The Value of a Business: What Value Is, How Value is Created, and How Value is Measured

8/14/2019 The Value of a Business: What Value Is, How Value is Created, and How Value is Measured

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The Value of a Business:What Value is, How Value is Created, and How Value is Measured

George C Currie

Introduction

Value is one of the most basic concepts in economics, philosophy, ethics and

sociology, yet is perhaps one of the least well-defined and most misunderstood

(Trotta 2003). This paper examines three main aspects of value as it may apply in

the business arena. It firstly provides a definition of value for business. It then

describes the how a company creates value, and the operational, financial, and

corporate governance issues involved. The paper finally introduces the main

approaches and associated methods by which the value of the company can be

measured.

What is value?

It is not only true (if somewhat trite) to say that value means different things to

different people, it is also necessary to recognize that value is dynamic, and that the

same persons definition or interpretation of value varies according to changingcircumstances. The first step in exploring value must therefore be to identify the

purpose and limits of our definition of value.

Throughout this paper the definition of value will be limited to its business sense.

British Standard BS EN 1325-1: 1997: Value management, value analysis, functional

analysis vocabulary, defines value as:

The relationship between the contribution of the function (or VA

subject) to the satisfaction of the need and the cost of the function.

This relationship is commonly represented as:

Value =Satisfaction of Needs

Cost


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This definition applies not only to the value of the firms products or services to its

customers, but also the value those sales create for the company, and through the

cash flow created from them, of the firm to its owners.

The primary function of business is to sell a product or service to a customer, since

without that transaction none of the other functions of the business create value for

its owners. At this individual transaction level, the customer has needs which he

expects the product or service to satisfy, and the firm is in business to produce a

product or deliver a service and offers this to the customer at a price. The selling

price either set or negotiated for this transaction is the buyers cost of the satisfaction

of his need. In our definition, the value of the product or service to the buyer is the

benefit the buyer expects to obtain from it divided by its cost, and unless this is

perceived to be greater than unity (i.e. the perceived or expected benefits exceed the

selling price), there will be no sale. One of the main functions of the companys

management is to ensure that either the selling price of the product is kept low

enough, or its benefits as perceived by the target market are high enough, that it has

sufficient value in the eyes of the buyer to ensure the sale.

The expected benefits (and hence the value) that the buyer expects to obtain are

however in most cases complex, and stem from either or both of the two

components of value identified by classical economics; value-in-use and value-in-

exchange (Smith 1776), together with the more modern concept of esteem-value.

All three of these components however, to a greater or lesser degree include a

subjective element. Esteem-value is the buyers internal answer to the question

How much do I want it? (SAVE 1998), and represents the amount he is willing to

pay for the perceived properties of a product or service which contribute to its

desirability in his eyes. As such it is almost entirely subjective in nature. Value-in-

exchange depends on the collective agreement of a society as to what the relative

value of things are, which varies - both over time as societal mores alter, and from

place to place between societies, and hence in any particular transaction depends

not only upon the personal circumstances and preferences of the buyer, but also on

how he may anticipate these may change or how society may come to view the

object in question. Even the direct benefit that the individual may obtain from the useof the object or service may change over time (and sometimes dramatically and over


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a short period of time) depending upon the particular circumstance 1. These

variations affect the benefit that any particular individual perceives he would gain

from the ownership of the object or receipt of the service, and hence his perception

of its value-in-use at the sellers price. When considering an individual object or

service, its value therefore lies in the eye of the buyer and, although the price in a

transaction may be set by the seller, value may only be determined by the buyer

according to his individual circumstances, preferences and expectations (Tucker

2002).

Assuming that the business has a viable product or service to offer to the market,

and that at least some of its target market perceive this to have value, the firm will

make sales and generate revenues. Each and every product or service sold by the

firm throughout its life thus makes some contribution to the cash that may be

distributed amongst the firms owners once it has paid all its costs and taxes. It is the

anticipated existence of this cash flow from future sales that creates the value of the

firm to its owners. The intrinsic value of the business is therefore the sum of its

expected future after-tax cash flows (i.e. the revenues expected to be generated

from its sales less the cost of the assets and other inputs used in their creation, and

of the business entity itself), adjusted by a discount rate that appropriately reflects

the relevant risk of the business, its products and its markets (McCarthy 2004).

