Corporate Valuation

This article focuses on the tools which corporations use to determine their value. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is potential to make fatal mistakes that may be detrimental to the organization's well-being. The role of managerial accounting as well as managerial economics is discussed. There are two types of techniques utilized by decision makers in the planning process, and they are cost/value/profit (CVP) analysis and financial budgeting. These techniques are explored.

In order to effectively manage a company, it is important to know how much it is worth. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is potential to make fatal mistakes that may be detrimental to the organization's well-being.

Methods for Determining Organizational Value

There are different ways one can determine the value of an organization; some of those methods are discussed below.

Asset-Based Methods

Asset-based methods began with the "book value" of an organization's equity. An organization's equity is defined as the organization's assets minus its debt. Corporations are charged with two major responsibilities, they are: Acquiring financial and productive resources and combining the resources in order to create new resources. Acquired resources are called assets, and the different types of assets are called equities. Therefore, the foundation for the basic accounting equation is "Assets = Equities." However, since equities can be divided into two groups, the basic accounting equation can be revised to read as "Assets = Liabilities + Owners' Equity."

• Assets. Although assets consist of financial and productive resources, not all resources are considered assets. In order to determine if a resource is considered an asset, it must satisfy all three of the following criteria:
• The resource must possess future value for the business. The future value must take the form of exchange ability (i.e. cash) or usability (i.e. equipment).
• The resource must be under the effective control of the business. However, legal ownership is not mandatory. As long as the resource can be freely used in business activities, the resource will meet the asset criteria. An example would be a leased computer. Although the organization may use the computer, legal rights still belong to the leasing company.
• The resource must have a dollar value resulting from an identifiable event or events in the life of the organization. The value assigned to the asset must be tracked to an exchange between the organization and others (Page & Hooper, 1985).

If the resource does not meet all of the criteria, it cannot be reported as an asset.

• Liabilities. When someone other than the owner provides an organization with an asset, the claims against the business take the form of a debt. Sources of assets from someone other than the owner are referred to as liabilities. Liabilities are the debts and legal obligations that a business incurs as the result of acquiring the assets from non-owners.
• Owners' Equity. Some businesses may obtain assets via owner investment or sale of stock. When the owner supplies the organization with assets, the claim against those assets is called owners' equity (or stockholders' equity) in a financial report.

When a business accepts assets from a source other than the owner, it can be reported as a liability or owners' equity. However, there are some differences between these two sources.

Liabilities Owners' Equity Legal Status Claims by external parties are considered legal obligations of the organization. Owners' claims are not binding and legally enforceable. If the claims are not satisfied, the only recourse for the owner is to sell his/her ownership. Amount Due Amount can be defined. Owners' claim is residual because the owners' claim all assets not specifically claimed by non-owners. Due Date Due date is established. Owners' claim is open-ended because there is no specific time in the future when the claim must be satisfied by the business.

Another way to measure an organization's value is to determine its current working capital and its relationship to market capitalization. Working capital can be defined as the amount left once one has subtracted the organization's present responsibilities from its present properties. Working capital is the amount of funding that an organization has immediate admission to use in their administration of daily duties and business.

Shareholder equity helps one to determine the value of an organization when there is a need to calculate the book value. The book value of an organization is located from the accounting ledger. To measure the book value as it stands per share, the company's shareholder's equity must be divided by the present number of shares that are left outstanding. The next step is to take the stock's present worth and divide it by the present book value so that a price-to-book ratio is reached.

Comparables

Using a company's earnings is the easiest and most often used form of determining its value. An earning, also referred to as the net income or net profit, is the amount of cash that is available following the organization's payment of all its bills. In order to make a valid comparison, one has to look at earnings and measure them according to its earnings per share (EPS). An accountant may evaluate the earnings per share by dividing the amount of outstanding shares it has into the cash amount of the earnings that is reported for an organization. However, it should be noted that earnings per share by themselves do not necessarily mean anything. In order to evaluate an organization's earnings relative to its price, most financial professionals will use the price/earnings (P/E) ratio. This ratio takes divides the stock price by the total of the most recent four quarters of earnings.

Free Cash Flow Methods

Cash flow is seen as the "most common measurement for valuing public and private companies used by investment bankers. Cash flow is defined as the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA)" (Giddy, n.d., "Using comparables"). Cash flow tends to be the one approach that has logical merit to it in most occurrences.

"The argument for the discounted free cash flow method is that an organization's value can be estimated by forecasting future performance of the business and measuring the surplus cash flow generated by the organization. The surplus cash flows and cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal operations of the company and its future" (Giddy, n.d., "How to use cash flow").

Steps of the Discounted Cash Flow Method

The discounted cash flow approach is often defined in six levels. Because this method is formulated on the basis of forecasts, it is crucial that the financial professionals of an organization have the proper knowledge base necessary for the company, its market and its preceding operations. The levels involved in making up the larger method of discounting cash flow are:

• Develop debt free projections of the company's future operations.

