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Wednesday 21 September 2011
Tuesday 20 September 2011
The Four Big Threats to Your Wealth in 2011 (MoneyWeek Magazine)
UK Housing threat
UK Stock market threat
Drop the Euro before it collapses
The "bond bubble" is about to burst
The fact is we're in unchartered territory ... and it's a very dangerous and unstable situation.
Does a 40% rise in the FTSE and a 9% rebound in property prices over the last 18 months seem right to you?
The way we see it, these aren't healthy markets at all ... they're not even recovering markets ...
...these are grossly inflated markets, pumped up by desperate government intervention.
Will the UK economyh sink into deflation if the Government follows through its pledge to rein in our national debt? ...
... Or, with the Bank of England's furious attempts to keep the ball rolling, is it inflation we have to fear?
So ... what should you do?
Survival Action #1 Buy defensives and "bear market protectors"
Defensive stocks: These kinds of companies don't need economic growth to make money, because people have to spend on their products out of necessity. In short, they're specifically suited to keep your portfolio ticking over in times of upheaval ... and GROW when the market truly recovers.
Survival Action #2 Get the right dividend players into your portfolio now
But since the bust up of 2008, investors have rediscovered the appeal of dividend cheques. This is for three reasons ...
1. Dividends outperform bond yields. According to Bloomberg, by the third quarter of 2010 more U.S. stocks were paying dividends that exceed bond yields than any time in the last 15 years.
2. Dividends can't be fudged - they have to be paid with real money.
3. Dividend-payers are excellent stocks to own in times of unprecedented uncertainty.
Dividends contribute to share price stability. If the share price of a dividend-paying firm falls, it is likely to fall less sharply than a pure growth stock. That's because as the price falls, the yield tends to pick up, encouraging investors to buy back in.
Survival Action #3 Ride gold all the way to $2,230 .. or even more!
... you're talking an eye-popping gold spike to $23,450 per ounce. And during times of confusion, gold often performs better than most other assets. Consider this ... adjusted for inflation, the 1980 gold peak of $850 gives you a price of $2,230 still on the horizon today.
UK Stock market threat
Drop the Euro before it collapses
The "bond bubble" is about to burst
The fact is we're in unchartered territory ... and it's a very dangerous and unstable situation.
Does a 40% rise in the FTSE and a 9% rebound in property prices over the last 18 months seem right to you?
The way we see it, these aren't healthy markets at all ... they're not even recovering markets ...
...these are grossly inflated markets, pumped up by desperate government intervention.
Will the UK economyh sink into deflation if the Government follows through its pledge to rein in our national debt? ...
... Or, with the Bank of England's furious attempts to keep the ball rolling, is it inflation we have to fear?
So ... what should you do?
Survival Action #1 Buy defensives and "bear market protectors"
Defensive stocks: These kinds of companies don't need economic growth to make money, because people have to spend on their products out of necessity. In short, they're specifically suited to keep your portfolio ticking over in times of upheaval ... and GROW when the market truly recovers.
Survival Action #2 Get the right dividend players into your portfolio now
But since the bust up of 2008, investors have rediscovered the appeal of dividend cheques. This is for three reasons ...
1. Dividends outperform bond yields. According to Bloomberg, by the third quarter of 2010 more U.S. stocks were paying dividends that exceed bond yields than any time in the last 15 years.
2. Dividends can't be fudged - they have to be paid with real money.
3. Dividend-payers are excellent stocks to own in times of unprecedented uncertainty.
Dividends contribute to share price stability. If the share price of a dividend-paying firm falls, it is likely to fall less sharply than a pure growth stock. That's because as the price falls, the yield tends to pick up, encouraging investors to buy back in.
Survival Action #3 Ride gold all the way to $2,230 .. or even more!
... you're talking an eye-popping gold spike to $23,450 per ounce. And during times of confusion, gold often performs better than most other assets. Consider this ... adjusted for inflation, the 1980 gold peak of $850 gives you a price of $2,230 still on the horizon today.
Monday 19 September 2011
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.
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.
Finance for Managers - Discounted Cash Flow Valuation Method
One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year. And as the oft-heard saying goes, past performance is no assurance of future results. If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead. Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.
We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method: discounted cash flow (DCF). The DCF valuation method is based on the same time-value-of-money concepts. DCF determines value by calculating the present value of a business's future cash flows, including its terminal value. Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.
For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:
1. The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow. They would use EBITDA and make some adjustment for taxes and for changes in working capital. Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.
