Different Methods of Valuing a Company – Valuations

Written by admin on October 9th, 2011


How does one value a company? While at a broad level one may be able to understand why a company may be worth a certain amount to an investor or a buyer, it is not always possible to understand why someone is willing to pay a certain amount for a business.  A business worth a significant amount at a certain point in time may suddenly lose much of its value a very short while later. This is what happened in many companies commonly referred to as ‘dot-com companies,’ which were valued at amounts which may seem absurd now…. in hindsight.


Review and selection of the methods of valuation, Understanding of issues which impact valuation, Special situations and their impact on valuation

What is value? – Cost vs. Market Value- Historical vs. Replacement

Differs depending on need of person doing valuation – buyer, seller, employee, banker, insurance company

Value to user- Valued because of expected return on investment over some period of time; i.e. valued because of the future expectation. Return may be in cash or in kind. Complex nature of valuation

Value A + Value B can be greater or less than Value (A+B)


These can be broadly classified into: Cost based, Income based, Market based,

Valuation methods

COST BASED METHODS, Book value, Replacement value, Liquidation value

Historical cost valuation-All assets are taken at historical book value- Value of goodwill is added to this above figure to arrive at the valuation

Current cost valuation- All assets are taken at current value and summed to arrive at value- This includes tangible assets, intangible assets, investments, stock, and receivables


Book value method

Current cost valuation- All assets are taken at current value and summed to arrive at value- This includes tangible assets, intangible assets, investments, stock, receivables

Current cost valuation: Difficulties -Technology valuation – whether off or on balance sheet- Tangible assets – valuation of fixed assets in use may not be a straightforward or easy exercise- Could be subject to measurement error

Current cost valuation: More difficulties -The Company is not a simple sum of standalone elements in the balance sheet- Organization capital is difficult to capture in a number – this includes

–             Employees, Customer relationships, Industry standing and network capital, Etc…

Valuation of goodwill

Based on capital employed and expected profits vs. actual profits, Based on number of years of super profits expected, May be discounted at suitable rate, Valuation of goodwill, Normal capitalisation method, Normal capital required to get actual return less actual capital employed , Super profit method, Excess of actual profit over normal profit multiplied by number of years super profits are expected to continue, Annuity method

Valuation of IA

The value of the IA is from – Economic benefit provided, Specific to business or usage

Have different aspects – Accounting value- Economic value- Technical value                       

Depends on objective and can vary widely depending on purpose: For accounting purposes – to show in financial statements, for acquisition/merger/investment, For management to understand value of company for decision making

IA value in transactions: – Often value paid in M&A deals is more than market value/book value. This could be: Partly due to over bidding due to strategic reason (existing or perceived) and, Partly due to IA of company, not captured in balance sheet, Replacement value method, Cost of replacing existing business is taken as the value of the business, Liquidation value method, Value if company is not a going concern, Based on net assets or piecemeal value of net assets.


Earnings capitalization methodor profit earning capacity value method:- This method is also known as the Profit earnings capacity value (PECV), Company’s value is determined by capitalizing its earnings at a rate considered suitable, Assumption is that the future earnings potential of the company is the underlying value driver of the business, Suitable for fairly established business having predictable revenue and cost models.

Discounted cash flow method (DCF)

Applicability of DCF method: – Cash flow to equity, Discount rate reflects cost of equity, Cash flow to firm, Discount rate reflects weighted average cost of capital

Cash flow to equity: – Valuation of equity stake in business, Based on expected cash flows , Net of all outflows, including tax, interest and principal payments, reinvestment needs

Limitations– Companies in difficulty, Negative earnings, May expect to lose money for some time in future, Possibility of bankruptcy, May have to consider cash flows after they turn negative or use alternate means, Companies with cyclic business, May move with economy & rise during boom & fall in recession, Cash flow may get smoothed over time, Analyst has to carefully study company with a view on the general economic trends. The bias of the analyst regarding the economic scenario may find its way into the valuation model

Unutilized assets of business:-Cash flow reflects assets utilized by company, Unutilized and underutilized assets may not get reflected in the valuation model, This may be overcome by adding value of unutilized assets to cash flow. The value again may be on assumption of asset utilization or market value or a combination of these, Companies with patents or product options, Unutilized product options may not produce cash flow in near future, but may be valuable, This may be overcome by adding value of unutilized product using option pricing model or estimating possible cash flow or some similar method

Companies in process of restructuring, May be selling or acquiring assets, May be restructuring capital or changing ownership structure, Difficult to understand impact on cash flow , Firm will be more risky, how can this be captured?, Historical data will not be of much help

Companies in process of M&A: – Estimation of synergy benefit in terms of cash flow may be difficult, Additional capex may be calculated based on inadequate information or limited data , Difficult to capture effect of change in management directly in cash flow, Analyst should try to study impact of M&A with due care,  Historically, many M&As have not done as well as expected. Many times this has been attributed to valuation being too high. To minimize this risk of over valuation, a proper due diligence review (DDR) exercise is to be done, with one of the mandates for this being careful review of the value drivers and the business proposition.

Unlisted companies: – Difficult to estimate risk, Historical information may not be indicative of future, particularly in early stage, growth phases, Market information on similar companies can be difficult to obtain

MARKET BASED METHOD:– Also known as relative method, Assumption is that other firms in industry are comparable to firm being valued, Standard parameters used like earnings, profit, book value, Adjustments made for variances from standard firms, these can be negative or positive

Using comparable

–             Valuation is estimated by comparing business with a comparable fit, Relative Valuation, Using fundamentals for multiples to be estimated for valuation, Relates multiples to fundamentals of business being valued, eg earnings, profits, Similar to cash flow model, same information is required, Shows relationships between multiples and firm characteristics

Using Comparable for estimation of firm value: – Review of comparable firms to estimate value, Definition of comparable can be difficult, May range from simple to complex analysis

Limitation: – Easy to misuse, Selection of comparable can be subjective, Errors in comparable firms get factored into valuation model

VALUATION:  What it depends on

Valuation depends on :- Management team, Historical performance, Future projections, Project, product, USP, Industry scenario, Country scenario, Market, opportunity, growth expected, barriers to competition,

Valuation depends on :-  Nature of transaction, Whether 1st round or later round, Whether family and friends or other parties, Amount of money required , Stage of company – early stage, mezzanine stage (pre-IPO), later stage (IPO)

Valuation depends on:- Strategic requirements and need for transaction, Demand  / supply position, Flavor of the season


Process of valuation

Net assets tangible and intangible, Financial data, Historical information, Company info, Industry info, Economic environment

Include elements of cash, costs, revenues, markets , Plan long term not short haul, Discount for risks, assign probabilities , Arrive at range

Finally after arriving at the value range

Raise some fundamental questions: – Does the value reflect the past performance and the expected future? Does the value reflect the USP as compared to competition? Does the

Pages: 1 2

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Leave a Reply