Appendix 4 - Which methods of valuing companies is best to ensure correct value is obtained?

Companies must understand what creates value before they put in a takeover bid to acquire another company. The offer value must be agreed between both companies and therefore have a alignment on the value of the soon to be acquired company's value. Shareholders wealth of the company to be sold will have been maximized due to the selling of the company and the shareholders of the company placing the bid will have expanded the companies portfolio and with the hope of seeing long term wealth gains.

A company could have maybe looked at the following three methods basic valuation methods to value the target company which they hope to acquire; Stock market valuation, net asset value based valuations and income based valuations.

Stock market valuation

Stock market valuation is the number of ordinary shares issued multiplied by market price. Market value is correct if efficient market hypothesis applies. The value is semi-strong based off past and present information. However manager could have new information such as new innovative products which would increase the value of the company. This method is useful as it gives an idea to the purchasing company to the purchase price.

There are issues with this valuation method such as it quotes share price and does not give true reflection on the value of all the shares as only a small proportion of shares are traded on a day to day basis so this method does not reflect all of the corporate value. If the company’s shares are not quoted or on a stock exchange this valuation method is impossible. This method will give the buyer a possible share purchase price but will not help with to working out the company’s value (worth). This method also requires a substantial premium to get shareholders to give up  their shares because of the above issues. Also when news breaks of a possible takeover bid, shareholders will be more reluctant to hold onto their shares and the buying company will have to pay higher prices for the shares to obtain them.

Net Asset Valuation

Also known as book value, can be worked out by fixed assets plus net current assets minus long term assets to give you the company’s net asset value. This method uses historical costs which are both factual and available then trends can be drawn up from previous year’s data. This method is not accurate as the buyer will not understand if the depreciation method was the right choice at the time and may have issues with the chosen method. The method ignores intangible assets such as brand names and patents.  Highly skilled work force is another intangible asset, if this work force left this would devalue the company as this would account for loss of assets but this method does not include these intangible assets. This method also does not detail any future wealth generation ability such as any new products been released to market. This method can be useful in liquidation.

Income based Valuations

Looks towards the future income of a company.

Issues with this method are that it is unreliable and inaccurate to predict value growth rates on past growth. Too reliant on predictions and assumptions. Quality of data very poor normally just estimates.Gordon's dividend growth model is an example of income based valuations as is price earnings ratio model and discounted cash flow valuation.

Income based Valuations - Gordon's dividend model

Gordon's dividend growth model determines the intrinsic value of stock, based on future series of dividends that have a constant rate of growth. Provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends. Since the assumption is based on the constant growth rate of dividends, this formula would be applicable mostly to well established and mature companies. This model was developed by Professor Myron Gordon, hence called Gordon Growth Model.
Formula:

Where: 
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)

The advantages of Gordon Growth Model are the Model is especially useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.

The disadvantages of Gordon Growth model are the Model’s simple calculations can prove to be the major disadvantage as the model takes into consideration the quantitative figures and not the qualitative ones. The future changes cannot be taken into consideration which is why this model is not much preferred.The calculations are basically on future assumptions, which can be subjected to market changes based on the economic conditions and various other factors which contribute to being one of the major disadvantage.The limitations to the model make it less favorable for market and companies which has rapid changing dividend patterns.This is why in spite of definite success with the companies that have a high cash flow in the company this model is not suitable for many other companies which are fast growing since it is not flexible enough to include the possible fluctuations in the dividend rates in the future. This model is especially not suited for companies that are in segregation but for companies that have a heavy cash in flow and out flow ratio.

Income based Valuations - Price earnings ratio

P/E ratio model is a valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

Market Value per Share / Earnings per Share (EPS)

A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry.

The P/E is a measure of how highly valued the company’s earnings are in the market by telling you

1. what an investor is prepared to pay for every £1 of those earnings and
2. how many years an investor would have to wait to get back his investment through current earnings (assuming all earnings are paid out as dividends, which would be somewhat unusual of course!).

Unlike other metrics such as cash flow and dividends, earnings can be subject to manipulation at company level, which means P/E can be distorted depending on how the company has accounted for particular items… The fact that accounting standards vary from country to country only adds to that problem. Warren Buffett instead judges performance using “owner earnings“, which is defined as:

• net income

• plus non-cash charges of depreciation and amortization

• less capital expenditures and any additional working capital that might be needed.

Buffett argues that owner earnings reflect the true cash flow generation of a company.

Income based Valuations - Discounted cash flow valuation

Is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital - WACC) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through Discounted Cash Flow analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Advantages of discounted cash flow valuation are it produces the closest thing to an intrinsic stock value. The alternatives to Discounted Cash flow valuation are relative valuation measures, which use multiples to compare stocks within a sector. Can apply the Discounted Cash flow model as a sanity check. Instead of trying to come up with a fair value stock price, you can enter the company's current stock price into the Discounted cash flow model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price.

There are however some disadvantages such as if the inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wrong, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. The model is sensitive to assumptions and not suited for short-term investing. Instead, it focuses on long-term value creation.

Conclusion

In this blog entry i have concentrated on three basic valuation methods; Stock market valuation, net asset value based valuations and income based valuations and their advantages and disadvantages for each. Dependent on the company they will use different methods to workout value, with a good company using a range of methods. A company needs to understand value and how to calculate value but this is a very difficult task especially when looking to acquire a new company as both company's need to agree on the value so which method of valuing companies is best to ensure correct value is obtained is dependent on the given business situation.