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09 Nov, 2017

Company Valuation Methods. Which is the Best Method to Use? (Part 7)

Company Valuation Methods. Which is the Best Method to Use? (Part 7)

The fundamental problem with the methods is that some are based solely on the balance sheet, others are based on the income statement, but none of them consider anything but historic data. We could imagine two companies with identical balance sheets and income statements but different prospects: one with high sales, earnings and margin potential, and the other in a stabilized situation with fierce competition.

We would all concur in giving a higher value to the former company than to the latter, in spite of their historic balance sheets and income statements being equal. The most suitable method for valuing a company is to discount the expected future cash flows, as the value of a company’s equity — assuming it continues to operate — arises from the company’s capacity to generate cash (flows) for the equity’s owners.

On many occasions, the company’s value is calculated as the sum of the values of its different divisions or business units. Holding companies are basically valued by their liquidation value, which is corrected to take into account taxes payable and managerial quality.

The growth of utility companies is usually fairly stable. In developed countries, the rates charged for their services are usually indexed to the CPI, or they are calculated in accordance with a legal framework. Therefore, it is simpler to extrapolate their operating statement and then discount the cash flows. In these cases, particular attention must be paid to regulatory changes, which may introduce uncertainties

In the case of banks, the focus of attention is the operating profit (financial margin less commissions less operating expenses), adjusting basically for bad debts. Their industry portfolio is also analyzed. Valuations such as the PER are used, or the net worth method (shareholders' equity adjusted for provision surpluses/deficits, and capital gains or losses on assets such as the industry portfolio).

Industrial and commercial companies the most commonly used valuations — apart from restated cash flows — are those based on financial ratios (PER, price/sales, price/cash flow).

Other parts of the article «Company Valuation Methods» (Part 1), (Part 2), (Part 3), (Part 4), (Part 5), (Part 6) and (Part 8)

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

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