Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based:  The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based.  The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money.  The DCF method has many advantages, the most important being its future-looking orientation.  This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.

How much should you pay for a business? Valuing a company (2)

Asset value

An obvious starting point for valuing a company is to look at the asset base of that organisation. On this basis the company would be worth its net asset value. There are some limitations to this approach:

Book value - Accountants usually value fixed assets at what they cost, depreciated to reflect the reducing value as items are worn out in use. Book value may not be an accurate reflection of the real value.

• This can apply when land and buildings were bought some time ago, and have grown in value; or 
• if the value of these assets has reduced significantly since purchase, due to new technologies. 
• There may also be a factor that has previously been ignored, such as environmental issues. Disposal or land remediation costs could wipe out any asset value.

Normally a company will have a fixed asset register that lists all its assets, and the current depreciated book value of those assets. A similar register might also exist for its other assets.

Working capital - Again, we must understand whether these items are accurately stated.

• Stock (inventory) is usually valued by accountants at what it cost. This may be far more than we can sell it for, especially if it is out of date. 
•  Debtors (receivables) is money owed to us by customers. How much of this might be bad debt (i.e. invoices that may never get paid)? 
•  Creditors (payables) is money we owe our suppliers. How much has our company avoided paying to improve its cash flow?

Intangible assets - This can take the form of

• goodwill (the difference between what we pay for an acquisition and what the assets are valued at) or 
• capitalised costs (such as research or start-up costs).

As there are no physical assets to underwrite these, the net assets may be overstated if these elements are high.

Investments - There might be some investments in other companies, which accountants will value at what was paid for them, rather than their realisable value in the market.

Unstated assets - Accountants usually put no value in the books on such things as people, brands, intellectual property, market position, forward order book etc. This means that the net asset figure alone might seriously understate the company value. This can apply especially in service-based businesses that have few tangible assets.

Also read:

Valuing a company (1)

Valuing a company using Asset Value (2)

Valuing a company using Multipliers (3)

Valuing a company using Market Capitalisation (4)

Valuing a company using Non-Financial Measures & Balanced Scoreboard (5)

Valuing a company using Cash Flows (6)

The 4 major asset classes: the building blocks of any investment plan

Any serious investor should have a basic knowledge of the 4 major asset classes and the risk inherent in each:

• Cash - low risk  (For Savings and Protection)
• Bonds - moderate risk (For Income)
• Property - moderate to high risk (For Growth and Income)
• Equities - high risk (For Growth)

Remember this fundamental rule:

The bigger the risk you take, the greater the possible reward or return (growth on capital) you can expect.

The safer your investment and the smaller the risk you take, the smaller the possibility of a great return.

Why do so many people invest themselves into bankruptcy?

Investment is simply the saving of money with the aim of making it grow.

The amount you invest is called your capital.  Investing is therefore the creation of more money through the use of capital.

The trick, of course, is finding the right assets in which to invest.

Why do so many people invest themselves into bankruptcy?

The answer is that they

• invest in dubious or risky products, or
• know too little about themselves and the product or asset classes in which they invest.