For privately-held businesses, their shareholder value is equal to the intrinsic value,

however for publicly-listed companies their shareholder value is determined by the

capital market in which the shares are traded, and the company has a fluctuating

market value which is simply the share price at any time multiplied by the number

of shares outstanding at that time. In a perfect capital market, i.e. one where all

information is immediately reflected in the share price of the company, the market

value (and hence the shareholder value) equals the intrinsic value. In real life

however, the two may differ (in some cases markedly), either due to inefficiencies

1 For example, an adventurous traveler whose boat develops a serious leak when crossing acrocodile- infested river will not place any value on the water which threatens to sink him, but wouldpay almost unlimited amounts for fuel to run his boats pump to keep him afloat until he can berescued or make it safely to shore. Conversely, the same adventurer whose 4WD breaks down when

traversing a sandy desert later in his travels will value the extra fuel he carries far less than he woulda supply of drinking water. The same two products, being employed by the same person, but havingdifferent values at different times due to different external circumstances.


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where the companys shares are traded in a small or illiquid capital market or, more

commonly in large capital markets such as those of the United States or Europe, due

to poor dissemination to the market of information affecting the intrinsic value. Whilst

these larger and more liquid capital markets may not always be efficient on an

absolute scale, at any given moment they are the most efficient reflection of what

the most likely future development could be, given the information available at that

time (Berendes, et al. 2001).

How Is Value Created?

The fundamental objective of the business corporation is to increase the value of its

shareholders investment (Rappaport 1986), particularly in Anglo-Saxon economies

such as the United States, the UK and Australia 1. From the definition of shareholder

value and the caveat on how the companys share price may or may not correctly

reflect its intrinsic value given above, it is apparent that increases of market value

happen when the companys management:

a. Increases the intrinsic value of the company; AND

b. Communicates and signals with the capital markets to ensure that they

appreciate and reflect the intrinsic value in the share price.

Shareholder value is added when the resulting increase in market value exceeds net

capital inflows (i.e. new share issues and/or a conversion of convertible debentures)

less payments to shareholders in the form of dividends or share buy-backs on the

market in the period. Shareholder value is created when the shareholder value

added exceeds the required return to equity, i.e. the return that shareholders expect

to earn in order to feel sufficiently remunerated for the risk they have taken

(Fernndez 2002).

As the intrinsic value of the company is the sum of its future net after-tax cash flows

discounted at a rate to reflect their uncertainty or risk (as so far as this is perceived

by its investors and debtholders), it can be increased by improving one or more of

1 In other countries, such as France, Germany and those in Scandinavia, the companys managementmay be required (or at least expected) to take into account the interests of its other stakeholders, andin particular its employees. It has been demonstrated however, that maximizing the value of the

company for its shareholders not only serves their interests but also the economic interests of allstakeholders over time (McTaggart and Kontes 1993), (Copeland, Koller and Murrin 2000) &(Berendes, et al. 2001).


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three main variables: the cash flows deriving from the companys existing assets; the

expected rate and duration of growth in its cash flows; and the cost of its capital

(Damodaran 2001). The companys intrinsic value is increased when its

management (at the corporate or business unit level) takes actions which

proportionately increase one (or preferably both) of the first two or decrease the last

one.

Increasing Cash Flows from Existing Assets

Since the cash flow from existing assets derives from income from investments

already made by the company, it is most likely to be the prime source of immediate

improvement in intrinsic value. Such improvements may involve one or more of the

following:

improving operating efficiencies;

divesting or liquidating investments that are earning less than the companys

cost of capital (and hence are destroying, rather than creating, value);

reducing the companys tax burden;

reducing net capital expenditures on existing assets; and

reducing noncash working capital

Improving Operating Efficiencies

Improving operating efficiencies increases the operating margin on existing assets,

and hence generates additional value. Although promoters of business process re-

engineering will normally argue that all businesses have the potential to improve

operating efficiencies, these opportunities are particularly marked where the firms

operating margins are well below those of its competitors. The key issue for the

companys management is to identify the source of the inefficiencies in the existing

business and how to fix it without sacrificing the companys future growth.

