COMPANY VALUATION METHODS. THE MOST COMMON ERRORS IN VALUATIONS. Pablo Fernández - PDF

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CIIF Working Paper WP no 449 January, 2002 Rev. February, 2007 COMPANY VALUATION METHODS. THE MOST COMMON ERRORS IN VALUATIONS Pablo Fernández IESE Business School University of Navarra Avda. Pearson,

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CIIF Working Paper WP no 449 January, 2002 Rev. February, 2007 COMPANY VALUATION METHODS. THE MOST COMMON ERRORS IN VALUATIONS Pablo Fernández IESE Business School University of Navarra Avda. Pearson, Barcelona, Spain. Tel.: (+34) Fax: (+34) Camino del Cerro del Águila, 3 (Ctra. de Castilla, km 5,180) Madrid, Spain. Tel.: (+34) Fax: (+34) Copyright 2004 IESE Business School. IESE Business School-University of Navarra - 1 The CIIF, International Center for Financial Research, is an interdisciplinary center with an international outlook and a focus on teaching and research in finance. It was created at the beginning of 1992 to channel the financial research interests of a multidisciplinary group of professors at IESE Business School and has established itself as a nucleus of study within the School s activities. Ten years on, our chief objectives remain the same: Find answers to the questions that confront the owners and managers of finance companies and the financial directors of all kinds of companies in the performance of their duties. Develop new tools for financial management. Study in depth the changes that occur in the market and their effects on the financial dimension of business activity. All of these activities are programmed and carried out with the support of our sponsoring companies. Apart from providing vital financial assistance, our sponsors also help to define the Center s research projects, ensuring their practical relevance. The companies in question, to which we reiterate our thanks, are: Aena, A.T. Kearney, Caja Madrid, Fundación Ramón Areces, Grupo Endesa, Royal Bank of Scotland and Unión Fenosa. IESE Business School-University of Navarra COMPANY VALUATION METHODS. THE MOST COMMON ERRORS IN VALUATIONS Pablo Fernández* Abstract In this paper, we describe the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods. The methods that are conceptually correct are those based on cash flow discounting. We will briefly comment on other methods since - even though they are conceptually incorrect - they continue to be used frequently. We also present a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. We conclude the paper with the most common errors in valuations: a list that contains the most common errors that the author has detected in more than one thousand valuations he has had access to in his capacity as business consultant or teacher. * Professor Financial Management, PricewaterhouseCoopers Chair of Finance, IESE JEL Classification: G12, G31, M21 Keywords: Value, Price, Free cash flow, Equity cash flow, Capital cash flow, Book value, Market value, PER, Goodwill, Required return to equity, Working capital requirements. IESE Business School-University of Navarra COMPANY VALUATION METHODS. THE MOST COMMON ERRORS IN VALUATIONS For anyone involved in the field of corporate finance, understanding the mechanisms of company valuation is an indispensable requisite. This is not only because of the importance of valuation in acquisitions and mergers but also because the process of valuing the company and its business units helps identify sources of economic value creation and destruction within the company. The methods for valuing companies can be classified in six groups: BALANCE SHEET Book value Adjusted book value Liquidation value Substantial value INCOME STATEMENT Multiples PER Sales P/EBITDA Other multiples MAIN VALUATION METHODS MIXED (GOODWILL) Classic Union of European Accounting Experts Abbreviated income Others CASH FLOW DISCOUNTING Equity cash flow Dividends Free cash flow Capital cash flow APV VALUE CREATION EVA Economic profit Cash value added CFROI OPTIONS Black and Scholes Investment option Expand the project Delay the investment Alternative uses In this paper, we will briefly describe the four main groups comprising the most widely used company valuation methods. Each of these groups is discussed in a separate section: balance sheet-based methods (Section 2), income statement-based methods (Section 3), mixed methods (Section 4), and cash flow discounting-based methods (Section 5). 1 Section 7 uses a real-life example to illustrate the valuation of a company as the sum of the value of different businesses, which is usually called the break-up value. Section 8 shows the methods most widely used by analysts for different types of industry. Another version of this paper may be found in chapter 2 of the author's book Valuation Methods and Shareholder Value Creation, Academic Press, San Diego, CA, The reader interested in methods based on value creation measures can see Fernández (2002, chapters 1, 13 and 14). The reader interested in valuation using options theory can see Fernández (2001c). IESE Business School-University of Navarra The methods that are becoming increasingly popular (and are conceptually correct ) are those based on cash flow discounting. These methods view the company as a cash flow generator and, therefore, assessable as a financial asset. We will briefly comment on other methods since - even though they are conceptually incorrect - they continue to be used frequently. Section 12 contains the most common errors in valuations: a list that contains the most common errors that the author has detected in more than one thousand valuations he has had access to in his capacity as business consultant or teacher. 