The Value Of A Business: What Value Is, How Value Is Created, And How Value Is Measured

The Value of a Business: What Value is, How Value is Created, and How Value is Measured George C Currie

Introduction “Value” is one of the most basic concepts in economics, philosophy, ethics and sociology, yet is perhaps one of the least well-defined and most misunderstood (Trotta 2003). This paper examines three main aspects of value as it may apply in the business arena. It firstly provides a definition of value for business. It then describes the how a company creates value, and the operational, financial, and corporate governance issues involved. The paper finally introduces the main approaches and associated methods by which the value of the company can be measured. What is value? It is not only true (if somewhat trite) to say that “value” means different things to different people, it is also necessary to recognize that value is dynamic, and that the same person’s definition or interpretation of value varies according to changing circumstances. The first step in exploring value must therefore be to identify the purpose and limits of our definition of value. Throughout this paper the definition of value will be limited to its business sense. British Standard BS EN 1325-1: 1997: Value management, value analysis, functional analysis vocabulary, defines value as: “The relationship between the contribution of the function (or VA subject) to the satisfaction of the need and the cost of the function.” This relationship is commonly represented as:

Value

=

Satisfaction of Needs Cost

This definition applies not only to the value of the firm’s products or services to its customers, but also the value those sales create for the company, and through the cash flow created from them, of the firm to its owners. The primary function of business is to sell a product or service to a customer, since without that transaction none of the other functions of the business create value for its owners. At this individual transaction level, the customer has needs which he expects the product or service to satisfy, and the firm is in business to produce a product or deliver a service and offers this to the customer at a price. The selling price either set or negotiated for this transaction is the buyer’s cost of the satisfaction of his need. In our definition, the value of the product or service to the buyer is the benefit the buyer expects to obtain from it divided by its cost, and unless this is perceived to be greater than unity (i.e. the perceived or expected benefits exceed the selling price), there will be no sale. One of the main functions of the company’s management is to ensure that either the selling price of the product is kept low enough, or its benefits as perceived by the target market are high enough, that it has sufficient value in the eyes of the buyer to ensure the sale. The expected benefits (and hence the value) that the buyer expects to obtain are however in most cases complex, and stem from either or both of the two components of value identified by classical economics; “value-in-use” and “value-inexchange” (Smith 1776), together with the more modern concept of “esteem-value”. All three of these components however, to a greater or lesser degree include a subjective element. Esteem-value is the buyer’s internal answer to the question “How much do I want it?” (SAVE 1998), and represents the amount he is willing to pay for the perceived properties of a product or service which contribute to its desirability in his eyes. As such it is almost entirely subjective in nature. Value-inexchange depends on the collective agreement of a society as to what the relative value of things are, which varies - both over time as societal mores alter, and from place to place between societies, and hence in any particular transaction depends not only upon the personal circumstances and preferences of the buyer, but also on how he may anticipate these may change or how society may come to view the object in question. Even the direct benefit that the individual may obtain from the use of the object or service may change over time (and sometimes dramatically and over

a short period of time) depending upon the particular circumstance1. These variations affect the benefit that any particular individual perceives he would gain from the ownership of the object or receipt of the service, and hence his perception of its value-in-use at the seller’s price. When considering an individual object or service, its value therefore lies in the eye of the buyer and, although the price in a transaction may be set by the seller, value may only be determined by the buyer according to his individual circumstances, preferences and expectations (Tucker 2002). Assuming that the business has a viable product or service to offer to the market, and that at least some of its target market perceive this to have value, the firm will make sales and generate revenues. Each and every product or service sold by the firm throughout its life thus makes some contribution to the cash that may be distributed amongst the firm’s owners once it has paid all its costs and taxes. It is the anticipated existence of this cash flow from future sales that creates the value of the firm to its owners. The intrinsic value of the business is therefore the sum of its expected future after-tax cash flows (i.e. the revenues expected to be generated from its sales less the cost of the assets and other inputs used in their creation, and of the business entity itself), adjusted by a discount rate that appropriately reflects the relevant risk of the business, its products and its markets (McCarthy 2004). For privately-held businesses, their shareholder value is equal to the intrinsic value, however for publicly-listed companies their shareholder value is determined by the capital market in which the shares are traded, and the company has a fluctuating “market value” which is simply the share price at any time multiplied by the number of shares outstanding at that time. In a perfect capital market, i.e. one where all information is immediately reflected in the share price of the company, the market value (and hence the shareholder value) equals the intrinsic value. In real life however, the two may differ (in some cases markedly), either due to inefficiencies 1

