Determination of Firm’s Value

15th October 2021 1 By indiafreenotes

Investing decisions can be made based on simple analysis such as finding a company you like with a product you think will be in demand. The decision might not be based on scouring financial statements, but the reason for picking this type of company over another is still sound. Your underlying prediction is that the company will continue to produce and sell high-demand products, and thus will have cash flowing back into the business. The second and important part of the equation is that the company’s management knows where to spend this cash to continue operations. A third assumption is that all of these potential future cash flows are worth more today than the stock’s current price.

To place numbers into this idea, we could look at these potential cash flows from the operations and find what they are worth based on their present value. In order to determine the value of a firm, an investor must determine the present value of operating free cash flows. Of course, we need to find the cash flows before we can discount them to the present value.

A firm’s value, also known as Firm Value (FV), Enterprise Value (EV). It is an economic concept that reflects the value of a business. It is the value that a business is worthy of at a particular date. Theoretically, it is an amount that one needs to pay to buy/take over a business entity. Like an asset, the value of a firm can be determined on the basis of either book value or market value. But generally, it refers to the market value of a company. EV is a more comprehensive substitute for market capitalization and can be calculated by following more than one approach.

EV = market value of common equity + market value of preferred equity + market value of debt + minority interest – cash and investments.

Another sound approach towards computing the value of a firm is to determine the present value of its future operating free cash flows. The idea is to draw a comparison between two similar firms. By similar firms, we mean similar in size, same industry, etc. The firm whose present value of future operating cash flows is better than the other is more likely to attract higher valuation from the investors. Operating Free Cash Flow (OFCF) is calculated by adjusting the tax rate, adding back depreciation and deducting the amount of capital expenditure, working capital and changes in other assets from earnings before interest and taxes. The formula for computing OFCF is as below:

OFCF = EBIT (1-T) + Depreciation – CAPEX – working capital – any other assets

Where,

EBIT = Earnings before interest and taxes,

T = Tax rate

CAPEX = Capital expenditure

Calculating OFCF in such a way gives a more accurate picture of cash generating capabilities of a firm. Once OFCF is computed, one can use a suitable discount rate to find the present value of OFCF. On the basis of the sum of all the present value of future operating cash flows, one can decide on whether to take over a firm or not.

(a) Earnings based valuation

(i) Discounted Cash Flow/Free Cash Flow: Being the most common technique takes into consideration the future earnings of the business and hence the appropriate value depends on projected revenues and costs in future, expected capital outflows, number of years of projection, discounting rate and terminal value of business.

(ii) Cost to Create Approach: In this approach the cost for building up the business from scratch is taken into consideration and the purchase price is typically the cost plus a margin.

(iii) Capitalized Earning Method: The value of a business is estimated in the capitalized earnings method by capitalizing the net profits of the business of the current year or average of three years or a projected year at required rate of return.

(iv) Chop-Shop Method: This approach attempts to identify multi-industry companies that are undervalued and would have more value if separated from each other. In other words, as per this approach an attempt is made to buy assets below their replacement value.

(b) Market based valuation

(i) For Listed Companies: It is same as Capitalized Earning Method except that here the basis is taken earning of similar type of companies.

(ii) For Unlisted Companies: The basics of valuation for listed and unlisted company stay the same. Only thing that is limited with an unlisted company is the ready-made price market perceives for its equity etc. In such cases we need to carry out an exhaustive/ disciplined “Benchmarking Analysis” and identify the most applicable “normalized” median multiples for company under consideration.

(c) Asset based valuation

(i) Net Adjusted Asset Value or Economic Book Value: Valuation of a ‘going concern’ business by computed by adjusting the value of its all assets and liabilities to the fair market value. This method allows for valuation of goodwill, inventories, real estate, and other assets at their current market value. In other words, this method includes valuation of intangible assets and also allows assets to be adjusted to their current market value.

(ii) Intangible Asset Valuation: Acceptable methods for the valuation of identifiable intangible assets and intellectual property fall into three broad categories. They are market based, cost based, or based on estimates of past and future economic benefits.

(iii) Liquidation Value: This approach is similar to the book valuation method, except that the value of assets at liquidation are used instead of the book or market value of the assets. Using this approach, the liabilities of the business are deducted from the liquidation value of the assets to determine the liquidation value of the business. The overall value of a business using this method should be lower than a valuation reached using the standard book or adjusted book methods.