Below-average operating margins may signify that the firm is attempting to compete

for customer sales on the basis of its selling prices (i.e. achieve a cost-leadership

position) but has failed to optimize its cost structure, or alternatively that it is

attempting to follow a differentiation strategy, but is failing to demonstrate the

additional benefits of its product or service to its target market, hence reducing its


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pricing power and margin. In either case, by identifying the source and reasons for

the low operating margin, the business-specific value drivers required to bring about

its improvement can be identified and suitable actions developed. These may be

either revenue-side (allowing the company to generate incremental revenues in

excess of related expense and investment), or expense-side ones focussed on

decreasing costs or making operational efficiencies (Clark and Neill 2001). Generally,

firms following a differentiation strategy may be expected to focus on revenue-side

initiatives to increase operating margins whilst those aiming for a cost leadership role

may generally be expected to concentrate on expense-side ones.

Typical revenue-side initiatives may involve additional marketing research and

promotional activities to improve customer segmentation and create awareness of

the additional product benefits in the target market, or the introduction of a customer

relationship management (CRM) system in order to allow the company to develop

customer-specific value propositions to identify the total value created by the

sale/purchase transaction and obtain a higher proportion of this over the life of the

market, particularly by maximizing customer retention (Payne 2004). Expense-side

initiatives, such as business process re-engineering, are aimed at identifying and

removing extraneous costs from the entire value system for the production or

delivery of the firms product or service, however in order to increase shareholder

value it is essential that these do not involve cutting back on current expenditures

(such as marketing or R&D) to the detriment of future growth and revenues. In either

case, whether revenue-side or expense-side measures are adopted, in order to

increase intrinsic value by improving operating margins it is essential that the correct

cost management and/or pricing strategy is identified. Measures aimed at increasing

revenues and/or reducing costs may, due to their effect on the existing balance of the

market, actually adversely affect sales growth, and hence lead to reduced market

share and/or product life. Increased product differentiation, for example, whilst

affording the opportunity for higher selling prices and margins, generally does so

only at the cost of reducing the size of the potential market. In more monopolistic

markets, increasing the selling price of its product to increase revenues reduces the

value of the product to its buyers and, depending upon their price-sensitivity for the

item in question, may lead to lower sales over time as substitutes are identified andadopted, and hence may actually reduce revenues over the products life (Docters,


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et al. 2004). Alternatively, if the market demonstrates price-inelasticity the higher

selling price available may increase the attractiveness of the market and precipitate

the entry of more competitors, reducing the firms pricing power and margins

(Copeland, Koller and Murrin 2000).

Asset Divestment

Where the company has investments tied up in assets that are earning less that its

cost of capital, then its value can be increased by divesting itself of these drags on

its finances, provided that the sale or scrap value realized from the disposal is

greater than the continuing value (i.e. the present value of the cash flows that will

derive from operating the asset through its remaining life). Where the continuing

value exceeds the value that would flow from liquidation or disposal of the asset,

then its value to the firm is maximised by continuing to operate the asset as a going

concern, irrespective of whether the cash flows exceed the cost of capital

(Damodaran 2001). This is particularly relevant in the case of project-financed or

structured-financed assets, where their loans are secured alternatively against the

asset itself or the cash flows generated from its use. Events in these markets over

the past few years have shown lenders even prepared to take over assets and

operate them themselves to allow the business (if not its original owners) to continue

as a going concern rather than selling them at their liquidation value in a depressed

market.

Reduce the tax burden

Since the intrinsic value of the firm derives from its after-tax cash flows, for any given

level of operating revenue the firms value may increase in proportion to any

reduction achieved in the tax payable. The companys management may reduce its

tax burden by:

transferring its income generation to lower-tax (or even no-tax) locations, often

by manipulation of the internal pricing for the supply or consumption of internal

products and/or services within the company;

acquiring net operating losses through the purchase of loss-making

businesses; and/or


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smoothing income to avoid exposure to higher tax rates in periods of

exceptional performance.

