The last 12 months has seen a resurgence in merger and acquisition activity and a lot of newsprint has related to bid prices that may or may not be at the correct level.
In this multi-part series of posts on corporate valuation, I will describe general approaches to valuing a firm. It is important to emphasise that the valuation techniques I present pay no attention to industry differences. Each specific industry has its own unique factors to consider and these will be covered in future articles.
Interested readers are invited to check out my textbooks for far more detailed information on corporate valuation.
My advice on corporate valuation 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. Sense checking with other companies is also advisable.
The four methods are:
- 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.
In this post, I will use the British construction firm, Carillion plc, as an example (the only reason being that it is in the news today for a possible merger with another construction firm, Balfour Beatty plc).
The Market Valuation method takes data from the stock market to value a firm.
- 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 and got the information below:
The Market Capitalisation of equity is £1.46 billion.
- Debt Value: In most countries outside of the US, corporate debt is traded irregularly. This means that the prices one gets from financial pages can be out of date by a long way.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 taken out since the most recent report because the cash raised would be reflected in the equity market capitalization.
From Figure 2, the value of the Debt is the total value of short-term and long-term creditors = £722.9 million + £579.7 million = £1.3026 billion.
The total value of Carillion plc according to the market valuation method is thus:
Value of Equity + Value of Debt = £1.46 billion + £1.3026 = £2.7626 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 changed in response to the potential bid.
- The company is not publicly traded and so there are 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.
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