For example, an adventurous traveler whose boat develops a serious leak when crossing a crocodile- infested river will not place any value on the water which threatens to sink him, but would pay almost unlimited amounts for fuel to run his boat’s pump to keep him afloat until he can be rescued or make it safely to shore. Conversely, the same adventurer whose 4WD breaks down when traversing a sandy desert later in his travels will value the extra fuel he carries far less than he would a supply of drinking water. The same two products, being employed by the same person, but having different values at different times due to different external circumstances.

where the company’s shares are traded in a small or illiquid capital market or, more commonly in large capital markets such as those of the United States or Europe, due to poor dissemination to the market of information affecting the intrinsic value. Whilst these larger and more liquid capital markets may not always be efficient on an “absolute scale”, at any given moment they are the most efficient reflection of what the most likely future development could be, given the information available at that time (Berendes, et al. 2001). How Is Value Created? The fundamental objective of the business corporation is to increase the value of its shareholders’ investment (Rappaport 1986), particularly in “Anglo-Saxon” economies such as the United States, the UK and Australia1. From the definition of shareholder value and the caveat on how the company’s share price may or may not correctly reflect its intrinsic value given above, it is apparent that increases of market value happen when the company’s management: a. Increases the intrinsic value of the company; AND b. Communicates and signals with the capital markets to ensure that they appreciate and reflect the intrinsic value in the share price. Shareholder value is added when the resulting increase in market value exceeds net capital inflows (i.e. new share issues and/or a conversion of convertible debentures) less payments to shareholders in the form of dividends or share buy-backs on the market in the period. Shareholder value is created when the shareholder value added exceeds the required return to equity, i.e. the return that shareholders expect to earn in order to feel sufficiently remunerated for the risk they have taken (Fernández 2002). As the intrinsic value of the company is the sum of its future net after-tax cash flows discounted at a rate to reflect their uncertainty or risk (as so far as this is perceived by its investors and debtholders), it can be increased by improving one or more of 1

In other countries, such as France, Germany and those in Scandinavia, the company’s management may be required (or at least expected) to take into account the interests of its other stakeholders, and in particular its employees. It has been demonstrated however, that maximizing the value of the company for its shareholders not only serves their interests but also the economic interests of all stakeholders over time (McTaggart and Kontes 1993), (Copeland, Koller and Murrin 2000) & (Berendes, et al. 2001).

three main variables: the cash flows deriving from the company’s existing assets; the expected rate and duration of growth in its cash flows; and the cost of its capital (Damodaran 2001). The company’s intrinsic value is increased when its management (at the corporate or business unit level) takes actions which proportionately increase one (or preferably both) of the first two or decrease the last one. Increasing Cash Flows from Existing Assets Since the cash flow from existing assets derives from income from investments already made by the company, it is most likely to be the prime source of immediate improvement in intrinsic value. Such improvements may involve one or more of the following: 

improving operating efficiencies;



divesting or liquidating investments that are earning less than the company’s cost of capital (and hence are destroying, rather than creating, value);



reducing the company’s tax burden;



reducing net capital expenditures on existing assets; and



reducing noncash working capital

Improving Operating Efficiencies Improving operating efficiencies increases the operating margin on existing assets, and hence generates additional value. Although promoters of business process reengineering will normally argue that all businesses have the potential to improve operating efficiencies, these opportunities are particularly marked where the firm’s operating margins are well below those of its competitors. The key issue for the company’s management is to identify the source of the inefficiencies in the existing business and how to fix it without sacrificing the company’s future growth. Below-average operating margins may signify that the firm is attempting to compete for customer sales on the basis of its selling prices (i.e. achieve a cost-leadership position) but has failed to optimize its cost structure, or alternatively that it is attempting to follow a differentiation strategy, but is failing to demonstrate the additional benefits of its product or service to its target market, hence reducing its