1. Value and Price. What Purpose Does a Valuation Serve? Generally speaking, a company s value is different for different buyers and it may also be different for the buyer and the seller. Value should not be confused with price, which is the quantity agreed between the seller and the buyer in the sale of a company. This difference in a specific company s value may be due to a multitude of reasons. For example, a large and technologically highly advanced foreign company wishes to buy a well-known national company in order to gain entry into the local market, using the reputation of the local brand. In this case, the foreign buyer will only value the brand but not the plant, machinery, etc. as it has more advanced assets of its own. However, the seller will give a very high value to its material resources, as they are able to continue producing. From the buyer s viewpoint, the basic aim is to determine the maximum value it should be prepared to pay for what the company it wishes to buy is able to contribute. From the seller s viewpoint, the aim is to ascertain what should be the minimum value at which it should accept the operation. These are the two figures that face each other across the table in a negotiation until a price is finally agreed on, which is usually somewhere between the two extremes. 2 A company may also have different values for different buyers due to economies of scale, economies of scope, or different perceptions about the industry and the company. A valuation may be used for a wide range of purposes: 1. In company buying and selling operations: - For the buyer, the valuation will tell him the highest price he should pay. - For the seller, the valuation will tell him the lowest price at which he should be prepared to sell. 2. Valuations of listed companies: - The valuation is used to compare the value obtained with the share s price on the stock market and to decide whether to sell, buy or hold the shares. - The valuation of several companies is used to decide the securities that the portfolio should concentrate on: those that seem to it to be undervalued by the market. 2 There is also the middle position that considers both the buyer s and seller s viewpoints and is represented by the figure of the neutral arbitrator. Arbitration is often necessary in litigation, for example, when dividing estates between heirs or deciding divorce settlements. 2 - IESE Business School-University of Navarra - The valuation of several companies is also used to make comparisons between companies. For example, if an investor thinks that the future course of GE s share price will be better than that of Amazon, he may buy GE shares and short-sell Amazon shares. With this position, he will gain provided that GE s share price does better (rises more or falls less) than that of Amazon. 3. Public offerings: - The valuation is used to justify the price at which the shares are offered to the public. 4. Inheritances and wills: - The valuation is used to compare the shares value with that of the other assets. 5. Compensation schemes based on value creation: - The valuation of a company or business unit is fundamental for quantifying the value creation attributable to the executives being assessed. 6. Identification of value drivers: - The valuation of a company or business unit is fundamental for identifying and stratifying the main value drivers. 7. Strategic decisions on the company s continued existence: - The valuation of a company or business unit is a prior step in the decision to continue in the business, sell, merge, milk, grow or buy other companies. 8. Strategic planning: - The valuation of the company and the different business units is fundamental for deciding what products/business lines/countries/customers to maintain, grow or abandon. - The valuation provides a means for measuring the impact of the company s possible policies and strategies on value creation and destruction. 2. Balance Sheet-Based Methods (Shareholders Equity) 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. IESE Business School-University of Navarra - 3 2.1. 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 Table 1. The shares book value (capital plus reserves) is 80 million dollars. It can also be calculated as the difference between total assets (160) and liabilities ( ), that is, 80 million dollars. Table 1 Alfa Inc. Official Balance Sheet (Million Dollars) 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 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 dollars of bad debt, this item should have a value of 8 million dollars. - Stock, after discounting obsolete, worthless items and revaluing the remaining items at their market value, has a value of 52 million dollars. - Fixed assets (land, buildings, and machinery) have a value of 150 million dollars, according to an expert. - The book value of accounts payable, bank debt and long-term debt is equal to their market value. The adjusted balance sheet would be that shown in Table IESE Business School-University of Navarra Table 2 Alfa Inc. Adjusted Balance Sheet (Million Dollars) ASSETS LIABILITIES Cash 5 Accounts payable 40 Accounts receivable 8 Bank debt 10 Inventories 52 Long-term debt 30 Fixed assets 150 Capital and reserves 135 Total assets 215 Total liabilities 215 The adjusted book value is 135 million dollars: total assets (215) less liabilities (80). In this case, the adjusted book value exceeds the book value by 55 million dollars 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 dollars, the shares liquidation value would be 75 million dollars (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 