This is clearly the critical element in the valuation. The more closely the projections reflect a good understanding of the business and its realistic prospects, the more confident investors will be with the valuation its supports.

• Quantify positive and negative cash flow in each year of the projections.

The cash flow being measured is the surplus cash generated by the business each year. In years when the company does not generate surplus cash, the cash shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had no debt. In other words, interest charges are backed out of the projections before cash flows are measured.

• Estimate a terminal value for the last year of the projections.

Since it is impractical to project company operations out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be contributed to the company by the cash flows generated after the last year in the projections. Without making such assumptions, the value generated by the discounted cash flow method would approximate the value of the company as if it ceased operations at the end of the projection period. One common and conservative assumption is the perpetuity assumption. This assumption assumes that the cash flow of the last projected year will continue forever and then discounts that cash flow back to the last year of the projections.

• Determine the discount factor to be applied to the cash flows.

One of the key elements affecting the valuation generated by this method is the discount factor chosen. The larger the factor is, the lower the valuation it will generate. This discount factor should reflect the business and investment risk involved. The less likely the company is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity investors want 30% for their funds, the discount factor would be somewhere in between -- in fact, the weighted-average cost of capital.

• Apply the discount factor to the cash flow surplus and shortfall of each year and to the terminal value.

The amount generated by each of these calculations will estimate the present value contribution of each year's future cash flow. Adding these values together estimates the company's present value assuming it is debt free.

• Subtract present long term and short term borrowings from the present value of future cash flows to estimate the company's present value (Giddy, n.d., p. 2).

Option-Based Valuation

Many financial professionals still have issues with the amount of risk and doubt inherent in measuring investments and obtainments. "Despite the use of net present value (NPV) and other valuation techniques, these individuals are often forced to rely on instinct when finalizing risky investment decisions. Given the shortcomings of NPV, real options analysis has been suggested as an alternative approach. This approach considers the risks associated with an investment while recognizing the ability of corporations to defer an investment until a later period or to make a partial investment instead. Basically, investment decisions are often made in a way that leaves some options open. The simple NPV rule does not provide accurate conclusions as to whether or not uncertainty can be managed. In acquisitions and other business decisions, flexibility is crucial, and the value of flexibility can be taken into account explicitly by using the real-options approach" (Giddy, n.d., "Option-Based Methods).

Financial options tend to help the managing of risk in banks and firms. Actual or entrenched choices are partners of these economic options and can be used for measuring investment choices decided under considerable doubt. "Real options can be identified in the form of an opportunity to invest in a currently available innovative project with an additional consideration of the strategic value associated with the possibility of future and follow-up investments due to emergence of another related innovation in future, or the possibility of abthe project" (Giddy, n.d., "Option-Based Methods").

The choice is worthy of some value, due to the fact that the worth of the item in the future remains unknown. Considerable doubt tends to advance the value of the choice. If the uncertainty is understood to be the difference, it's possible for the company to gain additional profits. "The loss on the option is equal to the cost of acquiring it. If the project turns out to be non-profitable, one may have the choice of not exercising the option. The real options approach is finding its place in corporate valuation (Giddy, n.d., "Option-Based Methods").

Application

Managerial Accounting

There are two types of techniques utilized by decision makers in the planning process; they are cost/value/profit (CVP) analysis and financial budgeting. An organization's income and profit is based on the structure of its revenues and costs as well as the volume of activity that it achieves. The CVP analysis is the decision making model that most managerial accountants utilize when predicting future actions, which is crucial in determining a corporation's value. Decisions, such as the pricing of products and services, selecting the appropriate advertising strategies, and deciding on which markets to enter, can be determined using this model. Page and Hooper (1985) determined that the steps in the cost/volume/profit analysis are as follows:

• Study cost behavior as volume changes and classify all costs as variable or fixed.

Some costs may be classified if one understands the nature of the cost while other costs may need the accountant to examine the organization's data on past activities in order to determine the amount of each cost at different volume levels and how each cost changed as volume changed.

• Determine total fixed costs (TFC) and variable cost per unit (VPU).

Add up the total amounts of all costs classified as fixed to get the TFC. Divide the amounts for each variable cost by the level of volume at which that cost was incurred to get the per unit amount for each variable cost. Then add the individual variable costs per unit to get the VCU for the business.

• Calculate Contribution margin per unit (CMU).

The selling price per unit of product or service should be available from the organization's records and CMU=SPU-VCU. CMU provides the amount left over from the sale of each unit after the direct costs of the unit are covered.

• Determine before-tax target profit (BTP).

This figure would be the after-tax desired profit of the business divided by the applicable income tax rate of the organization.

• Add TFC and BTP and divide the amount by CMU to get the number of units of product or service that must be sold to cover all costs and provide the desired profit for the business after taxes.

The CVP model is very versatile and can show the accountant the effect on the business given any change in one of the key variables in the equation.