pricing power and margin. In either case, by identifying the source and reasons for the low operating margin, the business-specific value drivers required to bring about its improvement can be identified and suitable actions developed. These may be either revenue-side (allowing the company to generate incremental revenues in excess of related expense and investment), or expense-side ones focussed on decreasing costs or making operational efficiencies (Clark and Neill 2001). Generally, firms following a differentiation strategy may be expected to focus on revenue-side initiatives to increase operating margins whilst those aiming for a cost leadership role may generally be expected to concentrate on expense-side ones. Typical revenue-side initiatives may involve additional marketing research and promotional activities to improve customer segmentation and create awareness of the additional product benefits in the target market, or the introduction of a customer relationship management (“CRM”) system in order to allow the company to develop customer-specific value propositions to identify the total value created by the sale/purchase transaction and obtain a higher proportion of this over the life of the market, particularly by maximizing customer retention (Payne 2004). Expense-side initiatives, such as business process re-engineering, are aimed at identifying and removing extraneous costs from the entire value system for the production or delivery of the firm’s product or service, however in order to increase shareholder value it is essential that these do not involve cutting back on current expenditures (such as marketing or R&D) to the detriment of future growth and revenues. In either case, whether revenue-side or expense-side measures are adopted, in order to increase intrinsic value by improving operating margins it is essential that the correct cost management and/or pricing strategy is identified. Measures aimed at increasing revenues and/or reducing costs may, due to their effect on the existing balance of the market, actually adversely affect sales growth, and hence lead to reduced market share and/or product life. Increased product differentiation, for example, whilst affording the opportunity for higher selling prices and margins, generally does so only at the cost of reducing the size of the potential market. In more monopolistic markets, increasing the selling price of its product to increase revenues reduces the value of the product to its buyers and, depending upon their price-sensitivity for the item in question, may lead to lower sales over time as substitutes are identified and adopted, and hence may actually reduce revenues over the product’s life (Docters,

et al. 2004). Alternatively, if the market demonstrates price-inelasticity the higher selling price available may increase the attractiveness of the market and precipitate the entry of more competitors, reducing the firm’s pricing power and margins (Copeland, Koller and Murrin 2000). Asset Divestment Where the company has investments tied up in assets that are earning less that its cost of capital, then its value can be increased by divesting itself of these drags on its finances, provided that the sale or scrap value realized from the disposal is greater than the continuing value (i.e. the present value of the cash flows that will derive from operating the asset through its remaining life). Where the continuing value exceeds the value that would flow from liquidation or disposal of the asset, then its value to the firm is maximised by continuing to operate the asset as a going concern, irrespective of whether the cash flows exceed the cost of capital (Damodaran 2001). This is particularly relevant in the case of project-financed or structured-financed assets, where their loans are secured alternatively against the asset itself or the cash flows generated from its use. Events in these markets over the past few years have shown lenders even prepared to take over assets and operate them themselves to allow the business (if not its original owners) to continue as a going concern rather than selling them at their liquidation value in a depressed market. Reduce the tax burden Since the intrinsic value of the firm derives from its after-tax cash flows, for any given level of operating revenue the firm’s value may increase in proportion to any reduction achieved in the tax payable. The company’s management may reduce its tax burden by: 

transferring its income generation to lower-tax (or even no-tax) locations, often by manipulation of the internal pricing for the supply or consumption of internal products and/or services within the company;



acquiring net operating losses through the purchase of loss-making businesses; and/or



smoothing income to avoid exposure to higher tax rates in periods of exceptional performance.

As will be discussed later, the firm’s choice of financing also affects its tax burden since interest paid on debt is a tax-deductible expense under most regimes, whereas the returns to equity holders for their financing of the firm are not. The tax burden can therefore be reduced by substituting debt for equity in the financing mix. Reduce maintenance capital expenditure Net capital expenditure consists of two component parts; investment in new assets designed to generate future growth, and expenditure on maintaining existing assets in order to keep them productive. As with most management issues however, using this lever to increase shareholder value must be done with the utmost care. Though current cash flows can be increased by reducing or eliminating capital maintenance expenditures, this may actually reduce the intrinsic value if it means that the productive output of the asset is adversely affected (which may be in terms of the quantity and/or quality of its product), its working life and/or residual value is reduced, and/or it leads to higher maintenance costs being incurred in the future. Reduce noncash working capital Noncash working capital is the difference between the firm’s noncash current assets, (primarily consisting of its inventory and accounts receivable) and the nondebt portion of its current liabilities (primarily its accounts payable) (Damodaran 2001). Since decreases in noncash working capital show up as cash inflows, improving cash flow management in the firm to reduce its noncash working capital requirement as a proportion of its revenues will increase its intrinsic value provided it is done in a way that does not impair the productivity of existing assets or jeopardize future growth. Reduction in inventory, for example, decreases noncash current assets (and hence noncash working capital) and thus might reasonably be expected to increase shareholder value. It may however actually destroy value instead, if it leads to shortages of raw materials or spare parts, adversely impacting production efficiency