As will be discussed later, the firms choice of financing also affects its tax burdensince interest paid on debt is a tax-deductible expense under most regimes, whereas

the returns to equity holders for their financing of the firm are not. The tax burden

can therefore be reduced by substituting debt for equity in the financing mix.

Reduce maintenance capital expenditure

Net capital expenditure consists of two component parts; investment in new assets

designed to generate future growth, and expenditure on maintaining existing assets

in order to keep them productive. As with most management issues however, using

this lever to increase shareholder value must be done with the utmost care. Though

current cash flows can be increased by reducing or eliminating capital maintenance

expenditures, this may actually reduce the intrinsic value if it means that the

productive output of the asset is adversely affected (which may be in terms of the

quantity and/or quality of its product), its working life and/or residual value is

reduced, and/or it leads to higher maintenance costs being incurred in the future.

Reduce noncash working capital

Noncash working capital is the difference between the firms noncash current assets,

(primarily consisting of its inventory and accounts receivable) and the nondebt

portion of its current liabilities (primarily its accounts payable) (Damodaran 2001).

Since decreases in noncash working capital show up as cash inflows, improving

cash flow management in the firm to reduce its noncash working capital requirement

as a proportion of its revenues will increase its intrinsic value provided it is done in a

way that does not impair the productivity of existing assets or jeopardize future

growth.

Reduction in inventory, for example, decreases noncash current assets (and hence

noncash working capital) and thus might reasonably be expected to increase

shareholder value. It may however actually destroy value instead, if it leads to

shortages of raw materials or spare parts, adversely impacting production efficiency


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and hence reducing the productivity of its existing assets. Similarly, attempting to

decrease noncash working capital by increasing accounts payable (i.e. by delaying

payments to suppliers) may often mean that the prices charged to the firm by its

suppliers will increase, or that the suppliers may give the firm lower priority during

periods of high demand from its competitors. The former clearly impacts the net cash

flows that the firm may generate unless it is able to pass these increased costs

through to its own customers without affecting the size of its market, whilst the latter

may reduce shareholder value if the non-availability of supplies jeopardizes (or is

perceived to jeopardize) its ability to serve its customers and to defend its market

share in profitable sectors (Harris and Goodman 2001). Either or both of these

responses from others in its value system to the firms attempt to decrease its

noncash working capital requirements would therefore result in shareholder value

being lost rather than gained. Cash management improvements targeting reduction

in accounts receivable, by contrast, are likely to have a direct and lasting positive

impact on shareholder value.

Rate and Duration of Growth

A significant component (and in many cases, particularly for industries and

companies that are based more on intangible assets, the overwhelming one) of a

firms value is the markets expectation for its growth. This future growth value

(Stern and Hutchinson 2004) accounts for around 16 per cent of the value of

consumer durables companies, rising to 137 per cent for technology hardware and

equipment ones, and an average of 58 per cent for the US stock market as a whole

(Ballow, Burgman and Molnar 2004). Although improvements to the cash flows

deriving from the current assets of the firm are generally the most immediate source

of increase of intrinsic value, in many cases the fruitful source of more long-lasting

improvement lies in increasing the potential rate and/or duration of future growth.

The key issue relating to growth is to grow only where the return on capital is greater

than its cost, i.e. economic profit is positive, since the alternative destroys rather than

creates value (McCarthy 2004). Identifying the type or source of future growth is

therefore of critical importance to allowing the firms management to take correct

strategic investment decisions aimed at increasing its intrinsic value. Where a firmhas profitable investments and reinvestment opportunities (i.e. those generating


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returns above its cost of capital), value is increased either by increasing the

reinvestment rate, and hence foregoing more of the free cash flow generated by the

existing assets in order to finance expansion in capacity, or by reinvesting its free

cash flow in projects or markets offering higher rates of return at the same cost of

capital. Even firms that are presently losing money however (those in the new

economy of the internet for example) may still create shareholder value from their

growth rate in revenues and the improvement this yields to their sales-to-capital ratio

provided this can be achieved without adversely affecting the operating margin

excessively (Damodaran 2001). The key in these cases is to identify the relationship

between these three variables, and to establish what, if any, improvement in intrinsic

value will be achieved by any strategy affecting these (noting that strong linkages

may exist between the three).