2. Your analysts would then estimate future annual cash flows - a tricky business to be sure.
3. Next, you would estimate the terminal value. You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows). That net figure after taxes will fall into the final year's cash flow. Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:
Present value = Cash Flow / Discount Rate
Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity). This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.
4. Compute the present value of each year's cash flow.
5. Total the present values to determine the value fo the enterprise as a whole.
We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2). Our calculated value there is $4,380,100. (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)
In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business. All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager. Such determinations are best left to the experts. What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.
Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)
Present Value Cash Flows
(in $1,000, Rounded) (in $1,000)
Year 1 446.5 500
Year 2 418.5 525
Year 3 398.7 500
Year 4 381.6+2,734.8 600+4,300
Total 4,380.1
The strength of the method are numerous:
- It recognises the time value of future cash flows.
- It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
- It accounts for the buyer's cost of capital.
- It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
- It is based on real cash flows instead of accounting values.
The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.
We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method: discounted cash flow (DCF). The DCF valuation method is based on the same time-value-of-money concepts. DCF determines value by calculating the present value of a business's future cash flows, including its terminal value. Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.
For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:
1. The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow. They would use EBITDA and make some adjustment for taxes and for changes in working capital. Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.
2. Your analysts would then estimate future annual cash flows - a tricky business to be sure.
3. Next, you would estimate the terminal value. You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows). That net figure after taxes will fall into the final year's cash flow. Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:
Present value = Cash Flow / Discount Rate
Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity). This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.
4. Compute the present value of each year's cash flow.
5. Total the present values to determine the value fo the enterprise as a whole.
We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2). Our calculated value there is $4,380,100. (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)
In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business. All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager. Such determinations are best left to the experts. What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.
Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)
Present Value Cash Flows
(in $1,000, Rounded) (in $1,000)
Year 1 446.5 500
Year 2 418.5 525
Year 3 398.7 500
Year 4 381.6+2,734.8 600+4,300
Total 4,380.1
The strength of the method are numerous:
- It recognises the time value of future cash flows.
- It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
- It accounts for the buyer's cost of capital.
- It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
- It is based on real cash flows instead of accounting values.
The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.
Finance for Managers - Earnings-Based Valuation - EBIT Multiple
The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate. In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's. Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders. How is this possible? The answer is twofold: the manner in which they are financed, and taxes. If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line. Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities. And taxes reduce bottom-line earnings.
Consider the hypothetical scenario in table 10-a. Notice that the two companies produce the same earnings before interest and taxes (EBIT). But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000). This dramatically reduces its earnings before income taxes relative to Amalgamated. Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.
This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company. The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process. Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization. Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms. By using EBITDA in the valuation equation, this potential distortion is avoided.
Table 10-a
Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation
Amalgamated Acme
Earnings before Interest and Taxes $757,500 $757,500
Less: Interest Expenses $110,000 $350,000
Earnings before Income Tax $647,500 $407,500
Less: Income Tax $300,000 $187,000
Net Income $347,500 $220,500
Consider the hypothetical scenario in table 10-a. Notice that the two companies produce the same earnings before interest and taxes (EBIT). But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000). This dramatically reduces its earnings before income taxes relative to Amalgamated. Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.
This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company. The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process. Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization. Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms. By using EBITDA in the valuation equation, this potential distortion is avoided.
Table 10-a
Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation
Amalgamated Acme
Earnings before Interest and Taxes $757,500 $757,500
Less: Interest Expenses $110,000 $350,000
Earnings before Income Tax $647,500 $407,500
Less: Income Tax $300,000 $187,000
Net Income $347,500 $220,500
Sunday 18 September 2011
Finance for Managers - Earnings-Based Valuation - Earnings Multiple (2)
We calculate the multiple from comparable publicly traded companies as follows:
Multiple = Share Price / Current Earnings
Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10. In stock market parlance, we'd say that XYZ is trading at ten times earnings.
We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples. This is a challenge, since no two enterprises are exactly alike. The uniqueness of every business is why valuation experts recognize their work as part science and part art. To examine this method further, let's return to our example firm.
Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares. But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size. We'll call one of these firms Acme Corporation. And let's suppose that Acme's P/E ratio is 8. Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8. This gives us confidence that our multiple of 8 is in the ballpark. With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.
Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:
Earnings x Appropriate Multiple = Equity Value
$347,500 x 8 = $2,780,000
Remember that this is the value of the company's equity. To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities. Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000. Thus, the value of the entire enterprise is as follows:
Enterprise Value = Equity Value + Value of Interest-Bearing Debt
$3,965,000 = $2,780,000 + $1,185,000
The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure. The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company. for this reason, it is essential that you factor out random and nonrecurring items. Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low. For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance. Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.
In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families. If these salaries have been unreasonably high or low, an adjustment of earnings is required. You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings. And while you're at it, take a hard look at the taxes that have reduced bottom-line profits. The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.
Multiple = Share Price / Current Earnings
Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10. In stock market parlance, we'd say that XYZ is trading at ten times earnings.
We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples. This is a challenge, since no two enterprises are exactly alike. The uniqueness of every business is why valuation experts recognize their work as part science and part art. To examine this method further, let's return to our example firm.
Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares. But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size. We'll call one of these firms Acme Corporation. And let's suppose that Acme's P/E ratio is 8. Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8. This gives us confidence that our multiple of 8 is in the ballpark. With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.
Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:
Earnings x Appropriate Multiple = Equity Value
$347,500 x 8 = $2,780,000
Remember that this is the value of the company's equity. To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities. Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000. Thus, the value of the entire enterprise is as follows:
Enterprise Value = Equity Value + Value of Interest-Bearing Debt
$3,965,000 = $2,780,000 + $1,185,000
The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure. The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company. for this reason, it is essential that you factor out random and nonrecurring items. Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low. For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance. Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.
In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families. If these salaries have been unreasonably high or low, an adjustment of earnings is required. You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings. And while you're at it, take a hard look at the taxes that have reduced bottom-line profits. The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.
Finance for Managers - Earnings-Based Valuation - Earnings Multiple
For a publicly traded company, the current share price multiplied by the number of outstanding shares indicates the market value of the company's equity. Add in the value of the company's debt, and you have the total value of the enterprise. Think of it this way: The total value of a company is the equity of the owners plus any outstanding debt. Why add in the debt? Consider your own home. When you go to sell your house, you don't set the price at the level of your equity in the property. Its value is the total of the outstanding debt and your equity interest. Likewise, the value of a company is shareholder's equity plus the liabilities. This is often referred to as the enterprise value.
For a public company whose shares are priced by the market every business day, pricing the equity is straightforward. But what about the closely held corporation, whose share price is generally unknown, since such a firm does not trade in a public market? We can reach a value estimate by using the known price-earnings multiple (often called the P/E ratio) of similar enterprises that are publicly traded. The price-earnings approach to share value begins with this formula:
Share Price = Current Earnings x Multiple
For a public company whose shares are priced by the market every business day, pricing the equity is straightforward. But what about the closely held corporation, whose share price is generally unknown, since such a firm does not trade in a public market? We can reach a value estimate by using the known price-earnings multiple (often called the P/E ratio) of similar enterprises that are publicly traded. The price-earnings approach to share value begins with this formula:
Share Price = Current Earnings x Multiple
Finance for Managers - Earnings-Based Valuation
Another approach to valuing a company is to capitalize its earnings. This involves multiplying one or another income statement earnings figure by some multiple. Some earnings-based methods are more sophisticated than others. There is also the question of which earnings figure and which multiple to use.
Finance for Managers: Asset-Based Valuations - Replacement Value
Some people use replacement value to obtain a rough estimate of value. This method simply estimates the cost of reproducing the business's assets. Of course, a buyer may not want to replicate all the assets included in the sale price of a company. In this case, the replacement value represents more than the value that the buyer would place on the company.
The various asset-based valuation approaches described here generally share some strengths and weaknesses. On the up side, the approaches are easy and inexpensive to calculate. They are also easy to understand. On the down side, both equity book value and liquidation value fail to reflect the actual market value of assets. And all approaches fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power from human knowledge, skill, and reputation.
The various asset-based valuation approaches described here generally share some strengths and weaknesses. On the up side, the approaches are easy and inexpensive to calculate. They are also easy to understand. On the down side, both equity book value and liquidation value fail to reflect the actual market value of assets. And all approaches fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power from human knowledge, skill, and reputation.
Finance for Managers: Asset-Based Valuations - Liquidation Value
Liquidation value is similar to adjusted book value. It attempts to restate balance-sheet values in terms of the net cash that would be realized if assets were disposed off in a quick sale and all liabilities of the company were paid off or otherwise settled. This approach recognizes that many assets, especially inventory and fixed assets, usually do not fetch as much as they would if the sale were made more deliberately.
