There are various methods adopted across the globe, however we discuss some of the common and widely accepted asset valuation methods.
1. Discounted Cash Flow Method
This valuation method based on free cash flow is considered a strong tool because it concentrates on cash generation potential of a business. This valuation method uses the future free cash flow of the company (after providing for changes in working capital and capital expenditures) and discounts it by the firm’s weighted average cost of capital (the average cost of all the capital used in the business, including debt and equity) to arrive at the value of the enterprise as a whole. According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flows are used to pay dividends to the shareholders. In general, the DCF method is a strong and widely accepted asset valuation tool, as it concentrates on cash generation potential of a business.
2. Net Asset Value Method
Under Net Asset Value Method a business is valued on the basis of the net assets of business i.e. the total assets less the liabilities and the preferred shareholders claims and dividing the resultant number by the equity shares outstanding as on a particular date. Valuation for this purpose can be done on a number of basis such as
- Book Value
- Net replacement value
- Net realizable value
NAV method of valuation is rarely used for valuing a going concern as it does not consider the future earnings capacity of the business. However it is a widely used method of valuation in cases where the projections of future profits cannot be made with reasonable accuracy, where there are losses or where the value of the entity is derived substantially from the value of its assets.
3. Comparable Company Analysis
Comparable company method of valuation is widely used to value private firms. It values an asset or firm based on how an exactly identical firm (in terms of risk, growth rate and cash flows) is priced. In this method, price multiples of comparable listed companies are applied to key financials to arrive at the valuation. Commonly used comparables are the PE multiple, EV/EBIDTA multiple, Price/Sales etc. Comparable company analysis method is much likely to reflect the current mood of the market since it attempts to measure the relative value and not the intrinsic value. Even though it is not an independent valuation methodology, comparable company method may be used to support valuations churned out by cash flow and other futuristic valuation methodologies. This is based on the premise that the market multiples of comparable listed companies are a good benchmark to derive valuation. The price earnings ratio expresses the stock price in terms of earnings per share (EPS). The P/E ratio uses the earnings of a company to value that company’s stock. The price to cash flow measure compares the value of a company relative to its cash flow generation. The price to cash flow ratio is based on the actual cash flow generated by the company unlike the PE ratio, which is an accounting measure and is susceptible to manipulation. The price to sales ratio measures the value of the company relative to its revenue. This measure provides a very useful benchmark for companies that are in commodity business with similar margins and operating characteristics. However certain issues like measurement of revenue and the revenue recognition policy need to be considered while using this ratio.
4. Maintainable Profit Method
Under this method a reasonable estimate of the average future maintainable operating profits is made by taking past earnings as a base and adjusting it for the trend and the future plans of the company. The resulting profit, after deducting for preference dividend, if any, is capitalized at an appropriate rate, and the resultant figure is the value of the equity shares. The determination of average future maintainable profits and suitable rate of capitalization is a complex task and necessitates subjective evaluation of many factors such as government policies, prospects of expansion, competition, nature of industry, entry barriers in business, technological obsolescence, investors perception etc. The capitalization rate could be taken as the aggregate of the long term risk free rate and the additional earnings expected to cover the risk involved in the business. If the company which is being valued has diversified businesses then the future maintainable profits may be capitalized at different rates on account of different risk levels of each business.