Valuation

Whatever the reason for establishing and running a company, you will, at some stage, want to know the value of the business. This could be because of one of the following reasons:

• To identify weaknesses
• To determine whether the business is growing, stagnant, or deteriorating
• To apply for a loan
• To attract investors
• To establish a reference point as a platform for driving future growth
• In preparation for divesting from the company

There are several methods of valuation, but the three main methods will be discussed in this chapter.

This chapter will cover the following topics:

• Absolute valuation
• Relative valuation
• Interpreting the results

Absolute valuation

It is widely accepted that the most accurate way to value an enterprise is by absolute valuation using the discounted cash flow (DCF) method. Crucially, this method considers the time value of money. It also considers the cash flow throughout the projected life of the enterprise. This adheres closely to the definition of an enterprise's worth as the total amount of cash flow it can generate.

The DCF method includes technical concepts and calculations. We will attempt to simplify those concepts, but nevertheless, you will not have to repeat most of the complex computations required to derive some of the parameters necessary for the valuation. There will always be resources available for you to refer to, and you will certainly create your own database of resources, which you can tap as required.

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Relative valuation – comparative company analysis

Relative valuation relies on the theory that, in general, similar companies will produce similar results. This may be a bit simplistic, but in a discipline that involves a lot of assumptions and estimates, relative valuation is popular among analysts as it provides a way to arrive at the value of a business that is plausible, quick, and simple. The actual calculations are simple and straightforward; the difficulty is in identifying comparable companies.

The main criteria to consider are as follows:

• Industry
• Size
• Capital structure
• Geographical location
• Growth rate

Industry: With reference to your major source of income, identify the appropriate industry to which the company belongs and look for examples within that industry class.

Size: The relationship between size and profits is not exactly linear. A company with twice...

Summary

In this chapter, we have looked at three different methods of valuation:

• Absolute valuation using the discounted cash flow method
• Relative valuation using trading comparatives
• Relative valuation using transaction comparatives

We have learned that the DCF method is widely accepted as the most accurate, but because of its simplicity and ease of application, relative valuation is also popular among investment analysts. We have seen that there is no one correct answer; rather, we arrive at a range of results that give us a range within which the share price should fall. We have also learned how to create a football field chart to display our results and have learned how to interpret them in a meaningful way.

In the next chapter, Model Testing for Reasonableness and Accuracy, we will test our model to see how it responds to changes in certain key variables. We will also...