Finance for Managers: Asset-Based Valuations - Adjusted Book Value
The weakness of the quick-and-dirty equity-book-value approach have led some to adopt adjusted book value, which attempts to restate the value of balance-sheet assets to realistic market levels. Consider the influence of adjusted book value in a leveraged buyout of a major retail store chain in the 1990s. At the time of the analysis, the store chain had an equity book value of $1.3 billion. Once its inventory and property assets were adjusted to their appraised values, however, the enterprise's value leaped to $2.2 billion - an increase of 69 percent.
When adjusting asset values, it is particularly important to determine the real value of any listed intangibles, such as goodwill and patents. In most cases, goodwill is an accounting fiction created when one company buys another at a premium to book value - that is, at a price higher than book value. The premium must be put on the balance sheet as goodwill. But to a potential buyer, the intangible asset may have no value.
When adjusting asset values, it is particularly important to determine the real value of any listed intangibles, such as goodwill and patents. In most cases, goodwill is an accounting fiction created when one company buys another at a premium to book value - that is, at a price higher than book value. The premium must be put on the balance sheet as goodwill. But to a potential buyer, the intangible asset may have no value.
Finance for Managers: Asset-Based Valuations - Equity Book Value
One way to value an enterprise is to determine the value of its assets. Here are four approaches to asset-based valuations:
1. Equity book value,
2. Adjusted book value,
3. Liquidation value, and,
4. Replacement value.
Equity Book Value
Equity book value is the simplest valuation approach and uses the balance sheet as its primary source of information. Here's the formula:
Equity Book Value = Total Assets - Total Liabilities
Example: Amalgamated Hat Rack
Total assets $3,635,000
Total liabilities $1,750,000
Equity book value = Total Assets - Total Liabilities = $1,885,000
In other words, reduce the balance sheet (or book) value of the business's assets by the amount of its debts and other financial obligations, and you have its equity value.
This equity-book-value approach is easy and quick. And it is not uncommon to hear executives in a particular industry roughly calculating their company's value in the context of equity book value.
For example, one owner might contend that his or her company is worth at least book value in a sale because that was the amount that he or she had invested in the business. But equity book value is not a reliable guide for businesses in many industries. The reason is that assets are placed on the balance sheet at their historical costs, which may not be their value today. The value of balance0sheet assess may be unrealistic for other reasons as well. Consider Amalgamated assets:
- Accounts receivable could be suspect if many accounts are uncollectible.
- Inventory reflects historic cost, but inventory may be worthless or less valuable than its stated balance-sheet value (or "book" value) because of spoilage or obsolescence. Some inventory may be undervalued.
- Property, plant, and equipment net of depreciation should also be closely examined - particularly land. If Amalgamated's property was put on the books in 1975 - and if it happens to be in the heart of Silicon Valley - then its real market value may be ten or twenty times the 1975 figure.
The preceding are just a few examples. For many reasons, however, book value is not always true market value.
1. Equity book value,
2. Adjusted book value,
3. Liquidation value, and,
4. Replacement value.
Equity Book Value
Equity book value is the simplest valuation approach and uses the balance sheet as its primary source of information. Here's the formula:
Equity Book Value = Total Assets - Total Liabilities
Example: Amalgamated Hat Rack
Total assets $3,635,000
Total liabilities $1,750,000
Equity book value = Total Assets - Total Liabilities = $1,885,000
In other words, reduce the balance sheet (or book) value of the business's assets by the amount of its debts and other financial obligations, and you have its equity value.
This equity-book-value approach is easy and quick. And it is not uncommon to hear executives in a particular industry roughly calculating their company's value in the context of equity book value.
For example, one owner might contend that his or her company is worth at least book value in a sale because that was the amount that he or she had invested in the business. But equity book value is not a reliable guide for businesses in many industries. The reason is that assets are placed on the balance sheet at their historical costs, which may not be their value today. The value of balance0sheet assess may be unrealistic for other reasons as well. Consider Amalgamated assets:
- Accounts receivable could be suspect if many accounts are uncollectible.
- Inventory reflects historic cost, but inventory may be worthless or less valuable than its stated balance-sheet value (or "book" value) because of spoilage or obsolescence. Some inventory may be undervalued.
- Property, plant, and equipment net of depreciation should also be closely examined - particularly land. If Amalgamated's property was put on the books in 1975 - and if it happens to be in the heart of Silicon Valley - then its real market value may be ten or twenty times the 1975 figure.