One of the key drivers of a companys future growth, particularly in determining its

duration by establishing and maintaining barriers to entry to prevent competitors from

entering the market space it occupies in the minds of its customers, is its intangible

assets, such as intellectual property, corporate and brand integrity, customer loyalty,

the skills and knowledge of its workforce, and its leadership capabilities (Sussland

2001). This is particularly true of new-economy and services-based firms, where

tangible assets like buildings and equipment are largely peripheral to their revenue

generation. In light of this it is essential to the long-term value of the company for its

management to be able to balance operations decisions, which tend to show

immediate (or at least relatively rapid) impact on the bottom-line, with its investment

in (and eventual returns from) its intangible assets. Failure to invest sufficiently in

intangible assets such as R&D or employee training, in an attempt to improve short-

term performance measures may jeopardize the long-term revenues, or even

viability, of the business (Sussland 2001).

A key feature of value particular to firms is that, in general, they are entities having

no fixed life and which are expected by their investors to exist (and provide returns)

in perpetuity 1. Growth and longevity of the existing business unit however, is finally

1 The Special Purpose Vehicle, or SPV, commonly adopted in project finance structures is an

exception to this requirement of the company to continuously reinvent itself, since these are createdwith the express purpose of investing in a single capital asset with a single purpose and generally witha limited life (Esty 2003).


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determined by the size and life-span of the market for its particular products or

services, and further growth beyond those external constraints must come from

expansion of the range of the companys business activities, either in terms of the

products or services offered, or the geographical markets served. Diversification is

therefore necessary to maintain and regenerate the companys rate and duration of

growth and hence create value over the long term, as the company must find new

businesses or markets to compensate for the normal decline of prospects for

creating value in its existing ones. The key to creating rather than destroying

shareholder value by such diversification lies in understanding the companys core

competencies and ensuring that the investment is in related industries and/or

markets where these may also apply. The capital markets generally reward

diversification into related or complementary markets but discount those which

appear unrelated to the existing businesses or skills. Total returns to shareholders of

the former may exceed even those of focussed companies whereas the capital

markets tend to discourage fully diversified companies (Harper 2002). This is

particularly true in cases of diversification through acquisitions, where unless there

are strong synergies, the value inherent in the deal more commonly flows to the

shareholder of the acquired company rather than to those of the buyer.

Cost of Capital

The cost of capital for a firm is a composite (usually a weighted average) of the cost

of its debt and that inherent in its equity. Since the intrinsic value is the sum of the

future cash flows discounted to the present at the firms cost of capital, it can be

increased by reducing this denominator. This may be achieved by:

changing the operating risk, for example by strengthening the brand image

and market positioning so as to make its market less discretionary;

reducing the operating leverage by reducing the proportion of fixed costs

(although it is imperative to note that no long term competitive advantage can

derive from any non-proprietary service or material, and so management must

ensure that the use of subcontracting or outsourcing does not diminish

margins or growth in the long-term);

changing the financing mix; and/or


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changing the financing type

(Damodaran 2001)

Substituting debt for equity in the capital structure of the firm can give rise to anincrease in value for two main reasons. The first is that the nominal cost of debt is

less than the current cost of equity; thus the shareholders expected return on their

equity can be increased by the use of debt, however the cost of debt increases as

the proportion of debt in the financing mix increases due to the increased risk to the

lender of the company being unable to service the loan, and the companys

managers must determine what this cost of debt will be for different amounts of debt.

Also, the equity return requirements must be determined since the cost of equity

capital will also change as the percentage of debt capital is changed. Only having

established both of these variables can the optimum mix of debt and equity for the

firm be determined.

The second reason for using debt is based on the tax law that allows debt interest to

be tax deductions, but recognizes no tax deduction for the return on an equity

security. The tax deductibility of interest can add significantly to the value of a firm

with the amount of value added depending on the corporate income before tax, the

corporate tax rate, and the amount of new debt. The investor tax rates also affect the

analysis.

The companys cost of capital is also dependent on its market value (directly in the

case of its equity and, in most cases, to a somewhat lesser extent for its debt) and

hence its managements financing decisions are inexorably linked with the need to

properly signal and communicate its intrinsic value to the capital markets.

