Corporate Finance
Valuation, risk and return are closely linked, from different perspectives. Primarily, risk determines, to some degree, the level of returns, while both need to be seriously considered when conduction a valuation. In many occasions, the analysts work with information from the present, creating forecasts about risk and return that allows them to give, with a reasonable probability, expectations about future events.
This paper aims to look into more details at aspects related to valuation, risk and return. It will look, in the beginning, at different valuation techniques, detailing each of them and presenting their advantages and disadvantages. It will then focus on the analysis of risk and return, as a fundamental component of the valuation process. The paper will conclude with an overview of the methods and techniques described and ideas on best practices.
Valuation techniques
Valuation is the process of putting value on something, of analyzing what something is worth. It is important to note that, while valuation is often associated to a business (analyzing what a business is worth), there are many other cases when valuations need to be undertaken, including asset and liability valuations or the valuation of a particular project (in order to determine its viability).
Valuation comes as a necessity in different situations, particularly when a company will be sold. The group that sells the company needs to know a fair value for the company, depending on which it can settle on an appropriate price for the organization. As theory discusses (Vault, 2005), in its basic form, the value of the company is given by the sum of its debt and equity. A future investor who purchases a company assumes both its equity and its debt.
The debt is easier to calculate than the equity, because it is, in fact, the accounting value for the debt. However, equity is more complicated to evaluate and there are different valuation techniques that are applied exactly so as to best value equity. The four major valuation techniques are the discounted cash flow (DCF) analysis, the multiples method, the market valuation method and the comparable transactions method. This paper will briefly look at each of these.
Discounted cash flow (DCF) analysis. This is considered the most thorough way to complete the valuation of a company (Vault, 2005). With this method, there are two techniques that can be implemented: the adjusted present value method and the weighted cost of capital method. The former focuses on the free cash flows that a company or project can generate over the next period of time. The latter looks at the market value of debt or equity. In its very simple form, as described by Penman (2011), the discounted cash flow analysis forecasts the future cash flows (or future rates of return), factors a growth rate into the equation and then discounts these cash flows to obtain their present-day value. The discount rate is usually the cost of capital, namely how much does it cost to borrow the funds that will finance this investment.
The multiples method. The multiples method takes into consideration the fact that, quite often, there is not enough information to complete the valuation process. With this method, the evaluator takes known indicators, such as EBITDA, and compares this to other indicators of relevant competitors in the market.
The market valuation method. This is considered the simplest of the four techniques, but is only applicable to companies that are publicly traded, at the stock exchange. The method implies multiplying the total number of shares by the price per share and the result is the market value of the equity. However, this is usually not the price that someone would pay if he were to acquire the company: the market value receives a discount or a premium, depending on the economic conditions, on supply and demand or on the way an acquisition is made (as a hostile takeover, for example).
The comparable transactions method. This method proposes a comparison with similar transactions that occurred on the market, under similar conditions, and uses discounts or multipliers to adjust the respective value. The method needs to analyze the way the previous valuation was completed, particularly as to what method was used and what the key valuation parameter was.
Strictly in terms of corporate valuation, professor Giddy (2006) proposes a different categorization approach that includes five general categories of methods. These include asset-based methods, comparables, free cash flow methods, option-based valuations and special applications. Since some of these have been previously described, the paragraphs below...
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