|Methods and techniques|
Appraisal right in case of merger prevents investor from paying to the shareholders less than the company is worth. Minority shareholders have the right for an independent valuation of company value and fair stock price. Then investor has to pay fair price for shares.
There are multiple methods of determining the fair price, starting with value of shares on stock exchange and ending with asset-based methods or cash flows. The most popular methods are:
- Asset-based valuation,
- Net asset value,
- Comparable markets data models,
- Income based methods,
- Cash flow based methods,
- Hybrid formulas,
- Price to earnings ratio (P/E),
- Discounted cash flow.
“The asset-based approach is sometimes called the asset approach to business valuation. Either name for this approach is generally accepted among valuation analysts and in the valuation literature.
The asset-based approach encompasses a set of methods that value the company by reference to its balance sheet. In contrast, income approach and market approach valuation methods primarily focus on the company’s income statement and/or cash flow statement.
One of the very first procedures in any closely held business valuation is to define the business ownership interest subject to valuation. That is, the assignment should specify whether the valuation intended to conclude a defined value for the subject company:
- Total assets,
- Total long-term interest-bearing debt and total owners’ equity,
- Total owners’ equity,
- One particular class of owners’ equity.
This method is easy to calculate, readily available and provide a minimum value of the company.
- Valuation of intangible assets is difficult such as intellectual property rights,
- Company’s future earnings are ignored,
- The statement of financial position may prematurely value assets because of depreciation element.
Net Asset Value
“The per-share value of a mutual fund, found by subtracting the fund’s liabilities from its assets and dividing by the number of shares outstanding. Mutual funds calculate their NAVs at least once daily.”
Net Asset Value is the current market value of all the fund’s assets, minus liabilities, divided by the total number of outstanding shares.
Comparable Markets Data Models
The sales comparison approach is based primarily on the principle of substitution. This approach assumes a prudent (or rational) individual will pay no more for a property than it would cost to purchase a comparable substitute property.
Data is collected on recent sales of properties similar to the subject being valued, called "comparables". Only SOLD properties may be used in an appraisal and determination of a property's value, as they represent amounts actually paid or agreed upon for properties. Sources of comparable data include real estate publications, public records, buyers, sellers, real estate brokers and/or agents, appraisers, and so on. Important details of each comparable sale are described in the appraisal report.
Income Based Methods
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation.
There are four income based methods:
- Direct capitalization,
- Discounted Cash Flow,
- Gross Rent Multipler,
- Short-cut DCF.
Price Earnings Ratio
The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
The P/E ratio can be calculated as: Market Value per Share / Earnings per Share.
Determines the profitability of buying the securities.
In fundamental analysis, it belongs to the category of market value indicators. It is also called the net profit coverage ratio. The size of this indicator is shaped by two main factors: the size of the company's risk and the prospects of its revenue growth. The higher the level of risk associated with a given company, the lower is the level of market prices of shares quoted on the capital market. Thus, the higher the level of risk, the lower the P / E ratio.
The increase in the ratio informs that investors are willing to pay more for the company's shares than before. A low level may suggest that the investment is advantageous because the company generates substantial profits, with a relatively low market valuation. Too low its level will be a buy signal for the investor, because the company's shares may be undervalued.
Discounted Cash Flow
“Discounted Cash Flow methodology assumes that the present range of values of the company as of the valuation date is equal to the present value of future cash flows to the company shareholders. Due to the limitation of the period of the financial projections the value of the company is a sum of two factors:
- The present value of cash flows (sum of the present value of dividends that the company may afford to pay out to shareholders and/or additional capital injections made by the shareholders),
- Residual value of the company, which is the discounted value of the company resulting from cash flows generated by the company after the projections period.”
There are five options of calculating DCF:
- Free Cash Flows to Equity (FCFE),
- Adjusted present value (APV),
- Weighted average cost of capital (WACC),
- Total cash flow (TCF),
- Free Cash Flow to the Firm.
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
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- Kirk W. C., Wishing K. J. (2018), pp 4-5.
- Grant R. M. (1991), pp 114-135.
- Investment Company Institute (2007), pp 5, 35.
- Lins M. P. E., Novaes L. F. D. L., Legey L. F. L. (2005), pp 79–96.
- Boughton D. et al.(2007), pp 64-101.
- Basu S. (1977), pp 663-668.
- Janiszewski S. (2011), pp 82.
Author: Daniel Żołna