In this four-part series on valuation, I will describe different approaches to valuing a firm.
My advice is to start off with the methods given in this post, adapt them to the specific industry and corporate conditions, and then come to a consensus view based on all four approaches.
The Four Valuation Methods:
- Market Valuation, where actual market information is gathered on the debt and equity of a firm.
- Free Cash Flow to the Firm, where the present value of future cash flows to the firm are calculated.
- Asset Approach, where the company’s assets are valued.
- Valuation Multiples, where information is used on peer firms in the same industry to arrive at a valuation of the firm.
To show valuation in action, I will use the global pharmaceutical firm, AstraZeneca plc, as an example.
The Market Valuation Approach
The Market Valuation method takes data from the stock market to value a firm.
- Find Equity Value: Visit any financial webpage (such as FT.Com, Yahoo! Finance, etc.) and find the market capitalization of equity. I went to FT.Com’s webpage for AstraZeneca plc and got the information below: Figure 1: Summary data on AstraZeneca, 26 November 2016 (source: FT.Com)
The Market Capitalisation of equity is £54.30 billion.
- Find Debt Value: In most countries, corporate debt is traded irregularly. This means that the prices you get from financial pages can be out of date by a long way. The fastest way to find the value of a company’s debt is to get the total value of its liabilities from the most recent set of accounts. Don’t worry about any bond issues or loans issued since the most recent report because the cash raised will be reflected in the equity market capitalization.
Figure 2: AstraZeneca Balance Sheet (Source: AstraZeneca 2016 Q3 Results)
From Figure 2, the value of the Debt is equal to total liabilities = $48.31 billion.
At an exchange rate of $1.2478/£ (source: XE.com, 26 November 2016), AstraZeneca’s debt is worth £38.72 billion.
The total value of AstraZeneca plc according to the market valuation method is £93.02 billion.
Value of Equity + Value of Debt = £54.30 billion + £38.72= £93.02 billion.
Strengths and Weaknesses
The strengths of the market valuation method are as follows:
- Share prices contain all available information in the stock market including future growth prospects, intangible assets and the quality of a firm’s management, among other factors.
- The information you are using is the most up to date out of all the valuation approaches. Other methods use figures that can be many months old.
- The method makes no theoretical assumptions and is based entirely on observed market valuations.
- Market prices may not reflect value fundamentals. This can occur if a firm is the target of a takeover and the price has responded to the potential bid.
- If the company is not publicly traded there will be no market prices. Most valuations are carried out for private companies with no share price, which makes it impossible to use this method.
- The company may be small and traded infrequently leading to stale market prices. Out of date information can cause as many issues as poorly estimated information.
If a company is large and traded on the stock market, the market valuation method can be used quickly and easily to arrive at a firm value.
In my next post, I will explain the Free Cash Flow to the Firm method, which is also known as the income approach to corporate valuation.