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by Shirley Hume 03 Nov 2000 Diploma in Financial Management Relevant to All Papers

There are a number of techniques which can be used to help a buyer or seller decide on the range of values that should be considered. There are three main methods of valuation:

Asset based methods
Earnings based methods
Discounted cash flow techniques

Often more than one method will be used, giving a range of values to be considered. We will look first at the valuation methods themselves and then at other factors that will need to be considered.

Asset based valuations
These are the least useful of the above methods as, by definition, the starting point has got to the Balance Sheet which is an historic document showing the assets and liabilities of the business at some previous point in time. It does not incorporate expectations of future performance and growth potential.

Asset based valuations need to be done using the current value of the assets rather than the historic cost, which is the figure typically shown on a balance sheet. The valuation should take account of the net realisable value of the assets rather than the net book value. This will ignore expertise, reputation and internal goodwill, since none of these feature on a balance sheet. In fact the latter could include assets which are not currently revenue generating and therefore of little interest to a potential purchaser.

Asset based valuations are only really appropriate for asset intensive companies (eg property companies) where the assets themselves drive the earnings. It is not appropriate for 'people based' service companies or for many of the new technology companies. The net realisable value of the assets can be used to give the liquidation value of the business - an absolute minimum that the seller would accept if they were determined to sell, but in normal circumstances the method will undervalue a profit making business.

Earnings based valuations
These are the most commonly used method in the UK and can be used for either listed or unlisted companies. If you consider an unlisted company, then no P/E ratio exists as there is no market price. To find a value for the business we need to identify a suitable P/E ratio to apply to the earnings [profit after tax]. Using the ratio:

P/E = Market value / Profit after tax

we can use a suitable P/E ratio to estimate the market value of an unlisted company.

Two issues arise here, what earnings do we realistically think can be sustained in the future and what is a suitable P/E ratio. Firstly we have to adjust the current earnings for any changes the buyer plans to make, such as economies of scale, reduction in staff levels etc. Finding a suitable P/E ratio can prove more difficult. Ideally you want to identify a similar quoted company and apply its P/E ratio to the earnings of the unquoted company. Finding this similar company can prove very problematic, as most quoted companies are more diversified, larger and often have quite different gearing levels to an unquoted company in the same sector.

The value you calculate using this method will be overstated as an unquoted company has lower liquidity and possibly higher risk and lower growth than the similar quoted company. The market value should be adjusted downwards by anything from 20% - 40%, although these are purely arbitrary figures and will be affected by other considerations. Note that this value reduction can be achieved either by adjusting the P/E ratio downwards or the market value [but not both!]

Discounted cash flow techniques
Earnings based valuations rely on comparisons with other companies, whereas DCF methods look at the company in isolation. Future cash flows are estimated over a suitable time period and then an estimate is made of the value of the company at the end of that period ie the price you would be able to sell it for. As a buyer you expect to receive the annual cash flows and then the terminal value at the end of the period.

One of the biggest problems is in estimating the terminal value - you don't even know what it is worth today and yet you are trying to estimate what it will be worth at some date in the future. As you can easily see this method is only as good as the estimates of the cash flows! Once you have estimated the cash flows, you need to decide on a suitable cost of capital to discount the flows at, taking into account both the inherent business risk and the gearing level.

The present value you calculate is the total value of the company - to find the value of the shares you need to subtract the debt and any preference shares. Although the cash flow method is technically the most accurate, the difficulties of projecting the flows often mean it is rejected in favour of the earnings method. However at present the cash method is really the only semi-scientific way of valuing an internet company which may have very few assets and no profits.

Industry rules of thumb
A number of industries have built up their own rules of thumb for valuation, e.g. Estate Agents may be valued on a multiple of the number of outlets, a mail order firm by number of customers, hotels on number of rooms, mobile phone companies by number of subscribers etc.

Other factors
Other factors which need to be considered include:

• Industry prospects
• Management quality / stability
• Growth potential
• Competitive bidding
• Strategic fit
• Alternative opportunities

Overall, valuation of a business is an art with a bit of science thrown in, liberally laced with common sense and commercial acumen. Different people will put different values on a company and the amount finally paid can only be assessed with the benefit of hindsight. A price that appears too high at the time of purchase may subsequently appear to be a bargain if rapid growth in profits follows the take over, whereas a seemingly reasonable price may with hindsight appear too high if anticipated cost savings fail to materialise. As with many other purchases - Caveat Emptor!

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