The Meaning Of Value And Company Values Finance Essay

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Date added: 17-06-26

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A value is a belief, a mission, or a philosophy that is really meaningful to the company. Every company has one or more values, whether they are consciously aware of it or not. Another way of saying it is that a value is a statement of the company's intention and commitment to achieve a high level of performance on a specific Qualitative factor. Value is the market worth of financial assets or liability. In management, business value is an informal term that includes all forms of value that determine the health and well-being of the firm in the long-run. Business value expands concept of value of the firm beyond economic value (also known as economic profit, Economic value added, and Shareholder value) to include other forms of value such as employee value, customer value, supplier value, channel partner value, alliance partner value, managerial value, and societal value. Many of these forms of value are not directly measured in monetary terms. Valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes. In finance, Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Value is about the following basic questions; What is my company worth? What are the ratios used by analysts to determine whether a stock is undervalued or overvalued? How valid is the discounted present value approach? How can one value a company as a going concern, and how does this change in the context of a potential acquisition, or when the company faces financial stress? Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. Fair Market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the real estate market. An estimate of fair market value may be founded either on precedent or extrapolation. Fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as: acquisition/production/distribution costs, replacement costs, or costs of close substitutes, actual utility at a given level of development of social productive capability and supply vs. demand and subjective factors such as, risk characteristics, cost of and return on capital and individually perceived utility. Intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value.

Valuation Methods:

Income-based.

These forward-looking methods are general enough to be applied to most types of businesses. Asset Valuation: This method is more appropriate for established companies with a large amount of tangible assets (such as property companies). The valuation is made by calculating the net realisable value of all assets. Discounted cash flow: This method involves forecasting earnings into the future (usually by three to 10 years) to determine the present value. Discounted cash flow is a good valuation method for fast-growth businesses; it can also be used if you're valuing your business for the purpose of bringing in a partner. Capitalization of cash flow: For this method, which is best used for mature companies with stable earnings, the value of one normalized earning period is used to predict future value.

Market-based.

If you're valuing your company in order to sell it, you'll want to look at how other businesses in your industry are valued. Capital market (or Guidance Company): This method looks at multiples of publicly traded stocks, and works best for any companies that are large enough to be comparable to publicly traded firms. For example, this method would be more appropriate to use for a chain of retail stores than a single-unit retail company. Transaction: Better for smaller companies, this method examines what other businesses in your industry y have sold for.

Cost- or asset-based.

This valuation method adds up all the individual components of your business to find its value. Manufacturing or asset-holding companies, which have few intangibles, can get the most from this method.

Using Comparables

The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for apples-to-apples comparisons, most people who look at earnings measure them according to earnings per share (EPS). One arrives at the earnings per share by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if XYZ Corp. has one million shares outstanding and has earned one million dollars in the past 12 months, it has a trailing EPS of $1.00. The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported. $1,000,000 -------------- = $1.00 in earnings per share (EPS) 1,000,000 shares The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. The Price-to-Sales Ratio: Every time a company sells a customer something, it is generating revenues. Revenues are the sales generated by a company for peddling goods or services. Whether or not a company has made money in the last year, there are always revenues. Even companies that may be temporarily losing money, have earnings depressed due to short-term circumstances (like product development or higher taxes), or are relatively new in a high-growth industry are often valued off of their revenues and not their earnings. Revenue-based valuations are achieved using the price/sales ratio, often simply abbreviated PSR. The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company XYZ Corp. has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million. Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies where one has taken out enormous debt that it has used to boast sales and one that has lower sales but has not added any nasty debt either.

Market Capitalization = (Shares Outstanding * Current Share Price) + Current Long-term Debt

The next step in calculating the PSR is to add up the revenues from the last four quarters and divide this number into the market capitalization. Say XYZ Corp. had $200 million in sales over the last four quarters and currently has no long-term debt. The PSR would be: ((10,000,000 shares * $10/share) + $0 debt PSR = ----------------------------------------- = 0.5 $200 million revenues The PSR is a measurement that companies often consider when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales," you have seen the PSR in use. As this is a perfectly legitimate way for a company to value an acquisition, many simply expropriate it for the stock market and use it to value a company as an ongoing concern.

Free Cash Flows Methods

Despite the fact that most individual investors are completely ignorant of cash flow, it is probably the most common measurement for valuing public and private companies used by investment bankers. Cash flow is literally the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the vagaries of the laws in a given year and actually can cause dramatic fluctuations in earnings power. For instance, Cyberoptics enjoyed a 15% tax rate in 1996, but in 1997 that rate more than doubled. This situation overstates CyberOptics' current earnings and understates its forward earnings, masking the company's real operating situation. Thus, a canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income in order to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits. As for depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting convention for tax purposes that allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally comes in when a company acquires another company at a premium to its shareholder's equity -- a number that it account for on its balance sheet as goodwill and is forced to amortize over a set period of time, according to generally accepted accounting principles (GAAP). When looking at a company's operating cash flow, it makes sense to toss aside accounting conventions that might mask cash strength. In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. Some counsel selling companies when their cash flow multiple extends beyond 10.0. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA.

IBM's Income Statement

Annual Income Statement (Values in Millions) 12/2002 12/2001 Sales 81,186.0 85,866.0 Cost of Sales 46,523.0 49,264.0 Gross Operating Profit 34,663.0 36,602.0 Selling, General & Admin. Expense 23,488.0 22,487.0 Other Taxes 0.0 0.0 EBITDA 11,175.0 14,115.0 Depreciation & Amortization 4,379.0 4,820.0 EBIT 6,796.0 9,295.0 Other Income, Net 873.0 1,896.0 Total Income Avail for Interest Exp. 7,669.0 11,191.0 Interest Expense 145.0 238.0 Pre-tax Income 7,524.0 10,953.0 Income Taxes 2,190.0 3,230.0

Total Net Income

3,579.0

7,723.0

Option-Based Methods

Executives continue to grapple with issues of risk and uncertainty in evaluating investments and acquisitions. Despite the use of net present value (NPV) and other valuation techniques, executives are often forced to rely on instinct when finalizing risky investment decisions. Given the shortcomings of NPV, real options analysis has been suggested as an alternative approach, one that considers the risks associated with an investment while recognizing the ability of corporations to defer an investment until a later period or to make a partial investment instead. In short, investment decisions are often made in a way that leaves some options open. The simple NPV rule does not give the correct conclusion if uncertainty can be "managed." In acquisitions and other business decisions, flexibility is essential -- more so the more volatile the environment -- and the value of flexibility can be taken into account explicitly, by using the real-options approach. Financial options are extensively used for risk management in banks and firms. Real or embedded options are analogs of these financial options and can be used for evaluating investment decisions made under significant uncertainty. Real options can be identified in the form of opportunity to invest in a currently available innovative project with an additional consideration of the strategic value associated with the possibility of future and follow-up investments due to emergence of another related innovation in future, or the possibility of abandoning the project. The option is worth something because the future value of the asset is uncertain. Uncertainty increases the value of the option, because if the uncertainty is interpreted as the variance, there are possibilities to higher profits. The loss on the option is equal to the cost of acquiring it. If the project turns out to be non-profitable, you always have the choice of non-exercising. More and more, the real options approach is finding its place in corporate valuation.
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