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Valuation Methods: The Valuation Process

discounted cash flows fair value free cash flows to equity free cash flows to the firm going concern value intrinsic value investment value valuation

The Valuation Process

Definitions of value

    Several value definitions serve as the foundation for the variety of valuation models available to the comparison of equity valuation methods, such as intrinsic value, going-concern value, liquidation value, and fair value.

    Intrinsic Value

      The intrinsic value of any asset is the value of the asset given a hypothetically complete understanding of the asset’s investment characteristics. The intrinsic value suggests that an asset’s market price is the best available estimate of its intrinsic value.

      Going-Concern Value and Liquidation Value

      In estimating value, a going- concern assumption is the assumption that the company will continue its business activities into the foreseeable future.

      If the company was dissolved and its assets sold separately this would be known as liquidation value.

      Fair Market Value and Investment Value

      Fair market value is the price at which an asset would change hands between a willing buyer and a willing seller when neither the buyer nor the seller is under any pressure to buy or sell respectively. Please note that fair market value implies that both buyer and seller are informed of all material aspects of the underlying investment.

      When a buyer considering acquiring a company takes into account specific synergies, tailor made requirements and expectations for the said company, then the value considered is referred to as investment value.[1]

      The Valuation Steps

      To obtain a useful estimate of value, accurate forecasts have to be combined with an appropriate valuation model or models.

       In order to be able to perform a proper valuation analysis and minimize the probability of significant errors five specific stages have to be followed in the valuation process of a company as presented below:

       

      Company Overview and Strategic Analysis

      This stage is necessary to understand the firm‘s operations and market conditions, and to form some expectations about the future development which can be used in the forecasting stage[2]

       

      Financial Analysis and Value Drivers Forecast

      Afterwards one needs to analyze the financial statements and extract the required value drivers in order to forecast the firm‘s future expected financial performance[3]. The performance of the company is analyzed and the relevant value drivers are derived based on the strategic analysis in order to forecast future cash inflows / outflows of the company.

       

      Cash Flows Discounting

      In the third stage, we are discounting the forecasted cash flows of the firm to the valuation date in order to obtain the firm value[4]. The dividends, the economic profit and the free cash flows to equity are discounted by using the cost of equity while the free cash flows to the firm and the economic value added are discounted with the WACC.

       

      Estimated Value Range from All methods

      Finally, the results have to be considered in a relevant context. Obtained results should be compared, and discussed in relation to the stock price.

       

      [1] J. Pinto, E. Henry, T. Robinson, and J. Stowe (2010), “Equity Asset Valuation”, CFA Institute Investment Series, John Wiley & Sons, Second Edition

      [2] Benninga S. Z. and Sarig O. H. (1997), Corporate finance – a valuation approach, McGraw Hill

      [3] Benninga S. Z. and Sarig O. H. (1997), Corporate finance – a valuation approach, McGraw Hill

      [4] Benninga S. Z. and Sarig O. H. (1997), Corporate finance – a valuation approach, McGraw Hill



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