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09 Nov, 2017

Company Valuation Methods. Balance Sheet-Based Methods (Shareholders' Equity) (Part 2)

Company Valuation Methods. Balance Sheet-Based Methods (Shareholders' Equity) (Part 2)

These methods seek to determine the company’s value by estimating the value of its assets. These are traditionally used methods that consider that a company’s value lies basically in its balance sheet. They determine the value from a static viewpoint, which, therefore, does not take into account the company’s possible future evolution or money’s temporary value. Neither do they take into account other factors that also affect the value such as: the industry’s current situation, human resources or organizational problems, contracts, etc. that do not appear in the accounting statements.

Some of these methods are the following: book value, adjusted book value, liquidation value, and substantial value.

1. Book Value

A company’s book value, or net worth, is the value of the shareholders' equity stated in the balance sheet (capital and reserves). This quantity is also the difference between total assets and liabilities, that is, the surplus of the company’s total goods and rights over its total debts with third parties.

Let us take the case of a hypothetical company whose balance sheet is that shown in the Table 1. The shares' book value (capital plus reserves) is 80 million euro. It can also be calculated as the difference between total assets (160) and liabilities (40 + 10 + 30), that is, 80 million euro.

Table 1. Alfa Inc. Official Balance Sheet (Million Euro)

ASSETS

LIABILITIES

Cash

5

Accounts payable

40

Accounts receivable

10

Bank debt

10

Inventories

45

Long-term debt

30

Fixed assets

100

Shareholders' equity

80

Total assets

160

Total liabilities

160

This value suffers from the shortcoming of its own definition criterion: accounting criteria are subject to a certain degree of subjectivity and differ from «market» criteria, with the result that the book value almost never matches the «market» value.

2. Adjusted Book Value

This method seeks to overcome the shortcomings that appear when purely accounting criteria are applied in the valuation. When the values of assets and liabilities match their market value, the adjusted net worth is obtained. Continuing with the example of Table 1, we will analyze a number of balance sheet items individually in order to adjust them to their approximate market value.

For example, if we consider that:

— Accounts receivable includes 2 million euro of bad debt, this item should have a value of 8 million euro.

— Stock, after discounting obsolete, worthless items and revaluing the remaining items at their market value, has a value of 52 million euro.

— Fixed assets (land, buildings, and machinery) have a value of 150 million euro, according to an expert.

— The book value of accounts payable, bank debt and long-term debt is equal to their market value.

Table 2. Alfa Inc. Adjusted Balance Sheet (Million Euro)

ASSETS

LIABILITIES

Cash

5

Accounts payable

40

Accounts receivable

8

Bank debt

10

Inventories

52

Long-term debt

30

Fixed assets

150

Shareholders' equity

135

Total assets

215

Total liabilities

215

The adjusted book value is 135 million euro: total assets (215) less liabilities (80). In this case, the adjusted book value exceeds the book value by 55 million euro.

3. Liquidation Value

This is the company’s value if it is liquidated, that is, its assets are sold and its debts are paid off. This value is calculated by deducting the business’s liquidation expenses (redundancy payments to employees, tax expenses and other typical liquidation expenses) from the adjusted net worth.

Taking the example given in Table 2, if the redundancy payments and other expenses associated with the liquidation of the company Alfa Inc. were to amount to 60 million euro, the shares' liquidation value would be 75 million euro (135−60).

Obviously, this method’s usefulness is limited to a highly specific situation, namely, when the company is bought with the purpose of liquidating it at a later date. However, it always represents the company’s minimum value as a company’s value, assuming it continues to operate, is greater than its liquidation value.

4. Substantial Value

The substantial value represents the investment that must be made to form a company having identical conditions as those of the company being valued. It can also be defined as the assets' replacement value, assuming the company continues to operate, as opposed to their liquidation value. Normally, the substantial value does not include those assets that are not used for the company’s operations (unused land, holdings in other companies, etc.).

Three types of substantial value are usually defined:

— Gross substantial value is the assets' value at market price (in the example of Table 2 it is 215).

— Net substantial value or corrected net assets is the gross substantial value less liabilities. It is also known as adjusted net worth (in the example of Table 2 it is 135).

— Reduced gross substantial value: this is the gross substantial value reduced only by the value of the cost-free debt (in the example of Table 2 it is 175 = 215 — 40). The remaining 40 million euro correspond to accounts payable.


Other parts of the article «Company Valuation Methods» (Part 1), and (Part 3), (Part 4), (Part 5), (Part 6), (Part 7), (Part 8)

Read also: DD Check List, Mandate F. A. Q.

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