Company Valuation Methods in Germany) - Assignment Example

Company valuation methods Name Subject Instructor Institution Date Company valuation methods Introduction Valuing a company is normally a tricky and difficult task. Valuation dictates how equity will be divided amongst company’s entrepreneurs and investors. If a company prepares a thorough valuation of its ventures, it will gain a strong negotiation position in the stock market. This paper elucidates the various methods of company valuations and discusses the current corporate valuation methods. Valuation methods that are mostly used include: discounted cash flow models, Capital Asset Pricing Models (CAPM) and Arbitrage Pricing Model (APM). Companies need more inventive methods to discover changes in financial setting to contend with the perpetual changes as noted by (Fernandez, 2004). Diverse corporate theories have been developed ever since 1950s. These theories explain reactions from investors to the financial and investment decisions by companies. Valuation of companies is crucial in cooperate finance (Inter Metro Business Journal Fall, 2006, p. 40). Several events change the validity of valuation models. An example is the Enron that resulted to the re-evaluation of classical and neo-classical valuation methods. It describes the basic valuation methods like models in discounted cash flow where the value of a company is expressed in terms of the net present value of future cash flow as noted by (Capiński and Patena, 2006, p.3). Capital Asset Pricing Model (CAPM) links the market risk with the returns from equity. Various investment decisions also contribute to company’s valuation. Discounted Cash Flow Models Different valuation models on discounted cash flow focus on assessment by reference to the anticipated cash-flow proxies which include dividends, earnings from accounting and cash flow. In ideal situations, results from these variables should be identical, but if this is not the case in real world (Revista Empresarial Inter Metro Business Journal Fall, 2006). Experiential analysis shows the variation in the outcomes is due to different estimates of the expected future cash flow. These models are written as P = CF1 + CF2 + CF3 + ……… (1+r) (1+r)2 (1+r)3 Capital Asset Pricing Model (CAPM) It postulates linear relationship between expected return rate and systematic security risk. It is considered to be an extension of portfolio theory by Markowitz’s (1952). Some of the researchers who have been credited with CAPM development are Sharpe (1964), Linter (1965) and Black (1972), hence the name SLB model as stated by (Fama and French, 2001, p36). Portfolio efficiency concept combines risky assets, reduces return and at times maximize the returns for a specific risk. Variance for the returns expected represent the locus of certain portfolios that facilitate reduction of return risk rate. Arbitrage Pricing Theory (APT) This theory was developed by Ross (1976). According to this theory, return value is dependent upon other independent factors but not on a single systematic risk factor. When these models contains CAPM beta, they are termed as extended CAPM. Major criticism of this theory is that there are no clear specifications on the model that should be used. Multifactor version by Fama and French (2001) is consistent with APT. CAPM is criticized of being ineffective in the prediction of the returns and instead market capitalization and book- market equity ratios are proposed in prediction of a larger variance proportion. Weighted Average Cost of Capital (WACC) Value of a particular company is free of capital and divided policies effects when taxes inclusion is omitted Easton, et al., (1992, pp.125-129). Introduction of cooperate taxes influences company’s valuation, and interest deduction facilitate cheaper cost of financing where assumptions of perfect capital markets and information are made. Studies reveal that value to equity proliferates intensely when a company incurs a debt in an effort to finance new projects rather than using internal finance or issuing of new equity. Value of a particular debtor decreases when a company issues new debts (Revista Empresarial Inter Metro / Inter Metro Business Journal Fall 2006, p. 47) Investment Models Optimization model forms the basis for the Neo-classical investment models. These models describe the relationships on capital stock, interest rates, output, assets on capital and the tax policies. Studies show that, companies possess an equal portion in capital access despite of risk associated with it; competent capital market and flawless information is assumed. Theory of Interest by Fama and French (2001), presents an abridgment of investment model. Fama and French (2001), allots a summarized representation of this theory. Investment demand by Gozzi et al., (2006) expressed the net investment as a function of the ratio of market value to the replacement cost. Letter ‘q’ represents the replacement ratio hence the name Tobin's q Model of investment. According to this model, investment for a particular company is incessant with capital marginal unit value exceeding the costs. In empirical testing, the average q ratio is applied rather than the marginal q. Further justification by (Miller, 1986) illustrates that investment is determined by average q only under certain assumptions. This include: production and adjustment cost functions which possess constant returns to scale, perfect competition in product and factor, and efficient stock market free of any consistent trounce from even the company’s insiders. Examination of internationalization effects by use of Tobin’s q was done by Racheva-Iotova and Stoyan (2002, p. 176) and Gozzi et al (2006). Their results have been used in supporting models which emphasize on q being continuous, and also accommodates models on Sales Accelerator Models that were designed by (Gabehart and Richard, 2002). These models by Jorgenson and Siebert explicitly demonstrate relationship of capital goods demand to changes in the output for a particular company. In these models, capital cost and production cost hold no absolute relation with investment; instead, they express optimal capital cost as a function of the sales and investments. The specifications of these models demand instantaneous adjustment of capital stock, but some experiential results reveal that some lagged output values affect the current investment. Investment