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: this is the assets value at market price (in the example of Table 2: 215). - Net substantial value or corrected net assets: this is the gross substantial value less liabilities. It is also known as adjusted net worth, which we have already seen in the previous section (in the example of Table 2: 135). IESE Business School-University of Navarra - 5 - 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: 175 = ). The remaining 40 million dollars correspond to accounts payable Book Value and Market Value In general, the equity s book value has little bearing to its market value. This can be seen in Table 3, which shows the price/book value (P/BV) ratio of several international stock markets in September 1992, August 2000 and February Table 3 Market Value/Book Value (P/BV), PER and Dividend Yield (Div./P) of Different National Stock Markets September 1992 August 2000 February 2007 P/BV PER Div./P (%) P/BV PER Div./P (%) P/BV PER Div./P (%) Spain 0,89 7,5 6,3 3,38 22,7 1,5 3,8 20,0 2,9 Canada 1,35 57,1 3,2 3,29 31,7 0,9 3,2 15,8 2,2 France 1,40 14,0 3,7 4,60 37,9 1,7 2,6 16,4 2,5 Germany 1,57 13,9 4,1 3,57 28,0 2,0 2,4 14,0 1,9 Hong Kong 1,69 14,1 3,9 1,96 8,4 2,3 2,5 15,2 2,4 Ireland 1,13 10,0 3,2 2,55 15,2 2,1 2,2 17,4 1,6 Italy 0,78 16,2 4,1 3,84 23,8 2,0 2,4 17,9 3,2 Japan 1,82 36,2 1,0 2,22 87,6 0,6 2,3 28,2 1,1 Switzerland 1,52 15,0 2,2 4,40 22,1 1,4 3,3 17,5 1,5 UK 1,88 16,3 5,2 2,90 24,4 2,1 3,0 14,4 2,9 US 2,26 23,3 3,1 5,29 29,4 1,1 3,2 18,0 1,7 P/BV is the share s price (P) divided by its book value (BV). PER is the share s price divided by the earnings per share. Div/P is the dividend per share divided by the price. Source: Morgan Stanley Capital International Perspective and Datastream. Figure 1 shows the evolution of the price/book value ratio of the British, German and United States stock markets. It can be seen that the book value, in the 90 s, has lagged considerably below the shares market price. Figure 1 Evolution of the Price/Book Value Ratio on the British, German and United States Stock Mmarkets Price / Book value Germany UK US /75 1/77 1/79 1/81 1/83 1/85 1/87 1/89 1/91 1/93 1/95 1/97 1/99 1/01 1/03 1/05 1/07 Source: Morgan Stanley and Datastream. 6 - IESE Business School-University of Navarra 3. Income Statement-Based Methods Unlike the balance sheet-based methods, these methods are based on the company s income statement. They seek to determine the company s value through the size of its earnings, sales or other indicators. Thus, for example, it is a common practice to perform quick valuations of cement companies by multiplying their annual production capacity (or sales) in metric tons by a ratio (multiple). It is also common to value car parking lots by multiplying the number of parking spaces by a multiple and to value insurance companies by multiplying annual premiums by a multiple. This category includes the methods based on the PER: according to this method, the shares price is a multiple of the earnings. The income statement for the company Alfa Inc. is shown in Table 4: Table 4 Alfa Inc. Income Statement (Million Dollars) Sales 300 Cost of sales 136 General expenses 120 Interest expense 4 Earnings before tax 40 Tax (35%) 14 Net income Value of Earnings. PER 3 According to this method, the equity s value is obtained by multiplying the annual net income by a ratio called PER (price earnings ratio), that is: Equity value = PER x earnings Table 3 shows the mean PER of a number of different national stock markets in September 1992 and August Figure 2 shows the evolution of the PER for the German, English and United States stock markets. 3 The PER (price earnings ratio) of a share indicates the multiple of the earnings per share that is paid on the stock market. Thus, if the earnings per share in the last year has been $3 and the share s price is $26, its PER will be 8.66 (26/3). On other occasions, the PER takes as its reference the forecast earnings per share for the next year, or the mean earnings per share for the last few years. The PER is the benchmark used predominantly by the stock markets. Note that the PER is a parameter that relates a market item (share price) with a purely accounting item (earnings). IESE Business School-University of Navarra - 7 Figure 2 Evolution of the PER of the German, English and United States Stock Markets PER Germany UK US 0 1/71 1/73 1/75 1/77 1/79 1/81 1/83 1/85 1/87 1/89 1/91 1/93 1/95 1/97 1/99 1/01 1/03 1/05 1/07 Source: Morgan Stanley and Datastream. Sometimes, the relative PER is also used, which is simply the company s PER divided by the country s PER Value of the Dividends Dividends are the part of the earnings effectively paid out to the shareholder and, in most cases, are the only regular flow received by shareholders. 4 According to this method, a share s value is the net present value of the dividends that we expect to obtain from it. In the perpetuity case, that is, a company from which we expect constant dividends every year, this value can be expressed as follows: Equity value = DPS / Ke Where: DPS = dividend per share distributed by the company in the last year; Ke = required return to equity. If, on the other hand, the dividend is expected to grow indefinitely at a constant annual rate g, the above formula becomes the following: Equity value = DPS 1 / (Ke - g) Where DPS 1 is the dividends per share for the next year. Empirical evidence 5 shows that the companies that pay more dividends (as a percentage of their earnings) do not obtain a growth in their share price as a result. This is because when a company distribut
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