and hence reducing the productivity of its existing assets. Similarly, attempting to decrease noncash working capital by increasing accounts payable (i.e. by delaying payments to suppliers) may often mean that the prices charged to the firm by its suppliers will increase, or that the suppliers may give the firm lower priority during periods of high demand from its competitors. The former clearly impacts the net cash flows that the firm may generate unless it is able to pass these increased costs through to its own customers without affecting the size of its market, whilst the latter may reduce shareholder value if the non-availability of supplies jeopardizes (or is perceived to jeopardize) its ability to serve its customers and to defend its market share in profitable sectors (Harris and Goodman 2001). Either or both of these responses from others in its value system to the firm’s attempt to decrease its noncash working capital requirements would therefore result in shareholder value being lost rather than gained. Cash management improvements targeting reduction in accounts receivable, by contrast, are likely to have a direct and lasting positive impact on shareholder value. Rate and Duration of Growth A significant component (and in many cases, particularly for industries and companies that are based more on intangible assets, the overwhelming one) of a firm’s value is the market’s expectation for its growth. This “future growth value” (Stern and Hutchinson 2004) accounts for around 16 per cent of the value of consumer durables companies, rising to 137 per cent for technology hardware and equipment ones, and an average of 58 per cent for the US stock market as a whole (Ballow, Burgman and Molnar 2004). Although improvements to the cash flows deriving from the current assets of the firm are generally the most immediate source of increase of intrinsic value, in many cases the fruitful source of more long-lasting improvement lies in increasing the potential rate and/or duration of future growth. The key issue relating to growth is to grow only where the return on capital is greater than its cost, i.e. economic profit is positive, since the alternative destroys rather than creates value (McCarthy 2004). Identifying the type or source of future growth is therefore of critical importance to allowing the firm’s management to take correct strategic investment decisions aimed at increasing its intrinsic value. Where a firm has profitable investments and reinvestment opportunities (i.e. those generating

returns above its cost of capital), value is increased either by increasing the reinvestment rate, and hence foregoing more of the free cash flow generated by the existing assets in order to finance expansion in capacity, or by reinvesting its free cash flow in projects or markets offering higher rates of return at the same cost of capital. Even firms that are presently losing money however (those in the “new economy” of the internet for example) may still create shareholder value from their growth rate in revenues and the improvement this yields to their sales-to-capital ratio provided this can be achieved without adversely affecting the operating margin excessively (Damodaran 2001). The key in these cases is to identify the relationship between these three variables, and to establish what, if any, improvement in intrinsic value will be achieved by any strategy affecting these (noting that strong linkages may exist between the three). One of the key drivers of a company’s future growth, particularly in determining its duration by establishing and maintaining barriers to entry to prevent competitors from entering the market space it occupies in the minds of its customers, is its intangible assets, such as intellectual property, corporate and brand integrity, customer loyalty, the skills and knowledge of its workforce, and its leadership capabilities (Sussland 2001). This is particularly true of “new-economy” and services-based firms, where tangible assets like buildings and equipment are largely peripheral to their revenue generation. In light of this it is essential to the long-term value of the company for its management to be able to balance operations decisions, which tend to show immediate (or at least relatively rapid) impact on the bottom-line, with its investment in (and eventual returns from) its intangible assets. Failure to invest sufficiently in intangible assets such as R&D or employee training, in an attempt to improve shortterm performance measures may jeopardize the long-term revenues, or even viability, of the business (Sussland 2001). A key feature of value particular to firms is that, in general, they are entities having no fixed life and which are expected by their investors to exist (and provide returns) in perpetuity1. Growth and longevity of the existing business unit however, is finally 1

The “Special Purpose Vehicle”, or SPV, commonly adopted in project finance structures is an exception to this requirement of the company to continuously reinvent itself, since these are created with the express purpose of investing in a single capital asset with a single purpose and generally with a limited life (Esty 2003).

determined by the size and life-span of the market for its particular products or services, and further growth beyond those external constraints must come from expansion of the range of the company’s business activities, either in terms of the products or services offered, or the geographical markets served. Diversification is therefore necessary to maintain and regenerate the company’s rate and duration of growth and hence create value over the long term, as the company must find new businesses or markets to compensate for the normal decline of prospects for creating value in its existing ones. The key to creating rather than destroying shareholder value by such diversification lies in understanding the company’s core competencies and ensuring that the investment is in related industries and/or markets where these may also apply. The capital markets generally reward diversification into related or complementary markets but discount those which appear unrelated to the existing businesses or skills. Total returns to shareholders of the former may exceed even those of focussed companies whereas the capital markets tend to discourage fully diversified companies (Harper 2002). This is particularly true in cases of diversification through acquisitions, where unless there are strong synergies, the value inherent in the deal more commonly flows to the shareholder of the acquired company rather than to those of the buyer. Cost of Capital The cost of capital for a firm is a composite (usually a weighted average) of the cost of its debt and that inherent in its equity. Since the intrinsic value is the sum of the future cash flows discounted to the present at the firm’s cost of capital, it can be increased by reducing this denominator. This may be achieved by:



