How reliable are share and company valuations?

Company and shares valuations are important for both investors and managers. In acquisition and merger analysis, valuation plays a crucial part (Damadoran 2012), it is therefore important for managers to be able to efficiently value the target company (Arnold 2013).  It is also essential for manages who wish to increase shareholder value (Grundy 2014). For investors, it can be used as a tool to compare similar equities in that sector. It is therefore clear that company and share valuations are significant, so how reliable are the methods used to calculate them? In today’s blog I will be analysing three basic valuation methods and assessing their reliability.

Stock Market Valuation

Stock market valuation is the number of issued ordinary shares multiplied by the company’s market price (Watson & Head 2010). This method of valuation is considered reliable if EMH applies. However, in merger and acquisition analysis it can be used as a starting point for estimating the purchase price of a potential target company (Grundy 2014).

Net Asset Valuation (NAV)

There are two different types of NAV: book value and net realisable value (NRV).

Book Value is a straight forward method which uses accounting measures to financially value the company’s assets (Arnold 2013). The main advantage of this method is that it uses historical costs that are both factual and easily available (Watson and Head 2013).

NRV is the residual value of a company’s assets.  It is calculated by working out how much cash would be received if a company’s assets were sold on the open market (Watson and Head 2013).  These values are particularly useful when looking at firms in financial difficulty (Arnold 2013) or firms where their main value comes from their underlying assets (Grundy 2014) e.g. property investment companies (Arnold 2013).

Income Based Valuation

Income based valuations are orientated towards the future, thus assuming the company will continue to remain a going concern (Grundy 2014). There are three main methods which can be used: dividend valuation models, price to earnings ratio model and discounted cash flows (DCF) (Arnold 2013).

Dividend valuation models (DVM)

The most common method is seen with Gordon’s Dividend Growth Model. This approach assumes the company’s growth rate will remain constant (Arnold 2013). The value is therefore calculated by using the present value of dividends in order to determine a price (Watson and Head 2013).

Price to earnings ratio model

PER is one of the most popular approaches to use as it determines the price investors are willing to pay for each unit of earnings (Arnold 2013). It is simply the market price of a share divided by the latest reported earnings per share (Grundy 2014). This ratio can also be used to understand the market’s expectations of that company.

Discounted Cash Flows (DCF)

DCF are based on future cash flows and discount rates (Damadaran 2012). It is the difference between the present values of its pre-and post-acquisition cash flows. This technique contrasts to all the others mentioned above, as it calculates the maximum amount the purchaser should be prepared to pay (Watson and Head 2013).

Issues

Each of the methods highlighted above, may provide managers with different options and techniques to use, however each methods has several issues due to the assumptions made (Fernandez 2005)
Firstly, stock market valuation can cause problems as listed company’s share price do not reflect the value of all shares as only a small proportion are traded daily ( Watson and Head 2013). Furthermore, stock market valuations are reliable if EMH applies. As discussed in my previous blog, are markets efficient? If not, how reliable is this method? It can be argued that these issues seriously question the credibility of this method.
Secondly, net asset valuation does not reflect current asset value. In fact, it ignores intangible assets such a human capital and brands (Watson and Head 2013). Therefore there is a miss- match between actual value and book value (Grundy 2014). Furthermore, NRV is hard to calculate due to the difficulty surrounding unique asset valuations and is only useful when used in liquidation.

Thirdly, all three methods under income based valuation share similar issues. DCF calculations rely on estimation, a common error can be seen with exaggerated optimism when forecasting cash –flows e.g. Enron (Fernandez 2005).  Looking at DVM’s, the  issues arising are due to the fact that the majority of the calculation is based on assumptions and estimates (Arnold 2013) Is the past really a good indicator of the future? Furthermore, PER does not recognise the time pattern of earnings growth (Grundy 2014) as well as the fact that the model is based on distributable earnings (Watson and Head 2013).

Finally, it can be argued that for all of the methods mentioned above these issues are brought to our attention when trying to value unquoted companies. This is because there is less information disclosed (Grundy 2014) making it difficult to estimate and forecast figures, highlighting their dependence on forecasts and estimations.

How reliable are these methods?

The use of valuations will ultimately impact the reliability of the method chosen. As an investor, using a stock market valuation may prove to be reliable when comparing two companies in the same industry. However, as a manager looking to acquire a company, stock valuation methods will not be sufficient enough to determine the value of the target company.

Another example can be seen with NRV. In theory, the market value of a company should be higher than its NRV. Therefore, using this technique only applies when valuing a company in financial distress. It is therefore unreliable to use for companies which are considered to be a going concern.

 Similarly DCF is an appropriate method to use for those firms with positive cash flows which can be easily estimated (Damadaran 2012). Due to the fact that this technique assumes the company is a going concern; it therefore does not work well on distressed firms with negative earnings (Damadaran 2012).

It can therefore be argued that using solely one method for valuation can result in an unreliable value being produced. Therefore, in order to increase the reliability of a company’s valuation, a combination of methods should be used, alongside an efficient management team who have the necessary skills to carry this out.

 References

Arnold, G (2013). 'Valuing Shares'. In: Corporate Financial Management. 5th ed. Great Britain: Pearson. pp.723-770

Damodaran, A, (2012). 'Approaches to Valuation'. In: (ed), Investment Valuation Tools and Techniques for Determining the Value of Any Asset. 3rd ed. New Jersey and Canada: John Wiley & Sons Inc. pp.(11-19).

Fernandez, P, (2005). Most Common Errors in Company Valuation. Investment Management and Financial Innovations. 2. pp.(133-136).

Grundy, D (2014). ‘Valuing Shares & Companies (Part 1).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Grundy, D (2014). ‘Valuing Shares & Companies (Part 2).’ In: International Finance and Financial Management. United Kingdom: Newcastle Business School.

Watson,D and Head, A, (2013). 'Mergers and Takeovers '. In: Corporate Finance Principles and Practice. 6th ed. United Kingdom: Pearson. pp.(358-365).