Major Methods of Company Valuation

Abstract

This paper will discuss valuing a company or business based on market capitalization method, book value method, expected future earning method and valuing company based on multiples, such as price/earnings method. After that, we will compare all these methods.

Keywords: market cap, book value, price to earning

 

 

 

 

 

 

 

 

 

 

 

 

Market Capitalization method is one of the easiest ways to value businesses/companies listed in the stock market. In this method, we need to multiply the number of outstanding stocks with the market price of each share to find out the market capitalization of the business/company (Investopedia, n.d.).

For example – a fictitious company ABC Inc. is listed in NYSE, it has 1 billion outstanding shares, and on NYSE each share is priced at $10, in this case, the market capitalization of AB Inc. is $10 billion.

 

Book value is very different than market capitalization. Book value is calculated based on the assets and liabilities a company has. So, it is more of an accountant’s job than the market price (Investopedia, n.d.).

Book Value = Total assets – Total liabilities

Book value per share = book value/number of shares outstanding

Note – here a company can have more current and long-term liabilities than its current and long-term assets, so book value can be negative.

 

On the other hand, an old company can have a lot of assets in land, real estate, equipment, unsold inventories and that would make the book value higher for the company, but the assets might not be income producing. But in certain businesses book value might help determine the size of the business, and real estate would be a good example of that, in such cases book value of a stock can impact the share price in the stock market.

Expected Future Earning is another method and most widely used method to value a company based on future earning potential by that company. Here we use NPV method, PV of all future earning and using a discount rate that will factor is the cost of capital, inflation etc.(Investopedia, N.d.).

But this is highly speculative too, analysts often take their best guess to estimate future earnings growth. But we need to remember the cost of capital can increase due to interest rate increase or due to inflation. And input cost can increase for the same reasons bringing down the cash flow.

For example, for a company XYZ Inc. the analysts forecast cash flow of $100000 in year 1, $150000 in year 2, $200000 in year 3, $250000 in year 4 and they do not have much information to calculate much further in time with much accuracy, so 5th year cash flow they will consider as Terminal value, $500000

If we use the discount rate of 10% then the estimated value of the company would be $846,353. But, in case the discount rate goes up to 12% then the company value would change to $793,813.

 

Valuing Company based on multiples is another quick way to value any business. And we can use price to earning to quickly value a business. P/E ratio is price one share / earning per share or

Market capitalization / Earning of one year.

The same way a company can be valued based on price/sales or price/asset too. These are all quick way to determine or get an idea of the price of a business.

Compare different valuation methodologies –

 

Market capitalization method Book value method Expected future earnings method Valuation based on multiples
This is a simple method to value public companies, price or 1 share multiplied with a number of outstanding shares would give market capitalization This can be applied to both privately held and public businesses. This valuation is also can be used for both public and private companies This can be used for public companies or for those companies those have outstanding shares.
In an open market when the shares are being traded, market capitalization can change in moments and news or speculation can affect the price Book value usually won’t change if there is no change in asset or liability, so this method is comparatively stable This is done based on estimation and based on discounted cash flow valuation can be way off too, things in economy might change very fast , very soon Valuation based on multiples are stable, although it might go up or down based on share price as they are traded in open equity market,
Valuation based on market cap often shows how market looks at a company’s future based on it’s earning potential Book value by itself can tell us if a company has enough asset to cover its liabilities, but that does not always tell us earning potentials Estimating future earning growth might go wrong, so this is not exact science, but usually people impose expectation based on the outlook of economy and for the company This is more of a comparative method, in the same sector the ratios can be compared to understand if a company is undervalued or overvalued, but after that future investigation is required
A Company can be overvalued due to over-optimism in traders A high book value might represent lot of unsold inventory and unproductive assets, which might justify ow price in stock During estimation in future earnings, the earnings growth can be overestimated, or economic slowdown can cause lower cash flow, that can throw off valuation The multiple can also vary based on high share price or low earning etc.

 

 

 

 

 

 

 

 

References:

 

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp

Retrieved on 5/14/2018. Retrieved from https://www.investopedia.com/terms/d/discounted-future-earnings.asp

 

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