changing the operating risk, for example by strengthening the brand image and market positioning so as to make its market less discretionary;



reducing the operating leverage by reducing the proportion of fixed costs (although it is imperative to note that no long term competitive advantage can derive from any non-proprietary service or material, and so management must ensure that the use of subcontracting or outsourcing does not diminish margins or growth in the long-term);



changing the financing mix; and/or



changing the financing type (Damodaran 2001)

Substituting debt for equity in the capital structure of the firm can give rise to an increase in value for two main reasons. The first is that the nominal cost of debt is less than the current cost of equity; thus the shareholders’ expected return on their equity can be increased by the use of debt, however the cost of debt increases as the proportion of debt in the financing mix increases due to the increased risk to the lender of the company being unable to service the loan, and the company’s managers must determine what this cost of debt will be for different amounts of debt. Also, the equity return requirements must be determined since the cost of equity capital will also change as the percentage of debt capital is changed. Only having established both of these variables can the optimum mix of debt and equity for the firm be determined. The second reason for using debt is based on the tax law that allows debt interest to be tax deductions, but recognizes no tax deduction for the return on an equity security. The tax deductibility of interest can add significantly to the value of a firm with the amount of value added depending on the corporate income before tax, the corporate tax rate, and the amount of new debt. The investor tax rates also affect the analysis. The company’s cost of capital is also dependent on its market value (directly in the case of its equity and, in most cases, to a somewhat lesser extent for its debt) and hence its management’s financing decisions are inexorably linked with the need to properly signal and communicate its intrinsic value to the capital markets. Signalling and Communications with Capital Markets The "returns" that investors receive consist of dividends and realized market appreciation. If the market’s expectations of the firm’s results or other performance metrics are too high, and that later becomes clear, the market value of the firm will drop. Good communication with the investment community, both of the company’s plans and expectations and of its results, and the reason for any variance, is

therefore essential for a company, not only to reduce its cost of capital and hence increase its intrinsic value, but also to increase its market value directly and hence the returns available to its shareholders. The key issue involved is how the company and its management are perceived by the capital markets and the effect that this perception has on investors’ expectations of its future performance, and so shareholder returns are correlated with the quality of investor relations (as judged by the quality of annual reports, analyst conferences and other investor events) (Berendes, et al. 2001). Summary on How Value Is Created In order for shareholder value to be created the company’s management has to: 1) produce continuous earnings flow through its operational decisions; 2) invest wisely for future growth; and 3) communicate with the investment community proactively and reliably. The environment within which the company must do so is complex and dynamic, and there is a dichotomy between the interests of the company’s shareholders on the one part and those of its customers, suppliers, host governments, and other stakeholders (including its management) on the other (McCarthy 2004). Increased shareholder value only occurs where the company is able to capture a proportionately higher share of the total value produced in the value system for its existing product, and hence one or more of the other stakeholders must be left with a proportionately smaller share (even though, in a growing market, the amount itself may have increased). Most importantly many of the measures available to increase value rely on management achieving a balance between short term results and long term performance, and it is therefore imperative, particularly for publicly-listed companies, to ensure that the metrics used to monitor and reward the management’s performance includes both long-term and short-term components designed so as to properly align their interests with those of the shareholders to maximize the shareholder value of the business from its long term performance and not simply to attempt to manipulate the share price for short-term personal gain. Measuring Value