expenditures in a particular company are independent of both the company demand and funds’ availability. Failure by a particular company to cover investment with any internal finance translates into inability of investing at the level desired when external finance cost supersedes those of internal finance. Estimation of these models is through use of cash flow as surrogate for the amount of internal funds at company’s disposal. Empirical evidence from empirical research depicts the link between investment expenditure and conditions on output and cash flow but not on the q ratio (Gabehart and Richard, 2002). When new market values capital exceeds book value, a company will thus have incentive to be invested (Revista Empresarial Inter Metro / Inter Metro Business Journal Fall 2006, p. 49) Measures on Growth of Potential Value Results from financial analysis deliberate much on the financial forecast that is based on current financial statements. They show that substantial value of a company is accredited to the growth potential. Excess Market Value (EMV) epitomizes growth potential and it rapt on company surplus value on investments. On the other hand, Economic Rent (ER) represents valuation in economy. It covers the economic profits created by companies from its operations, hence, it is different from accounting profits as it includes total costs; business opportunity cost on equity capital. Research shows that companies that engender ER create better profits than companies that have similar characteristics of risk; hence excess value. The excess value is defined as EMV. This shows that ER enhances monopolized power accessibility and specific factor rents but EMV indicates market valuation ascribed to an anticipated future ER. Association between ER and EMV is underscored by Edwards and Bell (1961), and later, it was elaborated by Racheva-Iotova and Stoyan (2002, p. 176). The significance of topical goodwill (EMV) is that it embodies present normal profits (ER) value. Book value can be assumed to represent investor’s money while the market value represents input value of the company’s market. Since EMV represents surplus for the market value over the book value, it clearly indicates the creation of value. Excess return describes the earning power of investments available hence acts as alternative for the company’s ability in an effort of adding value from the investments added. EMV and ER are argued to be strongly related theoretically (Gabehart and Richard, 2002). Empirical measures on accounting like earning per share (EPS), return on investment (ROI), return on equity (ROE) and return on assets (ROA) provides a basis for economic measures for the evaluation of the strategic accounting plans (Shim, 2000) EMV and ER have been strongly advocated as measures of a company’s performance by some investment companies (Stern Stewart Financial). There were proprietary names’ proposals by Inter Metro Business Journal Fall (2006) for their EMR and ER proxies. The measure that was used on EMR is referred to as Market Value Added (MVA) while the one for ER is referred to as Economic Value Added (EVA). Stewart (Miller, 1986) designed some accounting in estimation of MVA which was based on accounting data. He further argued that EVA and MVA facilitate interpretation of performance in business through application of Microeconomic and Corporate Finance principles in tracking of the true economic value by the management. However, Stewart was not the one who pioneered this method, but identification and measurement of the value from shareholders was by (Miller, 1986). (Gabehart and Richard, 2002) analyzed market value and ratio of book value and compared it to the ER proxy. ER proxy expresses the difference between average return rate and cost of equity. Conclusions from (Gabehart and Richard, 2002) examination reveals that, companies with high returns of equity relative to capital cost have high potential in investments and high market value relative to the book value. Fernandez (2004, p.147), analyzed the hypothetical relationship EMV and ER through the modification of DGM. Racheva-Iotova and Stoyan (2002, p. 176) shows that market value in a particular company is different from cost replacement of its assets by monopoly power of the present value. Therefore, market value for a particular company is expressed as EMV = MV – BV, thus MV = BV + EMV Where: BV=company’s book value MV= company’s market (Gabehart and Richard, 2002, pp.231-235) further supported this specification but with minor modifications. Green et al., (1996, pp.191-200) analyze empirical validity of value based models, by use of OLS methodology. They relied on framework from Miller (1986, pp.451-455) to show Profitability, growth and the company value relationship through regression of (MV/BV) for anomalous earnings, and was estimated by claims on the return on equity less capital cost. Regression of (MV/BV) was also based on earnings from growth rate from Revista Empresarial Inter Metro Business Journal Fall (2006, p. 52). Gozzi et al., (2006), studied the relation of different performance measures and stock returns. Data was collected from EVA and MVA from several sources in the analysis of relationship in measures of performance; ROS, ROA, ROE, MVA, EVA, and the market return. Findings show positive correlation with the market return. However, EVA shows higher return correlation than the rest. The analysis on qualitative characteristics on EVA and MVA performance by companies shows inverse proportionality to company’s CEO turnover Conclusion Company valuation methods have been examined in this paper, which included analysis of various theories. Most of empirical studies rely so much on assumptions from other valuation theories in testing theory prediction in question. In estimation of ER, most empirical works use Framework from CAPM in estimation of capital cost. Measures based on performance are preferred because they use Microeconomic and Corporate Finance theories in explanation of valuation, but this is still in early stages of development. Despite of it being at the infancy stages, it provides a better elaboration of valuation than most of the theories which are highly dependent on accounting measures of performance. References Capiński, M. and Patena, W., 2006. “Real Options – Realistic Valuation”, Journal of Business and Society, p.3. Dickie, B., 2006. 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