Economic and financial valuation

The valuation is a fundamental process in the identification of the sources of wealth creation, transfer and destruction. This process is applied in many operations related to mergers and takeovers, or in a company entrance to the stock market. The exit of a shareholder, the request for external financing or in business successions are also causes that require an assessment of the value of the company.



The process of business valuation requires a profound knowledge of the company in order to solve great difficulties when assessing value to a living company, value that can change depending on the management.  


Furthermore, nowadays the increasing importance of the intangible assets adds difficulty to the valuation activity as, more and more, the greatest weight of the company’s value does not come from their tangible assets but, instead, from the intellectual capital. (See the paragraph “Global business consultancy: Balanced Scorecard).

As a consequence of that, some methods have emerged to measure a company’s capacity to generate wealth and to identify the value of the intangible assets, all with the aim to have a more realistic valuation of the company’s real value.
The specific circumstances that might require a company valuation are: 
  • The sale of shares in the stock market.
  • Stock market public offerings: Public Offer for the Sales Shares (POSS).
  • The purchase of shares from a capital risk society.
  • Mergers, takeover bids for securities and joint ventures.
  • Leverage buy-outs.
  • Stock options plans
  • Buy and sell of shares of unlisted companies.
The main valuating methodologies:

1 - Discounted Cash Flows: The value of a company depends entirely on its capacity to create future wealth. Therefore, the valuating method that should be applied should be based on the discounted Cash Flows.

  • Free cash flow (FCF).
  • Equity cash flow (ECF).
  • Dividends.
  • Capital cash flow (CCF).
  • APV, NPV.

However, sometimes trying to calculate these cash flows can be a difficult process: Because not all necessary information is available, or due to the erratic behaviour of cash flows.  

2 - Balance Sheet: Static methods based on accounting information: Against these difficulties, the best way to assess a company’s value is through the static methods which take into account the accounting value of the company’s assets and liabilities.
  • The accounting book value.
  • The adjusted accounting book value.
  • The liquidation value.
  • The due diligence.
 3 - Income Statement: Valuation using multiples: In the market analysis these methods are complemented with a valuation using multiples, also known as relative valuation. 
  • Multiples based on company's value or profitability
    • Return on Assets (ROA).
    • Return on Equity (ROE).
    • Company’s value / EBITDA.
  • Multiples based on market capitalization: 
    • Price Earnings Ratio (PER).
    • Earning Yield Gap (EYG).
    • Price Cash Flow (PCFR) or Price to Cash Earnings.
    • Price to sales (P/S).
    • Price to Levered Free-Cash Flow (P/LFCF).
    • P/AV (Price Accounting Value).
    • Dividend yield.
  • Multiples based on company’s growth
    • Price Earnings Growth PEG = PER/g .
    • (Company’s value / EBITDA)/g . 

4 -Mixed valuation methods (Goodwill): A third way is to mix the two previous methods, a mixed valuation approach. 

  • Classic valuation method.
  • Union of European Accounting Experts Abbreviated Income.
  • Indirect method.
  • Direct method.
  • Annual results buying method.

5 - Value creation:

  • EVA.
  • Economic profit.
  • Cash Value Added.
  • CFROI. 

6 - Real options aviation: In case we can incorporate the uncertainty of the cash flows calculation, the best approach would be the real options valuation methodology (real options analysis). 

  • Options and types of options.
  • The binomial method of shares valuation.

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