It is important to recognise that, as value is subjective and is based on the expectations of individuals (acting singly as buyers, sellers or holders of the firm’s shares) of future returns, cost and risk, we cannot measure it in the strict sense. There are exact methods of calculation, but there are no exact measures of value and the various valuation methods, all of which involve a subjective element, are correctly seen as providing an estimate of the value of a firm. These methods can be considered in three groups according to their basic approach; the Asset Approach, the Income Approach, and the Market Approach (Evans 2002), with two or more specific valuation techniques or methods falling under each of these approaches (Abrams 2005). Asset Approach The Asset Approach is predicated on the assumption that the value of the firm lies in its tangible assets, and seeks to measure value through the calculation of assets net of liabilities. The methods within this approach are essentially the traditional accounting measures (book value, adjusted book value, liquidation value and substantial value), which derive their foundation from an industrial age model that is increasingly removed and lacking in relevance with today’s businesses and ignore the fundamental variables required to add economic value to the firm: free cash flows investment horizon, and risk (Morin and Jarrell 2001). Most significantly these traditional accounting metrics are primarily backward looking, and fail to reflect the major drivers of future cash flows and hence of the firm’s value - in particular (and most glaringly) its intangible assets (Howell 2002). Income Approach The Income Approach consists of methods of fundamental valuation, which aim to directly estimate the intrinsic value of the firm or its equity, with the assumption that markets are, at least in the long run, efficient and hence the market price will reflect intrinsic value. These methods can be further divided into two main types: (i) those involving discounting estimates of future cash flows to the firm or to its shareholders, and (ii) those applying option pricing techniques to estimate its value. Selection of the correct valuation method depends upon the form of growth opportunities available to the firm, with the latter type being more suitable in situations where its

growth opportunities are dependent upon some form of contingent decision (Amram 2002). Discounted Cash Flow (DCF) Methods The main forms of discounted cash flow valuation are: 

the enterprise DCF model;



the economic profit model;



the equity DCF model; and



the adjusted present value (APV) model (Copeland, Koller and Murrin 2000)

While all four approaches discount expected cash flows and, when correctly applied, both DCF and economic profit models will yield equivalent results of the firm’s value (Shrieves and Wachowicz 2001), the relevant cash flows and discount rates are different under each, and it is important when applying DCF methods to ensure that the cash flows and discount rates used are consistent throughout (Fernández 2003). All DCF methods share common problems in (i) forecasting the expected cash flows for the firm; and (ii) predicting the right discount rate(s) that will be applicable to these future cash flows. Given these informational requirements, this approach is easiest to use for assets (firms) whose cash flows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available. The further the firm being valued deviates from this idealized setting, the more difficult (and possibly unsuitable) discounted cash flow valuation becomes. Particular difficulties with DCF methods are faced when applied in the following cases (Damodaran 2002):



Firms in trouble with negative earnings and cash flows. For these firms, estimating future cash flows is difficult to do, since there is a higher probability of bankruptcy. DCF valuation methods are not well suited to firms which may be expected to fail, since the fundamental premise of these methods is that the firm will provide positive cash flows to its investors.



Cyclical Firms: The earnings and cash flows of cyclical firms tend to follow the economy - rising during economic booms and falling during recessions. If viewed during the low part of the cycle a cyclical firm may look like a troubled one, with negative earnings and cash flows. Two alternative techniques are used to apply DCF valuation methods to such firms, either expected future cash flows are smoothed out, or the analyst attempts to predict the timing and duration of economic recessions and recoveries and the resulting cash flows generated over the cycle. In the former case the actual results of the firm will vary from those used in the valuation throughout the cycle, making it difficult to identify whether the firm is delivering the anticipated results and cash flows or if there has been a fundamental change in its market or risk which might invalidate the valuation. The latter alternative however entangles the analyst’s estimate of the firm’s likely performance and future cash flows with his predictions about the overall economic cycle.



Firms with under-utilized assets: As it values the company on the basis of cash flows generated, rather than looking at the assets the firm uses to generate these, DCF valuation methods reflect only the value of assets that produce cash flows. If a firm has assets that are un-utilized (and hence do not produce any cash flows) or under-utilized then the value of these assets will not be reflected in the value obtained from discounting expected future cash flows. Companies that effectively use shareholder value as a parameter in determining their executives’ remuneration more effectively incentivise their management to dispose of non-productive assets so as to capture the value of these (Fernández 2002). Un-utilized patents or licenses that do not currently produce any cash flows (and which may not indeed do so in the near future) are intangible assets that are of particular relevance in a number of industries. Historically the value of such assets was normally estimated using the Market Approach, however more recently it is more common that, as their value often depends upon the future occurrence of favourable market conditions which allow the firm to sell the resulting product and create a cash flow from them, it may be more accurately estimated using contingent claim valuation methods.



Firms in the process of restructuring: Firms in the process of restructuring often sell some of their assets; acquire other assets; change their capital structure, dividend policy, and management compensation schemes; and may even change their ownership structure by being taken private. Such changes make estimating future cash flows more difficult and affect the riskiness of the firm, since using historical data for such firms would give a misleading picture of the firm's value. When valuing such firms using a DCF method it is important to ensure that the future cash flows projected reflect the expected effects of these changes and that the discount rate used reflects the new capital structure and risk in the firm.



