Valuation of Company – Part 1

Mahesh Savanth
Chartered Accountant

© 2010 Accolet Advisors Private Limited. All rights reserved.

Contents
• Why Value a Company?

• What is it Worth?

• Valuation Concepts

• What is Fair Market Value?

• Steps in Valuation

• Issues involved in Valuation

• What is cash flow to an enterprise?

• Some Important Ratios

• Glossary & Conclusion

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Why value a Company?
• To sell the company

• To raise capital from investors

• To demerge a unit

• For a management buy-out

• For employee stock ownership plan

• For taxation

• To gift or sell of shares

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What is a Company worth?
• Its worth its tangible assets

• Its worth its assets plus goodwill

• Its worth what ever someone would pay for it

Situations that increase the value

• A great product or service that people want to buy

• Customers who can afford to buy it

Situations that increase the value

• An obscure product or service with limited appeal

• Price is too high or customers are too poor

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Valuation Concepts
• Book Value
- Depreciated value of assets minus outstanding liabilities

• Price – Earnings ratio [ P/E ratio ]

-Value according to the market price of the outstanding stock

• Discounted Cash Flow or Intrinsic Value

- Net Future Value of future cash flows (discounted at required rate of return)

• Comparison to similar Companies

- Comparison of financial statements and appraisal of assets of comparables

• Liquidation Values

- Amount that would be realized if all the assets were sold independently

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What is Fair Market Value?

Fair market value (FMV) is the highest price obtainable in an

open and unrestricted market between knowledgeable,
informed and prudent parties acting at arm’s length, with
neither party being under any compulsion to transact.

Key phrases in this definition:

1. Open and unrestricted market (where supply and demand can freely
operate
2. Knowledgeable, informed and prudent parties
3. Arm’s length
4. Neither party under any compulsion to transact.

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Steps in Valuation
• Analyzing Historical Performance
• Forecast Future Performance
• Estimate the Cost of Capital
• Estimate the Cost of Equity Capital – CAPM model

ks  rf   E(rm )  rf  

where rf = the risk-free rate of return

E(rm) = the expected rate of return on the overall market portfolio
E(rm)- rf = market risk premium
В = the systematic risk of equity

• Calculating, Interpreting and Test the results

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Issues in Valuation
1. Find appropriate comparables
– Individual firm that is highly comparable to the target
– Industry average if appropriate

2. Adjust/normalize the data (income statement and balance sheet) for

differences between target and comparator including:
– Accounting differences
• LIFO versus FIFO
• Accelerated versus straight-line depreciation
• Age of depreciable assets
• Pension liabilities, etc.
– Different capital structures

3. Calculate a variety of ratios for both the target and the comparator including:
– Price-earnings ratio (trailing)
– Value/EBITDA
– Price/Book Value
– Return on Equity

4. Obtain a range of justifiable values based on the ratios

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Cash flow to the enterprise

Earnings before interest and taxes (EBIT)

 Minus Cash taxes on EBIT

 Minus Investments
 Plus Depreciation
 Plus (minus) Change in Working capital

 equals

Free Cash Flow…. Available to ALL INVESTORS

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Price to Sales

Share Price
P/S 
Revenue Per Share

• P/S ratio can be used in comparison to other companies

• How much is being paid for per share of sales
• If P/S < 1, it means investors are paying less for each unit of sales

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Price to Earnings

Share Price
P/E 
Earnings Per Share
• Companies with no growth do not have a P/E ratio
• A high P/E ratio could mean higher growth in the future

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Price to Book Value

Share Price
P/B 
Total Assets - Intangible Assets &Liabilities

• Compares the company’s share price to their book value

• A low P/B ratio could mean:
• Stock undervalued
• Something very wrong…

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Return on Equity

Net Income

Shareholder's Equity
Useful to comparing the profitability of a firm in regards to its’ competitors.

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Debt-Equity Ratio

Total Debts

Total Assets
Debt Ratio > 1= company has more debt than assets
Debt Ratio < 1 = company has more assets than debt

Used as a tool to measure risk of companies

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Glossary

• Arm’s Length
• Date of Valuation

• Discretionary Expenses
• Materiality
• One-time events

• Control / Minority Interest

• Ranges of Values

• Capital Structure

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Conclusion

Valuation is...

 A blend of art and science but a disciplined and systematic blend.

 Thoroughly dependent on all of the explicit and implicit assumptions
made.
 An estimation process whose outer limits ought to be tested for revision
purposes.
 Likely to perform best when it reflects “fit for purpose” decisions in
design.

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