Business valuation methods – types and practical use

valuation of a company - jcinus

 

The methods for valuation of a company

 

You can classify company valuation methods by several criteria. One of the criteria is to classify them based on whether you value the target company with its own financial status or its comparable companies’ market prices. The former is called the absolute valuation (or intrinsic valuation) method, and the latter is the relative valuation method. They are as follows:

Category

Absolute valuation

Relative valuation

Sub-category

  • Net asset valuation (or book value)
    – Valuing stocks
  • Discounted cash flow method
    • Dividend discount model
      – Valuing stocks
    • Free cash flow discount model
      – Valuing stocks or enterprise
  • Residual income model
    – Valuing stocks
  • Relative valuation (or Market approach)
    • Income multiples
      – Valuing stocks or enterprise
    • Book value multiples
      – Valuing stocks or enterprise
    • Sales multiples
      – Valuing stocks or enterprise

Classification of business valuation methods

 

Absolute valuation

 

Absolute valuation methods include net asset valuation, discounted cash flow method, and residual income model.

 

First, net asset value refers to the value of equity capital, i.e. the value of the company’s assets minus the value of liabilities.

 

Here, it can better reflect equity capital’s actual value when they are valued at market price rather than at book value. This method of valuation of a company has the advantage of being easy to calculate, but it has the disadvantage that it does not reflect the value of the profits a company gets from its business activities. Therefore, it might be suitable for companies that are about to be liquidated. It could also be better for companies with a high proportion of tangible assets rather than intangible assets. That is because it is not easy to assess the market value of intangible assets such as technology, brand, know-how, or copyright.

 

Second, the DCF (Discounted Cash Flow) model is to convert the future cash that stakeholders earn from the business into present value.

 

DCF model - jcinus

 

The DCF model can be applied not only to companies but also to other assets such as real estate and projects. That is because those assets also generate cash flows from their business activities. For companies, the dividend discount model and the free cash flow model fall into the DCF model.

 

The DDM (Dividend Discount Model) is to value stocks by converting the future dividends that shareholders expect to receive into present values. Since it reflects the cash flow attributable to shareholders, this method calculates the stock value, not the entire enterprise.

 

FCF (Free Cash Flow) refers to the cash flow left in the company after spending on investment from the cash flow generated by the company’s business. There are two types of free cash flow. One is FCFF (Free Cash Flow to Firm), which is attributed to both creditors and shareholders, and the other is FCFE (Free Cash Flow to Equity), which is attributed only to shareholders. When you calculate the value with the former cash flow, it becomes the enterprise value (EV), and when you do with the latter, it becomes the stock value. The free cash flow model is critical in practice along with the relative valuation method because it does not reflect the atmosphere of the stock market but value a company only with its own cash flow.

 

Lastly, the Residual Income model is a method to value stocks by adding the company’s future residual income to its current book value. Residual income means the income remained after subtracting expenses attributable to shareholders from net income. The model derives the stock value because the present value of future residual profit is added to the company’s net asset value.

 

Residual Incoome Model - jcinus

 

 

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Relative Valuation

 

Relative valuation is a method of estimating a target company’s value by referring to the market price of companies similar to the target company.

 

That is like referencing other apartments’ transaction prices in similar conditions to estimate your apartment’s price. Meanwhile, since it refers to the transaction price in the market, the relative valuation method is also called the market approach.

 

The relative valuation method use multiples obtained using similar companies to value a target like in the formula below. Financial indicators, which are denominators, consist of comparable companies’ profits, book value, or sales. The market price, which is the numerator, can be the companies’ stock price or the entire enterprise value (EV). If you use stock price in the numerator, you estimate the target’s stock value, and if you use EV in there, you will assess its EV.

 

relative valuation method - jcinus

 

Multiples mean ‘how many times the market price has been formed compared to a specific financial value’. Depending on the type of financial indicators in the denominator, multiples can be divided into three main categories.

 

The first is income multiples. It shows how many times the stock price is formed more compared to the profit of $1. In other words, you can think of it as how many times the investor pays for the profit of $1 to buy one stock. Representative earnings multiples are price-to-earnings ratio (PER) and EV/EBITDA. The former is the ratio of stock price divided by EPS, and the latter is the ratio of the enterprise value divided by the EBITDA, which is the sum of operating income and depreciation and amortisation expenses.

 

The second is a book value multiple, which expresses a company’s value as a multiple of net assets. It means how many times the company’s stock price is higher than its book value. The higher the multiple, the higher the market value of the company’s book value. PBR (Price to Book-value Ratio) is representative. That is the ratio of the stock price divided by the book value per share.

 

The last is a sales multiple. The company’s value is expressed as a multiple of sales. It shows how many times the stock price or enterprise value is formed compared to sales. Sales multiples include PSR (Price to Sales Revenue Ratio) and EVSR (Enterprise Value to Sales revenue Ratio). The former is the stock price divided by the sales per share, and the latter is the enterprise value divided by the sales.

 

In addition to the above three types, there are also ratios such as enterprise value divided by free cash flows or enterprise value divided by the number of users in a particular sector. However, in general practice, the above three types are most often used. The relative valuation method has the advantage of being relatively easy to use and reflecting the market price. But sometimes reflecting the mood of the stock market can be a weakness. That is because if a specific sector is overvalued or undervalued in the stock market, the target company valuation can also reflect market bias.

 

Valuation of a company can be classified by other criteria. Depending on which aspect it starts from, it can be classified into asset approach, income approach, and market approach. However, only the method categorising each valuation of a company is different, but the actual content does not change.

 

Category

Asset Approach Income Approach

Market Approach

Sub-category

  • Net asset valuation
  • Discounted cash flow method
  • Residual income model
  • Relative valuation Method

Classification of business valuation methods

 

One thought on “Business valuation methods – types and practical use

  1. Pingback: Why analysts prefer relative valuation multiples? | JCINUS [제이씨이너스]

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