Share valuation, the process of determining the fair market value of a company’s shares, is a critical aspect of corporate finance. Accurate share valuation has far-reaching implications, influencing decisions related to mergers and acquisitions, initial public offerings (IPOs), estate planning, and tax assessments.
Understanding the various methods used for share valuation is essential for investors, business owners, and financial professionals alike. By grasping these techniques, individuals can make informed decisions, mitigate risks, and maximise returns.
In this blog post, we will delve into the different methods used for share valuation, exploring their strengths, weaknesses, and applicability in various contexts.
The Discounted Cash Flow (DCF) method is one of the most widely used approaches for valuing a company’s shares. It estimates the anticipated future cash flows for a business and discounted it to its current value.
Steps Involved in the DCF Method:
1. Forecast Future Cash Flows:
- Operating Cash Flows: Estimate the company’s future operating income, considering revenue growth, cost of goods sold, operating expenses, and taxes.
- Capital Expenditures: Estimate the future capital expenditures required for the company’s growth and maintenance.
- Working Capital: Compute the working capital change over time (current assets less current liabilities).
- Free Cash Flow: Calculate the free cash flow by subtracting capital expenditures and changes in working capital from operating cash flows.
2. Determine the Discount Rate:
- The discount rate represents the rate of return investors require to invest in the company’s shares.
- The discount rate represents the rate of return investors require to invest in the company’s shares.
3. Compute the Future Cash Flows' Present Value:
- Discount each year’s free cash flow to its present value using the discount rate.
- Sum up the present values of all future cash flows to obtain the total present value.
4. Divide by the Number of Shares Outstanding:
- Divide the total present value by the number of shares outstanding to determine the intrinsic value per share.
Relative Valuation Methods
Relative valuation is a method of valuing a company’s shares by comparing it to similar companies or industry benchmarks. This method is predicated on the idea that businesses with comparable attributes need to be valued similarly.
Different Types of Relative Valuation Methods:
- Price-to-Earnings (P/E) Ratio: The P/E ratio is calculated by dividing a company’s stock price by its earnings per share (EPS). A higher P/E ratio suggests that investors are willing to pay more for each dollar of earnings, indicating a higher perceived growth potential or future earnings potential.
- Price-to-Book (P/B) Ratio: The stock price of a corporation is divided by its book value per share to get the P/B ratio. A higher P/B ratio indicates that investors are willing to pay more for each dollar of net assets, suggesting a premium for intangible assets or growth opportunities.
- Price-to-Sales (P/S) Ratio: The P/S ratio is calculated by dividing a company’s stock price by its revenue per share. A higher P/S ratio suggests that investors are willing to pay more for each dollar of revenue, indicating a premium for growth potential or market share.
How to Use Relative Valuation Methods:
- Identify comparable companies: Select companies that operate in the same industry, have similar business models, and are of equivalent size.
- Calculate valuation ratios: Calculate the P/E, P/B, and P/S ratios for both the target company and its comparable peers.
- Compare valuations: Compare the target company’s valuation ratios to the average or median ratios of its peers.
- Adjust for differences: If there are significant differences between the target company and its peers (e.g., size, growth rate, or risk), adjust the valuation ratios accordingly.
Asset-Based Valuation
The fair market value of a company’s assets less its obligations is the basis for asset-based valuation. This approach assumes that a company’s value is primarily determined by the underlying value of its tangible and intangible assets.
Steps Involved in Asset-Based Valuation:
- Identify and value assets: List all of the company’s assets, including intangibles like trademarks, patents, and goodwill as well as tangibles like property, plant, and equipment. Ascertain each asset’s fair market value. Appraisals or other methods of value may be necessary for this.
- Identify and value liabilities: Identify all of the company’s liabilities, including debt, accounts payable, and other obligations. Determine the fair market value of each liability.
- Calculate net asset value: Subtract the total liabilities from the total assets to determine the net asset value.
- Divide by the number of shares outstanding: Divide the net asset value by the number of shares outstanding to determine the intrinsic value per share.
Market-Based Valuation
Market-based valuation is a method of valuing a company based on the current market price of its shares. This approach assumes that the market price reflects the collective wisdom of all investors and is therefore a reliable indicator of the company’s value.
Concept of Market-Based Valuation:
- Market efficiency: Market-based valuation relies on the assumption of efficient markets, where all available information is reflected in the stock price.
- Price discovery: Given that market prices are established by the exchange of goods and services, it is thought that they provide the most realistic picture of a company’s worth.
- Simplicity: Market-based valuation is relatively straightforward, as it involves simply observing the current stock price.
Choosing the Right Method
When selecting a share valuation method, several factors should be considered:
- Industry: Different industries may have different valuation norms and practices.
- Stage of development: The stage of the company’s life cycle (e.g., startup, mature, declining) can influence the appropriate valuation method.
- Purpose of the valuation: The reason for the valuation (e.g., mergers and acquisitions, IPOs, estate planning) will determine which method is most relevant.
- Availability of data: The availability of financial data and information about the company and its industry will affect the feasibility of certain methods.
- Company’s unique characteristics: The specific characteristics of the company, such as its intangible assets, growth prospects, or risk profile, may make one method more suitable than others.
Often, a combination of methods is used to provide a more comprehensive and accurate valuation. For example, the DCF method can be used to estimate the intrinsic value of a company, while relative valuation methods can provide a benchmark against similar companies. By combining multiple approaches, analysts can obtain a more robust and reliable valuation.
Conclusion
Share valuation is a complex process that requires careful consideration of various factors. The methods discussed in this blog post, including discounted cash flow, relative valuation, asset-based valuation, and market-based valuation, each offer unique perspectives.
When choosing a valuation method, consider the specific circumstances of the company and the purpose of the valuation. A combination of methods may often provide the most accurate and reliable assessment.
Marcken Consulting specializes in comprehensive share valuation services. Contact us for expert guidance.
Frequently Asked Questions
Q1. What is the most accurate method for valuing shares?
The “most accurate” way to value shares does not exist. The best method depends on various factors, including the company’s industry, stage of development, and the specific purpose of the valuation. A combination of methods is often used to provide a more comprehensive and accurate assessment.
Q2. How do market value and intrinsic worth differ from one another?
Intrinsic value is the perceived value of a company based on its underlying fundamentals, such as its future cash flows and assets. Market value, on the other hand, is the current price at which a company’s shares are trading on the market.
Q3. Can share valuation be used for tax purposes?
Yes, share valuation is often used for tax purposes, such as determining capital gains or losses and calculating estate taxes. Seeking advice from a tax expert is crucial to guaranteeing accurate assessment and compliance with relevant tax regulations.
