There are three approaches in valuing a company :income, market and asset.
| Income Approach |
- The income approach is the most appropriate method for valuing an on-going company.
- An investment in any asset is worth no more than the present value of its expected future cashflow, which can be in the form of earnings, dividends or free cashflow to equity.
- The most common method used by analysts is single period capitalisation method (SPCM) (some finance text books call it the Gordon growth model for discounting back future dividends).
- SPCM converts the single period of income into value by dividing it with a capitalisation rate.
- This method relies on two assumptions: A stable annual financial return, which can be a proxy for every year in perpetuity; and a constant growth rate, which is a proxy for the annual compound growth rate in perpetuity.
Value of a company
Cashflow (1+g) R – g
where Cashflow can be in the form of dividend per share (DPS) or free cashflow per share g refers to the future growth rate of cash flow R refers to the required rate of return for an investor Capitalisation rate = R - g
Illustration:
- Company A provided a DPS of 50 sen last year. Let us assume that we expect the company’s DPS to grow at 8% (g = 8%). The value of a company is equal to RM10.80 if an investor’s required rate of return (R) is equal to 13%.
Value of company A = RM0.50 x (1 + 0.08) = RM10.80 0.13 -0.08
- The computed value of RM10.80 is the intrinsic value for Company A. We will rate it a “buy” if the current price is lower than RM10.80.
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| Market Approach |
| This method uses historical market data. The general theory is that if one can find sufficiently similar companies that have been sold in arms-length transactions, those transactions may form a foundation for an indication of value for the interest being valued. The common method uses the price-earnings ratio (PER). Analysts normally compare this ratio with the industry or its historical figures.
PER = Market price/Earnings per share (EPS)
- If Company A’s PER is 10 times against the industry’s 15 times, we can conclude that company A is undervalued.
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| Asset Approach |
| Asset approach is also known as adjusted book value or net asset value. The book value of the assets and liabilities are adjusted to reflect its fair market value. The asset values are totalled, and the total of the liabilities is subtracted to derive the total value of the company. The most common method is the revised net asset value (RNAV) where analyst adjusts all its assets and liabilities to market value.
For example, Company A is a holding company. It has a subsidiary, Company B, which is also listed on the exchange. The RNAV will use the market value instead of the book value of Company B to determine the overall revised market value of Company A’s assets. This figure will provide a more reflective value for Company A compared with its historical book value. Among the three approaches, the value indicated by the income approach is more appropriate and will have the greatest influence in valuing an operating company. |
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on Friday, October 26th, 2007 at 11:49 pm and is filed under Valuation of Company.
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