Signalling and Communications with Capital Markets

The "returns" that investors receive consist of dividends and realized market

appreciation. If the markets expectations of the firms results or other performance

metrics are too high, and that later becomes clear, the market value of the firm will

drop. Good communication with the investment community, both of the companys

plans and expectations and of its results, and the reason for any variance, is


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therefore essential for a company, not only to reduce its cost of capital and hence

increase its intrinsic value, but also to increase its market value directly and hence

the returns available to its shareholders. The key issue involved is how the company

and its management are perceived by the capital markets and the effect that this

perception has on investors expectations of its future performance, and so

shareholder returns are correlated with the quality of investor relations (as judged by

the quality of annual reports, analyst conferences and other investor events)

(Berendes, et al. 2001).

Summary on How Value Is Created

In order for shareholder value to be created the companys management has to:

1) produce continuous earnings flow through its operational decisions;

2) invest wisely for future growth; and

3) communicate with the investment community proactively and reliably.

The environment within which the company must do so is complex and dynamic, and

there is a dichotomy between the interests of the companys shareholders on the

one part and those of its customers, suppliers, host governments, and other

stakeholders (including its management) on the other (McCarthy 2004). Increased

shareholder value only occurs where the company is able to capture a

proportionately higher share of the total value produced in the value system for its

existing product, and hence one or more of the other stakeholders must be left with a

proportionately smaller share (even though, in a growing market, the amount itself

may have increased). Most importantly many of the measures available to increase

value rely on management achieving a balance between short term results and long

term performance, and it is therefore imperative, particularly for publicly-listed

companies, to ensure that the metrics used to monitor and reward the

managements performance includes both long-term and short-term components

designed so as to properly align their interests with those of the shareholders to

maximize the shareholder value of the business from its long term performance and

not simply to attempt to manipulate the share price for short-term personal gain.

Measuring Value


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It is important to recognise that, as value is subjective and is based on the

expectations of individuals (acting singly as buyers, sellers or holders of the firms

shares) of future returns, cost and risk, we cannot measure it in the strict sense.

There are exact methods of calculation, but there are no exact measures of value

and the various valuation methods, all of which involve a subjective element, are

correctly seen as providing an estimate of the value of a firm. These methods can be

considered in three groups according to their basic approach; the Asset Approach,

the Income Approach, and the Market Approach (Evans 2002), with two or more

specific valuation techniques or methods falling under each of these approaches

(Abrams 2005).

Asset Approach

The Asset Approach is predicated on the assumption that the value of the firm lies in

its tangible assets, and seeks to measure value through the calculation of assets net

of liabilities. The methods within this approach are essentially the traditional

accounting measures (book value, adjusted book value, liquidation value and

substantial value), which derive their foundation from an industrial age model that is

increasingly removed and lacking in relevance with todays businesses and ignore

the fundamental variables required to add economic value to the firm: free cash

flows investment horizon, and risk (Morin and Jarrell 2001). Most significantly these

traditional accounting metrics are primarily backward looking, and fail to reflect the

major drivers of future cash flows and hence of the firms value - in particular (and

most glaringly) its intangible assets (Howell 2002).

Income Approach

The Income Approach consists of methods of fundamental valuation, which aim to

directly estimate the intrinsic value of the firm or its equity, with the assumption that

markets are, at least in the long run, efficient and hence the market price will reflect

intrinsic value. These methods can be further divided into two main types: (i) those

involving discounting estimates of future cash flows to the firm or to its shareholders,

and (ii) those applying option pricing techniques to estimate its value. Selection of

the correct valuation method depends upon the form of growth opportunities

available to the firm, with the latter type being more suitable in situations where its


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growth opportunities are dependent upon some form of contingent decision (Amram

2002).

Discounted Cash Flow (DCF) Methods

The main forms of discounted cash flow valuation are:

the enterprise DCF model;

the economic profit model;

the equity DCF model; and

the adjusted present value (APV) model

(Copeland, Koller and Murrin 2000)

While all four approaches discount expected cash flows and, when correctly applied,

both DCF and economic profit models will yield equivalent results of the firms value

(Shrieves and Wachowicz 2001), the relevant cash flows and discount rates are

different under each, and it is important when applying DCF methods to ensure that

the cash flows and discount rates used are consistent throughout (Fernndez 2003).

