out to be significantly undervalued. On the contrary, due to the presence of uncollectible debt, NAV may lead to an overvaluation of a company. Lastly, NAV does not offer any straightforward ways of valuing intangible assets such as intellectual property, which, again, might lead to undervaluation.
The discounted cash flow (DCF) is a forward-looking approach that seeks to calculate future cash flows. The discounted cash flow is often contrasted with the payback period approach. The payback period is a capital management concept that defines a period that is necessary for a project or a company to generate revenue that will make for what has been initially invested at the start. The intuition behind the payback period is quite straightforward; however, its most significant drawback is its dismissal of the time value of money (Rak-Młynarska & Skobelska 2018). Firstly, a project’s cash inflow is not always regular. Besides, projects or businesses with great potential can be overlooked merely because they have a longer payback period. On top of that, the payback period method only emphasises liquidity as opposed to profitability: it only takes into account cash returns.
Price-to-Earnings Ratio
The price-to-earnings ratio, also commonly referred to as the P/E ratio, compares a company’s share price to its earnings on a per-share basis. To calculate a company’s P/E ratio, one must simply divide its price per share by its earnings: P/E = (market value per share)/ (earnings per share). Despite the seeming simplicity of the method, it requires an investor to make certain predictions based on a limited amount of information (McNeil, Frey & Embrechts, 2015). To retrieve the market value per share for a particular company, it suffices to consult any reliable finance website. On the contrary, the EPS (earnings per share) is a much more nebulous value.
Ghaeli (2017) opines that there are two ways to retrieve the value. Firstly, the metric can be found on the Internet with the notation “P/E (TTM).” The latter stands for “trailing 12 months” and is essentially a reflection of the company’s financial performance for the past year. Another way is to study the company’s earnings release as it contains its best-educated assessment of its future earning expectations. The interpretation of the P/E value is quite intuitive and straightforward: a lower ratio suggests that a company uses its resources wisely and manages to generate the maximum amount of profit. In turn, a higher ratio may mean that a company’s shares are overpriced: they do not have a return of investment (ROI) to match.
The P/E approach is often criticized for its crudeness and necessity to make sometimes unreasonable assumptions (Ghaeli, 2017). It relies on the idea that the market is rational: in other words, the market is always right, and it assigns fair prices to assets. However, there are many historical examples of market bubbles dating to as early as the 17th century when participants drove prices way above the assets’ actual value. Another limitation of the method is the use of information that becomes outdated quite fast. Typically, companies report their earnings quarterly, so figures that may be as old as three months may not be indicative of future success.
Discounted Cash Flow
The DCF tackles the main disadvantage of the payback period: it revolves around applying the time value of money. The key assumption of the time value of money is that an amount of money at disposal today can have a higher worth tomorrow because it can be invested. Building on this assumption, a DCF analysis is applicable in any situation when an individual paying in the present does so with an expectation to receive more in the future. Conducting a DCF analysis requires an estimation of future cash flows and the terminal value of the investment, equipment, or any other asset. The DCF model also implies the determination of an appropriate discount rate (an interest that a company has to pay on its debt), which may vary a lot. The formula for DCF is: DCF = CF1/(1+r)1 + CF2/(1+r)2 + CFn/(1+r)n where CF stands for the cash flow for the given year and r stands for the discount rate. The DCF model requires setting a horizon or a boundary of the time period on which future cash flows are projected.
Since the DCF seeks to calculate the intrinsic value of a company, it is a significantly more thorough method than the CCA and the cost-based approach. However, simply because it is superior to the first two does not mean that it is completely devoid of shortcomings. Probably, the greatest issue with the DCF model is the fact it requires making many assumptions (Pivorienė, 2017). The future cash flows, as well as the discount rate for the next few years, are hard to predict. If an investor is not able to estimate the key variables with a high degree of precision, it may render the entire model useless.
When it comes to assessing the intrinsic value of a company, two concepts may prove to be useful: NPV (net present value) and IRR (internal rate of return). Both of these measurements are applied to capital budgeting when companies determine the worth of a new investment or purchase (Pinto 2020). At that, net present value (NPV) denotes the difference between the present value of cash inflows and the present value of cash outflows for a particular time period. On the contrary, the internal rate of return (IRR) is used to evaluate the profitability of a potential investment.
The formula for the NPV is: NPV = CF1/(1+r)1 + CF2/(1+r)2 + CFn/(1+r)n – initial investment. Ideally, the projected future cash flows should be greater than the initial investment; in other words, the value of the NPV as per the formula above should be positive. A common variation of the NPV value is the PI (profitability index). Contrary to the NPV, the PI uses division on the same variables: PI = present value of future cash flows/ initial cost of investment. Obviously, a value above one is desirable as it denotes that a project is worthwhile. However, an investor might decide that the NPV alone is not enough to determine whether an investment is worthwhile. To gain a deeper insight, the NPV equation needs to be recalculated with the NPV factor set to zero and solved for the discount rate. The latter will signify the project’s rate of return (IRR).
Gordon Growth Model
The Gordon Growth Model (GGM) is a popular variant of the dividend discount model method. Its main use is for determining the intrinsic value of a stock based on the assumption that future dividends will be showing continuous growth. The model allows for solving its equation for the present value of the infinite series of successive dividends (Goedhart, Koller & Wessels 2015). Due to the model’s key assumption of the perpetuity of the growth rate, it is more appropriate for companies with a stable growth rate in dividends per share. The idea behind the Gordon Growth Model can be generalized in the following formula: P0 = D0 (1+g)/ (ke –g) = D1 / (ke –g). In this formula, P0 stands for current stock price, D1 – the value of next year’s dividends, ke – the return of return, and g – for the expected constant growth rate. If the value derived from this model is higher than the current stock price, it means that the stock is probably undervalued and worth investment.
Like any other model, the GGM has its own set of limitations. Firstly, it ignores the reality of the market and does not consider any prevailing conditions. The GGM simply assumes that a company will not be affected by business cycles and adverse events (Doshi, Kumar & Yerramilli, 2018). Besides, it is rather uncommon for companies to show constant growth, even if they are mature. The second problem lies in the relationship between the discount factor and the growth rate. If their difference is negative, then the model is practically useless. Alternatively, if the required rate of return is equal to the growth rate, the value per share approaches infinity.
Conclusion
The process of valuing private companies is arguably more complicated than that of publicly-traded companies. Regardless of whom the valuation is intended for, the process requires attention to minute details. It is often complicated by the fact that companies typically do not report their financials publicly, which subtracts from transparency and straightforwardness. Company valuation is challenging due to the unpredictability of both intrinsic and extrinsic factors. This paper addressed four common company valuation methods: net asset value, price earning ratio, discounted cash flow, and Gordon dividend growth model. All the analyzed methods are useful for evaluating a potentially good investment or critically revising one’s investment portfolio. Still, any model has its drawbacks, mainly because it either requires an investor to make assumptions about the future or fails to take into account all the factors that might inform the final decision.
Reference List
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