The preceding are just a few examples. For many reasons, however, book value is not always true market value.
Finance for Managers: What is its value?
Whether you are buying or selling a global corporation, an operating division, a local restaurant, or a share of stock, the question, "What is its value?" outweighs most others, and for good reason. The rate of return from a good company or a good stock is likely to be disappointing if purchased at too high of a price. Likewise, underestimating the value of an entity in a sales transaction can leave plenty of the owners' money on the table.
Valuing an ongoing business - large or small - is neither easy nor exact. The field of finance, however, has developed methods for getting close to the value. This post will introduce you to several methods.
But before we get started, consider several cautions. The true value of a business is never knowable with certainty. We may seek it, but we can never be sure that we have found the true value of the business. This lack of certainty is the result of two problems.
1. Alternative valuation methods consistently fail to produce the same outcome, even when meticulously calculated.
2. The product of valuation methods is only as good as the data and the estimates we bring to them, and these are often incomplete or unreliable. For example, one method depends heavily on estimates of future cash flows. In the very best cases, those estimates will only be close. In the worst cases, they will be far from the mark.
Another consideration is that a company is worth different amounts to different parties. Different prospective buyers are likely to assign different values to the same set of assets.
The acquisition of a small, high-tech company, for example, might provide an acquirer with the technology it needs to leverage its other operations. This explains, in part, why so many firms are bought out for more than the market value of their existing share.
It is also important to keep in mind that valuation is the province of specialists. Small and closely held businesses typically turn to professional appraisers when their value must be established for purpose of the entity's sale, to determine the value of its shares when an employee stock ownership trust is used, or for some other purpose. When large, public firms or their business units are the subject of a valuation, executives generally turn to a variety of full-service accounting, investment banking, or consulting firms. Many of these vendors have departments devoted entirely to mergers and acquisitions, in which valuation issues are a central focus. Nevertheless, a well-rounded manager should understand the nature of different valuation methods - and their strengths and weaknesses.
Valuation problems often arise in the context of closely held businesses - that is, businesses with only a few owners - or in the sale of an operating unit of a public company. In neither case are there publicly traded ownership shares. Public markets for ownership, such as NASDAQ or the New York Stock Exchange, make value more transparent. Everyday buying and selling in these markets establishes a company's per-share price. And that price, multiplied by the number of outstanding shares, often provides a basis for a fair approximation of company value at a point in time.
Valuing an ongoing business - large or small - is neither easy nor exact. The field of finance, however, has developed methods for getting close to the value. This post will introduce you to several methods.
But before we get started, consider several cautions. The true value of a business is never knowable with certainty. We may seek it, but we can never be sure that we have found the true value of the business. This lack of certainty is the result of two problems.
1. Alternative valuation methods consistently fail to produce the same outcome, even when meticulously calculated.
2. The product of valuation methods is only as good as the data and the estimates we bring to them, and these are often incomplete or unreliable. For example, one method depends heavily on estimates of future cash flows. In the very best cases, those estimates will only be close. In the worst cases, they will be far from the mark.
Another consideration is that a company is worth different amounts to different parties. Different prospective buyers are likely to assign different values to the same set of assets.
The acquisition of a small, high-tech company, for example, might provide an acquirer with the technology it needs to leverage its other operations. This explains, in part, why so many firms are bought out for more than the market value of their existing share.
It is also important to keep in mind that valuation is the province of specialists. Small and closely held businesses typically turn to professional appraisers when their value must be established for purpose of the entity's sale, to determine the value of its shares when an employee stock ownership trust is used, or for some other purpose. When large, public firms or their business units are the subject of a valuation, executives generally turn to a variety of full-service accounting, investment banking, or consulting firms. Many of these vendors have departments devoted entirely to mergers and acquisitions, in which valuation issues are a central focus. Nevertheless, a well-rounded manager should understand the nature of different valuation methods - and their strengths and weaknesses.
Valuation problems often arise in the context of closely held businesses - that is, businesses with only a few owners - or in the sale of an operating unit of a public company. In neither case are there publicly traded ownership shares. Public markets for ownership, such as NASDAQ or the New York Stock Exchange, make value more transparent. Everyday buying and selling in these markets establishes a company's per-share price. And that price, multiplied by the number of outstanding shares, often provides a basis for a fair approximation of company value at a point in time.
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