All DCF methods share common problems in (i) forecasting the expected cash flows

for the firm; and (ii) predicting the right discount rate(s) that will be applicable to

these future cash flows. Given these informational requirements, this approach is

easiest to use for assets (firms) whose cash flows are currently positive and can be

estimated with some reliability for future periods, and where a proxy for risk that can

be used to obtain discount rates is available. The further the firm being valued

deviates from this idealized setting, the more difficult (and possibly unsuitable)

discounted cash flow valuation becomes. Particular difficulties with DCF methods are

faced when applied in the following cases (Damodaran 2002):

Firms in trouble with negative earnings and cash flows . For these firms,

estimating future cash flows is difficult to do, since there is a higher probability

of bankruptcy. DCF valuation methods are not well suited to firms which may

be expected to fail, since the fundamental premise of these methods is that the

firm will provide positive cash flows to its investors.


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Cyclical Firms: The earnings and cash flows of cyclical firms tend to follow the

economy - rising during economic booms and falling during recessions. If

viewed during the low part of the cycle a cyclical firm may look like a troubled

one, with negative earnings and cash flows. Two alternative techniques are

used to apply DCF valuation methods to such firms, either expected future

cash flows are smoothed out, or the analyst attempts to predict the timing and

duration of economic recessions and recoveries and the resulting cash flows

generated over the cycle. In the former case the actual results of the firm will

vary from those used in the valuation throughout the cycle, making it difficult to

identify whether the firm is delivering the anticipated results and cash flows or if

there has been a fundamental change in its market or risk which might

invalidate the valuation. The latter alternative however entangles the analysts

estimate of the firms likely performance and future cash flows with his

predictions about the overall economic cycle.

Firms with under-utilized assets: As it values the company on the basis of cash

flows generated, rather than looking at the assets the firm uses to generate

these, DCF valuation methods reflect only the value of assets that produce

cash flows. If a firm has assets that are un-utilized (and hence do not produce

any cash flows) or under-utilized then the value of these assets will not be

reflected in the value obtained from discounting expected future cash flows.

Companies that effectively use shareholder value as a parameter in

determining their executives remuneration more effectively incentivise their

management to dispose of non-productive assets so as to capture the value of

these (Fernndez 2002).

Un-utilized patents or licenses that do not currently produce any cash flows

(and which may not indeed do so in the near future) are intangible assets that

are of particular relevance in a number of industries. Historically the value of

such assets was normally estimated using the Market Approach, however

more recently it is more common that, as their value often depends upon the

future occurrence of favourable market conditions which allow the firm to sell

the resulting product and create a cash flow from them, it may be moreaccurately estimated using contingent claim valuation methods.


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Firms in the process of restructuring: Firms in the process of restructuring often

sell some of their assets; acquire other assets; change their capital structure,

dividend policy, and management compensation schemes; and may even

change their ownership structure by being taken private. Such changes make

estimating future cash flows more difficult and affect the riskiness of the firm,

since using historical data for such firms would give a misleading picture of the

firm's value. When valuing such firms using a DCF method it is important to

ensure that the future cash flows projected reflect the expected effects of these

changes and that the discount rate used reflects the new capital structure and

risk in the firm.

Firms involved in acquisitions: Specific issues that need to be taken into

account when using DCF valuation methods to value acquisition target firms

are: the form any synergy will take, and its effect on cash flows (Evans 2002);

possible changes in management, particularly in hostile takeovers, and their

impact on cash flows and risk; and the impact of significant changes in capital

structure, since many acquisitions burden the target firm with a significant

burden of debt, and their impact on cash flows and risk.

Private Firms: The biggest problem in applying DCF valuation methods to

private firms is the estimation of the riskiness of the investment (to use in

estimating discount rates). Most risk/return models estimate risk parameters

from historical price, but as shares in private firms are not traded this is not

possible. One solution is to look at the riskiness of comparable firms which are

publicly traded. The other is to relate the measure of risk to accounting

variables, which are available for the private firm.