Firms involved in acquisitions: Specific issues that need to be taken into account when using DCF valuation methods to value acquisition target firms are: the form any synergy will take, and its effect on cash flows (Evans 2002); possible changes in management, particularly in hostile takeovers, and their impact on cash flows and risk; and the impact of significant changes in capital structure, since many acquisitions burden the target firm with a significant burden of debt, and their impact on cash flows and risk.



Private Firms: The biggest problem in applying DCF valuation methods to private firms is the estimation of the riskiness of the investment (to use in estimating discount rates). Most risk/return models estimate risk parameters from historical price, but as shares in private firms are not traded this is not possible. One solution is to look at the riskiness of comparable firms which are publicly traded. The other is to relate the measure of risk to accounting variables, which are available for the private firm.

Contingent Claim Valuation Methods Contingent claim valuation methods are variations on standard DCF methods that adjust the valuation to account for the value of flexibility in the firm’s response to future eventualities affecting its markets and opportunities through the application of option pricing models. While these models were initially used to value traded options, contingent claim valuation methods extend the reach of these models to value

strategic and operating flexibility in areas such as new product launches (through the possession of patents or licences), opening and closing plants, or natural resource exploration and exploitation rights (Copeland, Koller and Murrin 2000). When analysing a company using contingent claim methods it should be noted that the method most commonly used for valuing options, the Black-Scholes model, correctly applies only to European-type options (which are exercisable only on maturity), whereas strategic and operating flexibility and other corporate assets may more correctly be viewed as American-type options (which may be exercised at any time). Valuation of such assets using the Black-Scholes model in an unadjusted form underestimates their value (Damodaran 2001). Market Approach Valuation methods within the Market Approach aim to estimate the market value of the firm’s shares directly by comparison with other listed firms which are judged to be sufficiently similar in their structure and in the markets they serve. Because of their ease and speed of use, such relative valuations account for the majority of valuations performed (Damodaran 2002). Besides being useful valuation tools in their own right, particularly for valuing non-productive assets such as real estate, market approach valuation methods can be a useful check for errors in DCF valuations and may also serve to allow the company’s management to better understand mismatches between the company and its competitors (Goedhart, Koller and Wessels 2005). The first stage in performing a relative valuation is for the variables to be used for comparison of the firms to be standardized, usually by converting prices into multiples of earnings, book values or sales, although sector-specific variables may also be used. It is then necessary to identify similar firms, which is difficult to do since no two firms are identical and even firms in the same business can still differ on risk, growth potential, financing structure and mix, and cash flows. The question of how to control for these differences, when comparing a multiple across several firms, becomes a key one. The market value of the firm is then estimated by comparing its multipliers with those of the selected comparable firms and with their

market value. The following types of multiples are commonly used (Damodaran 2002):



Earnings Multiples. When buying a stock, it is common to look at the price paid as a multiple of the earnings per share generated by the company. This price/earnings ratio can be estimated using current earnings per share (yielding a current PER), earnings over the last 4 quarters (resulting in a trailing PER), or an expected earnings per share in the next year (providing a forward PER). When buying a business, as opposed to just the equity in the business, it is common to examine the value of the firm as a multiple of the operating income or the earnings before interest, taxes, depreciation and amortization (EBITDA).



Book Value or Replacement Value Multiples. As already noted, traditional accounting measures of value often provide a very different estimate of the same business. The ratio of the share price and the book value of equity or the replacement cost of the asset(s) may be a measure of how over- or undervalued a stock is within its sector (although the price/book value ratio that emerges can vary widely between different sectors, depending again upon the growth potential and the quality of the investments in each).



Sales or Revenue Multiples. Both earnings and book value are accounting measures which are determined according to accounting rules and principles which, as noted above, are poor metrics of economic value. An alternative approach, which is far less affected by accounting choices, is to use the ratio of the value of an asset to the revenues it generates. For equity investors, this ratio is the price/sales ratio (PS), where the market value per share is divided by the revenues generated per share. This makes it easier to compare firms in different markets, with different accounting systems at work, than it is when comparing earnings or book value multiples.



Sector-Specific Multiples. While earnings, book value and revenue multiples are multiples that can be computed for firms in any sector and across the entire market, there are some multiples that are specific to a sector. It is common

practice, for example, to use ratios involving annual production capacity, number of parking spaces, and annual insurance premiums in performing relative valuations of (respectively) cement companies, car parking firms and insurance companies (Fernández 2003). This method may be dangerous for two reasons; firstly, since they cannot be computed for other sectors or for the entire market, sector-specific multiples can result in persistent over or under valuations of sectors relative to the rest of the market, and secondly it is far more difficult to relate sector specific multiples to fundamentals, which is an essential ingredient to using multiples well.

