Concepts of business valuation – Critical review of the Discounted Cash Flow (DCF) analysis and its applicability in today’s business world
SEMINAR PAPER
Table of contents page 1. Introduction...............................................................................................................3 1.1 1.2 2. The importance of business valuation ..................................................................3 Key indicators covered in this seminar paper .......................................................4
The Discounted Cash Flow Analysis .......................................................................4 2.1 2.2 2.3 2.4 Foundational principles
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While there are many stakeholders who care about the financial situation of associated companies, like suppliers, customers, or creditors, the main addressees of business valuation are strategic investors who want to buy a significant stake in a company, as well as companies in the same industry that consider merging with another firm in order to push forward vertical or horizontal integration.1 And as a matter of fact, business valuation is by far not an easy task. There are hundreds of possible factors adding to the equation when it comes to determining the value of a business.2 Actually, just knowing the current value3 of an entire corporation, a factory or a certain department within an existing enterprise, usually does for itself not help much. Rather it is actually very uncommon that the current value of a business equals the price that’s paid by investors.4 The purchase price for a company is largely dependent on influences like the economic environment in general (boom or crisis), the demand for one single enterprise or its products5, the situation of the current shareholders6 etc. Other factors which can result in a difference between the value of a company and the price paid are for example the qualification of the existing management, the extent to which the company is seen
Valuations depend on forecasts. The reliability of the forecasts will then depend heavily on complete analysis of the industry, in addition to the evolving changes in the economy. It also requires understanding of the business and financial characteristic of the industry.
How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?
Valuation is the estimation of an asset’s value, whether real or financial, based on variables perceived to be related to future investment returns, on comparison with similar assets, or, when relevant, on estimates of immediate liquidation proceeds (Pinto, Henry, Robinson, Stowe; 2010). Correct valuation of real assets can present challenges to financial analysts. Different models can be used to arrive at the closest estimate of value and yet certain issues will always arise. This case attempts to tackle two approaches in real asset valuation: Discounted Cash Flow (DCF) analysis and the issues surrounding such, as well as the Black-Scholes Model for Real Options. Questions to be addressed in the study are:
1. The first step to evaluating the cash flows is to conduct the depreciation tax flow analysis. Depreciation is not a cash flow, but the depreciation expense lows the taxes payable for the company. As a result, the tax effect of deprecation needs to be calculated as a cash flow. There are two depreciable items on the company's balance sheet the building and the equipment. The equipment is known to have a seven year depreciable life, which will be assumed to be straight line. The building is also assumed to be subject to straight line depreciation, this time of forty years. The tax saving reflects the depreciation expense multiplied by the tax rate, which in this case is assumed to be 28%. The following table illustrates the tax effect in future dollars of the depreciation expense:
4. The case indicates that the company’s “market value” of equity at June 30, 1999 was $460 billion. Compare this to the company’s “book value” of equity. What factors likely explain the difference between these two values?
It is important to know the proper technique and method of valuing a company because different people may have different ways of assessing the value; it is also important in understanding the bank’s method of appraising and valuing a company or business
He can use two methods to determine the value of the company: discount cash flow (DCF) approach and /or comparison with similar companies, which are publically traded.
Our approach to valuing the processing plant can easily be decomposed into three distinct steps first, find the value of the foreseeable free cash flows. Next, calculate the terminal value of the project. Finally, take the present value of those flows. The next few paragraphs walk through each of these steps in order of progression.
in our calculations, as this company exhibited dramatic value differences to others in the sample, (likely to skew our results and prove misleading). Using the average of the revised sample field for each ratio, we inserted Torrington’s values where appropriate to generate an entity value. The findings generated two values for Torrington, 606 million and 398 million. Taking the average of these two numbers, Torrington exhibited a relative value of 502.41 million. Because of the lack of related information given in the case, and the often large differences in measures amongst competitors, different capital structures, internal management strategies, there remained many unknowns in our model. We decided it would be best to use this valuation to reaffirm our assumptions in our DCF valuation. (Please see exhibits)
The topic of valuation of early-stage companies, patents, and technologies have been a topic of study since the late 1980’s. Since the work published by Amit et al (1990) a body of management science literature was published around the value relevance of non-financial information that quantifies the human capital of the founding team. Amit et al posit that
This case attempts to tackle two approaches in real asset valuation: Discounted Cash Flow (DCF) analysis and the issues surrounding such, as well as the Black-Scholes
3. develop a deeper appreciation for challenges of valuing unseasoned firms and enhance corporate valuation skills
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
The National Bank of Greece, Deutsche Bank, and YF Securities all provided different offers for the purchase of major or controlling interests in Finansbank Turkish operations, which they derived using different valuation methodologies. A comparison of these valuation methodologies, insofar as they can be ascertained from published literature and other sources, provides an understanding of the appropriateness and influence of different financial considerations on overall valuations as seen from varying perspectives. A comparison of the three methodologies employed by the three competing institutions is provided in the following paragraphs.
After subtracting all economic costs from operating profits after taxes EVA reveals the true economic surplus available for further investment. Traditional cash flow analysis can easily disregard companies with negative cash flows because main purpose of traditional cash value metric is to control cash generation. In contrast, the main purpose of EVA is to optimize resource allocation. At difference to accounting measures, EVA highlights the gap in performance, and hence, aligns the interests of managers and shareholders. The link between shareholders value and economic profit of the company becomes more transparent. At difference to traditional accounting measures of corporate profit, EVA fully accounts for the company¡¦s overall capital costs. It includes both, the direct cost of debt capital and the indirect cost of equity capital. The cost of capital is the minimum return required to pay shareholder¡¦s equity . EVA can therefore determine whether or not the business is creating value but it can also indicate how much value is created at different business levels.