Contingent Claim Valuation Methods

Contingent claim valuation methods are variations on standard DCF methods that

adjust the valuation to account for the value of flexibility in the firms response to

future eventualities affecting its markets and opportunities through the application of

option pricing models. While these models were initially used to value traded options,contingent claim valuation methods extend the reach of these models to value


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strategic and operating flexibility in areas such as new product launches (through the

possession of patents or licences), opening and closing plants, or natural resource

exploration and exploitation rights (Copeland, Koller and Murrin 2000).

When analysing a company using contingent claim methods it should be noted that

the method most commonly used for valuing options, the Black-Scholes model,

correctly applies only to European-type options (which are exercisable only on

maturity), whereas strategic and operating flexibility and other corporate assets may

more correctly be viewed as American-type options (which may be exercised at any

time). Valuation of such assets using the Black-Scholes model in an unadjusted form

underestimates their value (Damodaran 2001).

Market Approach

Valuation methods within the Market Approach aim to estimate the market value of

the firms shares directly by comparison with other listed firms which are judged to be

sufficiently similar in their structure and in the markets they serve. Because of their

ease and speed of use, such relative valuations account for the majority of

valuations performed (Damodaran 2002). Besides being useful valuation tools in

their own right, particularly for valuing non-productive assets such as real estate,

market approach valuation methods can be a useful check for errors in DCF

valuations and may also serve to allow the companys management to better

understand mismatches between the company and its competitors (Goedhart, Koller

and Wessels 2005).

The first stage in performing a relative valuation is for the variables to be used for

comparison of the firms to be standardized, usually by converting prices into

multiples of earnings, book values or sales, although sector-specific variables may

also be used. It is then necessary to identify similar firms, which is difficult to do

since no two firms are identical and even firms in the same business can still differ

on risk, growth potential, financing structure and mix, and cash flows. The question

of how to control for these differences, when comparing a multiple across several

firms, becomes a key one. The market value of the firm is then estimated by

comparing its multipliers with those of the selected comparable firms and with their


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market value. The following types of multiples are commonly used (Damodaran

2002):

Earnings Multiples. When buying a stock, it is common to look at the price paid

as a multiple of the earnings per share generated by the company. This

price/earnings ratio can be estimated using current earnings per share

(yielding a current PER), earnings over the last 4 quarters (resulting in a trailing

PER), or an expected earnings per share in the next year (providing a forward

PER). When buying a business, as opposed to just the equity in the business,

it is common to examine the value of the firm as a multiple of the operating

income or the earnings before interest, taxes, depreciation and amortization

(EBITDA).

Book Value or Replacement Value Multiples. As already noted, traditional

accounting measures of value often provide a very different estimate of the

same business. The ratio of the share price and the book value of equity or the

replacement cost of the asset(s) may be a measure of how over- or

undervalued a stock is within its sector (although the price/book value ratio that

emerges can vary widely between different sectors, depending again upon the

growth potential and the quality of the investments in each).

Sales or Revenue Multiples. Both earnings and book value are accounting

measures which are determined according to accounting rules and principles

which, as noted above, are poor metrics of economic value. An alternative

approach, which is far less affected by accounting choices, is to use the ratio of

the value of an asset to the revenues it generates. For equity investors, this

ratio is the price/sales ratio (PS), where the market value per share is divided

by the revenues generated per share. This makes it easier to compare firms in

different markets, with different accounting systems at work, than it is when

comparing earnings or book value multiples.

Sector-Specific Multiples. While earnings, book value and revenue multiples

are multiples that can be computed for firms in any sector and across the entiremarket, there are some multiples that are specific to a sector. It is common


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practice, for example, to use ratios involving annual production capacity,

number of parking spaces, and annual insurance premiums in performing

relative valuations of (respectively) cement companies, car parking firms and

insurance companies (Fernndez 2003). This method may be dangerous for

two reasons; firstly, since they cannot be computed for other sectors or for the

entire market, sector-specific multiples can result in persistent over or under

valuations of sectors relative to the rest of the market, and secondly it is far

more difficult to relate sector specific multiples to fundamentals, which is an

essential ingredient to using multiples well.

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The Value of a Business: What Value Is, How Value is Created, and How Value is Measured

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