Corporate Valuation

Measuring the Value of Companies in Turbulent Times

Mario Massari, Gianfranco Gianfrate, Laura Zanetti

• Publisher: Wiley
• Year: 2016
• ISBN:
  9781119003342
• Edition: 1
• Topic: Business
• Subtopic: Valuation
• Index: Business

Risk consideration is central to more accurate post-crisis valuation

Corporate Valuation presents the most up-to-date tools and techniques for more accurate valuation in a highly volatile, globalized, and risky business environment. This insightful guide takes a multidisciplinary approach, considering both accounting and financial principles, with a practical focus that uses case studies and numerical examples to illustrate major concepts. Readers are walked through a map of the valuation approaches proven most effective post-crisis, with explicit guidance toward implementation and enhancement using advanced tools, while exploring new models, techniques, and perspectives on the new meaning of value. Risk centrality and scenario analysis are major themes among the techniques covered, and the companion website provides relevant spreadsheets, models, and instructor materials.

Business is now done in a faster, more diverse, more interconnected environment, making valuation an increasingly more complex endeavor. New types of risks and competition are shaping operations and finance, redefining the importance of managing uncertainty as the key to success. This book brings that perspective to bear in valuation, providing new insight, new models, and practical techniques for the modern finance industry.

• Gain a new understanding of the idea of "value, " from both accounting and financial perspectives
• Learn new valuation models and techniques, including scenario-based valuation, the Monte Carlo analysis, and other advanced tools
• Understand valuation multiples as adjusted for risk and cycle, and the decomposition of deal multiples
• Examine the approach to valuation for rights issues and hybrid securities, and more

Traditional valuation models are inaccurate in that they hinge on the idea of ensured success and only minor adjustments to forecasts. These rules no longer apply, and accurate valuation demands a shift in the paradigm. Corporate Valuation describes that shift, and how it translates to more accurate methods.

Chapter 1
Introduction

1.1 WHAT WE SHOULD KNOW TO VALUE A COMPANY

This book is based on the idea that mastering valuation techniques is possible only after having gained a sound theoretical knowledge. But theory is not enough. In order to evaluate an enterprise or an acquisition, an analyst should have enough first-hand experience: such experience usually does not depend on the quantity of the previous valuations carried-out but on the quality of the work done.

A distinguishing feature of the valuation process is that to produce convincing valuations, analysts should master various areas of expertise, and three in particular:

1. Industrial economics and business strategy with reference to the analysis of the industry and competitive context devoted to understanding the validity of the company's business model, its past results, and its future plans
2. Theory and techniques of finance with regard to the basic principles of net present value, to the underlying links between leverage and value, to models that explain stock prices on financial markets, and finally to the techniques which correctly depict the business plan in terms of cash flow
3. Economic theory, in particular with regard to the relationship between uncertainty and value¹
4. in all those cases in which the simplifications assumed in the standard models presented in the finance textbooks do not permit the development of convincing valuations

Despite the fact that theoretical contributions in all three disciplines are widely known, valuation is more than a collage of knowledge and technique. In a valuation, critical drivers are so bound together that the real distinguishing element is the “glue” that holds them together. This glue consists of the ability to balance the different choices made in each phase of which the evaluation process is composed, of correctly weighing the empirical evidence, and of the ability to perform coherent estimates within the final objectives of the valuation work.

1.2 VALUATION METHODS: AN OVERVIEW

Finance textbooks offer several different options to perform the valuation of a firm or of an acquisition. Furthermore, financial institutions and consulting firms typically work out tailor-made models expanding the spectrum of available techniques. In the end, in assessing value of firms belonging to particular industries, several empirical techniques have gained quite a standing among practitioners.

Given the number of methodologies made available by theorists and practitioners, we find it useful, before getting into the core of this book, to explore a classification of the most widely used methodologies (Exhibit 1.1).

Exhibit 1.1 An overview of the main valuation methodologies/approaches

Exhibit 1.1 shows that the methodologies available (excluding simplistic empirical approaches) can be grouped into four fundamental approaches, each a function of the relevant link between corporate value and relevant value driver. A methodology is then a choice of the relevant driver, chosen out of the above-mentioned four approaches in order to assess value:

1. Income approach
2. Economic profit approach
3. Market approach
4. Net asset approach

The first approach expresses the value of a company or an investment as a function of the expected returns it generates. The so-called financial method (or, better, discounted cash flow, or DCF) falls into this approach and is the methodology most consistent with those found in standard finance textbooks.

The second approach is based on the idea that the value of a company is determined by two components: net asset value and earnings that exceed the “normal” return of the assets (economic profit is then the difference—when positive—between realized returns and “normal” industry returns).

The third approach is empirical: valuations are performed through a comparison with comparable assets traded on the market.

Finally, the fourth approach determines value from the estimation of the assets (tangible and intangible) that, net of the liabilities, constitute the net invested capital of the firm.

1.2.1 Common Practices in the Accounting and Financial Communities

Often, professionals separate methodologies into two main approaches to valuation: the first is the standard practice adopted by the financial community; the second one is the most widely used by accounting professionals.

The common practice in the financial community can be traced back to the methodologies adopted by investment and merchant banks—in particular:

• The DCF method based on the discounting of future cash flows derived from the company's business plan or assumed by the analyst
• Stock market multiples or multiples derived from comparable transactions

In other professional fields, the other methods set forth in Exhibit 1.1 seem to be preferred, partly because of cultural affinities and partly because of the specific goal of the valuation.

Indeed, some methods (particularly those based on excess earnings):

• better fit into some economic and accounting environment;
• follow, therefore, a logic more understandable to the actors for whose benefit the valuation is performed; and
• allow one to effectively and convincingly deal with special valuation problems, such as third-party interests or tax benefit valuations.

1.2.2 Approach of This Book

Despite the widespread use of alternative methodologies, most of this book will be devoted to the DCF analysis.

The reason for this choice is that DCF valuation processes allow a clear focus on the fundamental principles underlying valuation conditions that need to be met, and also when the professional believes a different methodology to better fit the final valuation objective.

In this chapter, we introduce, following a logical order that teaching experience has shown to be effective, the basic principles and themes that form the pillars of the DCF valuation approach:

• The net present value (NPV) principle
• How to deal with uncertainty
• The relationship between uncertainty and value
• The need for preventing, when possible, subjective judgments in value determination

1.3 THE TIME VALUE OF MONEY

Irving Fisher is considered the founding father of modern finance theory, not only for his market equilibrium model, which explains investment and consumption decisions, but also because of his almost-obsessive insistence on the need to determine any asset value exclusively as a function of its expected discounted cash flows.

Thanks to Fisher, since the early 1920s the main building block of valuation has been identified as follows: any asset value (financial or real) is a function of the cash flows it can generate and of the time distributions of the cash flows.²

Through Fisher's contribution, the concept of time value of money became solidified, thus building the rationale for the universally agreed need for a present value approach to valuation.

So, without uncertainty, or, as it is often said, in a deterministic framework, an investment, firm, or more generally any asset value can be obtained by the following:

• Calculate the asset relevant cash flows and their time distributions.
• Discount any cash flows at a rate expressing the time value of money.

Typically, this rate is the return rate of investments whose issuers are virtually free of any insolvency risk...