Valuation methodologies may broadly be classified into three main approaches, namely:
ឣ the market approach;
ឣ the income approach; and
ឣ the asset-based approach.
Earnings-based valuations
Earnings-based valuation methods are frequently used in practice and generally ascribe a value to a company by using a method that compares the subject business to similar businesses.
The method involves identifying the underlying maintainable earnings of the business and applying an appropriate price multiple. The method is thus straight- forward; the difficulties lie in determining underlying earnings and deciding on an appropriate multiple.
Issues to consider with regard to underlying earnings include deciding which earnings to use as a basis (historical, current or future) and whether any adjustments need to be made to the reported information in order to establish a true underlying and maintainable level of profitability.
The pro forma or underlying earnings upon which the valuation is based must consider the following: past results, which are important as they are factual and offer a solid platform to compare with current trading and forecasts for future trading; and forecasts, which are clearly relevant, particularly where significant profit growth is forecast and must be factored into the calculation.
Having determined a view on the underlying maintainable earnings, the second issue is what multiple to apply to those earnings. The most common multiple is the P/E ratio, and this is often used by brokers in determining value. In order to identify an appropriate P/E ratio to apply to the company under review, P/E ratios for compa- rable listed companies can be used as a basis for determining a multiple, although the difficulty with this approach is in finding comparable quoted companies. In the absence of comparable companies, sector average P/Es may be helpful.
Having identified a suitable comparable multiple, adjustments may be made to reflect the individual circumstances of the business in question. Such adjustments may include the need to reflect particular aspects of the business, including:
ឣ the size of the business;
ឣ the quality of the management team;
ឣ the growth prospects, and certainty of that growth;
ឣ the vulnerability of the business to outside forces;
ឣ other special factors such as dependency on contracts.
Other common measures of profitability that may be used in valuation calculations are PBIT (using profit before interest) and EBITDA (earnings before interest, tax, depreciation and amortization). EBITDA is becoming a more common measure of value on the basis that it ignores depreciation and amortization policy differences between businesses. Turnover multiples that assess the value of the business relative to turnover may also be considered. To the extent that these measures derive the enterprise value of the business, ie the value attributable to debt and equity in total, debt would need to be deducted to arrive at the value of equity.
Discounted cash flow
Discounted cash flow (DCF) techniques tend not to be as straightforward as earnings-based methods but they do look at the cash generated by business activ- ities, not reported earnings, and therefore as a basis for valuation are not subject to the vagaries of accounting policies.
The DCF method requires an estimate of the amount and timing of future cash flows. The cash flows are then discounted to present value with an appropriate risk- adjusted discount rate.
Discount rate factors often include general market rates of return at the valuation date, business risks associated with the industry in which the entity operates, and other risks specific to the asset being valued.
The discount rate is usually derived from the cost of debt and the cost of equity using a weighted average approach to give an overall weighted average cost of capital (WACC) discount rate.
The cost of equity (ke) for a company is commonly derived using the capital asset pricing model (CAPM), and the formula is as follows:
ke = rf + (× MRP) where:
rf = the return on long-term risk-free securities, normally taken as government securities;
= beta factor, which represents the volatility of comparable companies or the sector (and a value of 1 implies a level of risk typical of the market as a whole);
MRP = the premium added for market risk.
The cost of debt (kd) is found using the following formula:
kd = (rf + cs) × (1 – tax) where:
rf is as above;
cs = credit spread (the additional cost of borrowing for the company);
tax = the tax shield available to the company on its borrowing.
A company’s WACC is the result of applying the optimal gearing structure of the company to the cost of equity and cost of debt above. It is important to note that DCF calculation uses total cash flows and therefore debt must then be deducted to give a value for equity.
However, CAPM only allows for systematic risk, the risk associated with the market and macroeconomic factors, which is adjusted by beta. The greater risk of small-company shares may not be fully accounted and this may be adjusted through a small-company premium. Small-company premiums have been identified through studies examining the difference in returns between large companies and small companies.
The DCF method is useful, as it does focus on the cash generated by business activities, but it does require rigorous forecasting to be conducted for extended periods of typically between 5 and 10 years. In addition, the value is heavily influ- enced by the terminal value – the value at the end of the forecast period – which can be as much as 75 per cent of the total value.
Asset-based valuations
A business can be seen as a collection of assets, whose value is based on the company’s audited balance sheet. While an asset-based valuation may be appro- priate for an asset-based business such as a property company, for most companies it is largely irrelevant for the following reasons:
ឣ It is based on accounting policies, the choice of which may be subjective.
ឣ Accounts are drawn up on a going-concern basis; balance sheet values are not based on values that would be achieved in a break-up situation.
ឣ It may not deal adequately with intangible assets, particularly brand values, goodwill and intellectual property rights.
Publications such as the Investors Chronicledo compare a company’s share price to the value of the company’s underlying net assets, but the fact that the two valuations are usually quite different emphasizes the irrelevance, in most cases, of net asset value to a company’s market capitalization.
However, asset values can underpin the market value of a company, particularly if balance sheet values do not fully reflect the realizable value of certain assets. This may be relevant if a company has significant property assets that have not been revalued for a number of years.
A company’s assets are valuable to the extent that they enable the company to trade and to generate profits. Their value to a business is the value of the cash that those assets generate. For most investors, that cash flow takes the form of dividends.
As indicated above, there are certain types of business for which an asset-based valuation is appropriate. For a property company, whose value is represented by its underlying assets, an asset-based valuation is appropriate. A natural resource company, whether it is in production or simply exploring for oil, gas or minerals, may also be valued on the basis of actual or potential reserves.