Valuations Analysis University of the People
For the following essay, I am going to describe several different valuation methods: Market Capitalization, Book Value, Expected Future Earnings, Discounted Cash Flow, and the
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Payback Method. I will then compare the methods using the methods of determination and their individual pros and cons.
Market Capitalization is a very easy method of valuation, being simply the number of share's multiplied by the price of stock. There is a benefit to using Market Capitalization due to the fact it is representative of factors that investors care deeply about because it takes into account what investors are willing to pay. By reflecting what individuals are willing to pay, it also inherently takes into account intangible assets. For instance, the future value of the company and even the competence of the CEO are reflected in this value because what consumers are willing to pay is impacted by these intangible assets. Having a CEO that wins the confidence of the stock consumers, like perhaps tech visionaries like Steve Jobs, may be enough for consumers to pay more than they would for stock in a company whose CEO is only in the news for scandals.
However, Market Capitalization does not take into the account the company's debt, nor does it take into account dividends, both of which will affect the 'true value' of a company (Kennon, 2016).
Book Value is the same as Net Present Value (NPV), found by subtracting total liabilities from total assets. Effectively it tells you how much cash your investment will generate, as Gallo explains. Book Value is an important figure because it accounts for the time value of money (Gallo, 2014). Its benefits are in assessing the assets of larger companies with significant inventory, property, and other assets. It is not suitable for smaller businesses, but can be used on businesses which are either losing money or making a very small profit as well. It is also useful in non-service businesses because it can be used to compare the industry average. It can also have a significant impact on the Earnings Before Interest and Taxes (EBIT); Book Value is more
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than half of the selling price, buyers might raise their multiples of EBIT considerably ("Business Valuation Using Book Value", n.d.).
Expected Future Earnings = earnings in future years/discount rate- growth rate. Expected Future Earnings is also known as the capitalization of earnings method. The future earnings are effectively the NPV of the future profits. According to Investopedia, this is is an income valuation method which helps an investor decide whether the risks are worth the investment. If, for example, the company has had roughly the same earnings and expenses for the past ten years, it is likely a safe investment based on the Expected Future Earnings method (Investopedia Staff, n.d. c). However, they note that the data provided to determine this valuation may be unreliable due to not being up to accounting standards. Further, outside factors that would quickly change this company's value, such as new competitors, are not taken into account, nor are intangible assets. Due to the short-term analysis as well as the assumption of continuing stable growth, this valuation can be used for smaller firms (AM Corporate Services Pte. Ltd, 2017).
The Discounted Cash Flow Valuation is, like Expected Future Earnings, an income valuation. It is calculated as Discounted Cash Flow = [Cash flow 1/(1+discount rate)^1] + [Cash flow 2/ (1+discount rate)^2]…. (Investopedia Staff, n.d.a). This calculation determines future cash flow and then applies a discount. It is more difficult than others because there are many more factors to take into account before making the valuation: All assumptions on costs and revenue, as well as taxes and depreciation, are typically looked over by not only management but an outside appraiser (AM Corporate Services Pte. Ltd, 2017).
All of these factors along with the appraisal will then be used find the terminal value using the Gordon Growth Model, which determines stock value based on future dividends that
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will result from the discounted cash flow (Investopedia Staff, n.d.b). This is far more detail than goes into other income valuations.
The final valuation is the Payback Method. According to Accounting Explained, for even inflows the Payback Period= Cost of investment/annual net cash flow. For uneven cash inflows: Payback period = last period with a negative cash flow+ absolute value of cumulative cash flow at the end of the last period with a negative cumulative cash flow/ the total cash flow during the period after the last period with a negative cumulative cash flow ("Payback Period", n.d.)
The Payback Period is how long it's expected to take before an investment will be paid back to the investor, and is the most common method of determining the value of investments, according to Joe Knight (Gallo, 2014). It is easy to compare to other businesses, as it comes down to the longer the payback period is, the worse the investment will be. The major downside of this method as compared to Book Value is that it doesn't take into account the time value of money ("Payback Period", n.d.)
Pros
Cons
Market Capitalization
Useful for large businesses
Not useful for small businesses
Includes intangible assets
Not as useful for unstable businesses
Easy to calculate
Usually for stable businesses
Book Value
Useful for large businesses
Not useful for small businesses
Doesn't include intangible assets
Takes into account monetary value being different currently than in the future
Easy to calculate
Takes into account past performance
Future Earnings
Can be used for all sized businesses
Short-term usefulness
Easy to calculate
Estimates of future earnings may be incorrect
Useful for stable businesses
Not useful for unstable businesses
Not useful for new businesses with limited history
Discounted Cash Flow
Useful for large or mid-sized businesses
Not useful for small businesses
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Useful for stable and unstable businesses
Difficult to calculate
Highly detailed
Time consuming
The Payback Method
Useful for various sizes of business
Does not take into account time value of money
Generally easy to calculate, though this may be more difficult if the inflows are uneven over the years
Useful for even or uneven inflows
The pros and cons of the valuations listed above show some of their similarities and differences. For instance, all methods can be used for large businesses, but only capitalized future earnings is particularly useful for small businesses. Market Capitalization, Book Value, and capitalized Future Earnings all are simple to calculate, but are less accurate due to not including enough factors. For instance, Market Capitalization doesn't include dividends or debts, Book Value doesn't include intangible assets, capitalized future earnings rely on information that may be inaccurate, and the Payback Method does not include the time value of money. Discounted cash flow provides the most accurate future information, but due to the amount of details required is a very difficult valuation to find.
In conclusion, which valuation is used depends on the company and the needs of the investor. A good starting point would be first determining the size, then whether or not the company has dividends. From there, the stability of the company should be evaluated, as well as the need for time value of money. These parameters should narrow the choices considerably and give the investor one or few valuations to perform.