Bibliography Abrams, Jay B. How to Value Your Business and Increase Its Potential. McGraw-Hill, 2005. Amram, Martha. Value Sweep - Mapping Corporate Growth Opportunities. Boston: Harvard Business School Press, 2002. Ballow J, Burgman R & Molnar M. "Managing for Shareholder Value: Intangibles, Future Value and Investment Decisions." Journal of Business Strategy 25, no. 3 (2004): 26-34. Berendes, Robert, et al. "Today's Challenge - Value Creation." In Value Creation, edited by Budde, Farha & Frankemölle. Wiley-VCH Verlag GmbH, 2001. Clark, Peter J., and Stephen Neill. The Value Mandate: Maximizing Shareholder Value Across the Corporation. AMACOM, 2001. Copeland, Tom, Tim Koller, and Jim Murrin. Valuation - Measuring and Managing the Value of Companies. New York: John Wiley & Sons, Inc., 2000. Damodaran, Aswath. The Dark Side of Valuation -Valuing Old Tech, New Tech, and New Economy Companies. Upper Saddle River, NJ: Prentice Hall, 2001. Damodaran, Aswath. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New York: John Wiley & Sons, 2002. Docters, Robert G., et al. "Turning Value Into Money." Journal of Business Strategy 25, no. 4 (2004): 25-30. Esty, Benjamin C., Harvard Business School. "The Economic Motivations for Using Project Finance," February 2003.

Evans, Frank C. “Valuation essentials for CFOs.” Financial Executive; Morristown; Mar/Apr 2002; Fernández, Pablo. "Company Valuation Methods. The Most Common Errors in Valuation." ICFAI Journal of Accounting Research II, no. No. 3 (July 2003): 3156. Fernández, Pablo. "A Definition of Shareholder Value Creation," January 2002. Goedhart, Marc, Timothy Koller, and David Wessels. "The Right Role for Multiples in Valuation." The McKinsey Quarterly March 2005. Harper, Neil W.C. & Viguerie S. Patrick. "Are You Too Focused?" The McKinsey Quarterly Special Edition 2002. Harris, Randy and Goodman, John. “B2B: Back to Basics – Driving Shareholder Value.” Strategy & Leadership; Chicago; Nov/Dec 2001; Howell, Robert A. "Fixing Financial Reporting: Financial Statement Overhaul." Financial Executive, March/April 2002, 40-42. McCarthy, Brian F. "Instant Gratification or Long-Term Value? A Lesson in Enhancing Shareholder Wealth." Journal of Business Strategy 25, no. 4 (2004): 10-17. McTaggart, James M., and Peter W. Kontes. "The Governing Corporate Objective: Shareholders Versus Stakeholders." Marakon Associates Commentary June 1993. Morin, Roger A. & Jarrell, Sherry L. Driving Shareholder Value - Value-Building Techniques for Creating Shareholder Wealth. New York, NY: McGraw-Hill, 2001. Payne, Adrian. "The Value Creation Process in Customer Relationship Management." Centre for Relationship Marketing, Cranfield School of Management, 2004. Rappaport, Alfred. Creating Shareholder Value: The New Standard for Business Performance. New York: The Free Press, 1986. SAVE. Value Methodology Standard. Society of American Value Engineers. SAVE International, 1998. Shrieves, Ronald E. and Wachowicz, John M Jr. “Free cash flow (FCF), Economic Value Added (EVA), and Net Present Value (NPV): A reconciliation of variations of discounted-cash-flow (DCF) valuation” The Engineering Economist; Norcross; 2001. Smith, Adam. The Wealth of Nations. 1776.

Stern, Erik, and Mike Hutchinson. The Value Mindset: Returning to the First Principles of Capitalist Enterprise. Hoboken, New Jersey: John Wiley & Sons, Inc., 2004. Sussland, Willie A. "Creating Business Value Through Intangibles." Journal of Business Strategy 22, no. 6 (November/December 2001): 23-28. Trotta, Raymond J. Translating Strategy Into Shareholder Value - A Company-Wide Approach to Value Creation. New York: AMACOM, 2003. Tucker, Robert B. “Adding Value Profitability.” The American Salesman; Burlington; Apr 2002.