The CVP model can be a powerful tool for managerial accountants because it allows one to evaluate different courses of action and see what their results would be before implementing a decision. Also, by looking at the relationship between the key variables, the accountant has the ability to analyze the total impact of a decision on the organization. However, it must be noted that the usefulness of the CVP model is dependent on the accountant's ability to properly classify the costs of the organization as variable or fixed. If one does not fully comprehend the organization's cost behavior patterns, errors can be made in the decision making process. On a positive note, an organization's information system can assist in documenting and storing the necessary information over a period of time.

The second technique is financial budgeting. Financial budgeting is the function that connects a manager's ability to plan and control the process. The financial budget is a summary of the manager's decision making process for a particular project. It will show the overall impact of all of the possible alternative decision making ideas. The projected financial statements are referred to as the master budget of the organization. The master budget becomes the standard benchmark by which all future performance will be measured and evaluated.

The master budget has three components that may influence an organization's future:

• Profit Plan -- An income statement projected over a future period.
• Cash Budget -- A statement of budgeted cash flows that can be in many forms and may cover any period of timed deemed important by the managers. Most organizations will budget cash on a monthly basis to make sure that there is ample funds available to meet short term needs such as payroll and accounts payable.
• Budgeted Balance Sheet -- This statement summarizes everything by showing the final effects on the financial position of the organization based on the manager's decisions, assumptions and projections.

The financial budgeting process can be accomplished by utilizing an information system to perform a spreadsheet analysis. This process will eliminate the need for paperwork. One popular software package is VisiCalc. VisiCalc was one of the first spreadsheet programs designed for microcomputers, and was created by Dave Bricklin and Bob Frankston.

Viewpoint

Managerial Economics

Managerial economics highlights how financial professionals make decisions with regards to resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. These professionals use a series of techniques in order to find the most efficient way to reach the best decisions for the firm, which assists in determining the value of a corporation. The larger emphasis is to allow for the evaluation tools and administrative awareness necessary for the interpretation and resolution of the issues that have important financial consequences, both for the corporation and for the global economy.

Managerial economics occurs when the fundamental principles of microeconomics are applied in the decision making process of business and managerial problems. It can be applied to problems in private, public and non-profit organizations. According to Skim and Siegel (1998), the basic steps in the decision making process are:

• Recognize and define the problem. Once a problem has been identified, an exact statement describing the problem should be prepared.
• Select a goal. Is it profit maximizing or cost minimizing?
• Identify any constraints. All possible constraints need to be identified.
• Identify alternatives or define decision variables a firm is trying to solve for.
• Select the alternative consistent with the firm's objectives or determine the optimal solution (i.e. profit-maximizing or cost-minimizing solution), p. 3.

Managerial economics connects the practical and theoretical aspects of economics. Many economists will utilize a variety of techniques from other business fields such as finance and operations management. Most business decisions can be analyzed with the techniques used in managerial economics. However, it is most often used in:

• "Risk Analysis: Various uncertainty models, decision rules, and risk quantification techniques are used to assess the risk of a decision.
• Production Analysis: Microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.
• Pricing Analysis: Microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method.
• Capital Budgeting: Investment theory is used to examine a firm's capital purchasing Decision" (Shim & Siegel, 1998, p. 2).

Managerial economics is "the systematic study of how resources should be allocated in such a way to most efficiently achieves a managerial goal" (Shim & Siegel, 1998, p. 2).

Profits

Profits are very crucial to a firm's bottom line. When a firm is able to make a profit, there is an assumption that the company has done a good job of being effective and efficient in controlling cost while producing a quality product or performing a quality service. However, there are different types of profits. Two types of profits are accounting profits and economic profits. Accounting profits are the difference between the total revenue and the cost of producing products or services, and they appear on the firm's income statement. The difference between total revenue and total opportunity costs makes up the financial profit. The opportunity costs tend to be higher than accounting and bookkeeping costs.

Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs. Five of the most discussed theories in this area are:

• Risk-Bearing Theory. When the owners of a company make investments into the firm, they take on a certain amount of risk. In order to compensate them for their investment, the company will need to have an above average return on economic profits. An example would be a firm that has investors such as venture capitalists or angel investors.
• Dynamic Equilibrium Theory. Every firm should strive to have a normal rate of profit. However, each firm has the opportunity to earn returns above or below the normal level at any time.
• Monopoly Theory. There are times when one firm many have the opportunity to dominate in its industry and earn above normal rates of return over a long period of time. These firms tend to dominate the market as a result of economies of scale, control of essential natural resources, control of crucial patents and/or government restrictions. An example would be utility companies.
• Innovation Theory. A firm may earn above normal profits as a reward for its successful innovations such as patents. An example would be a pharmaceutical organization such as Astra Zeneca.
• Managerial Efficiency Theory. A firm may be able to earn above average profits based on its strong leadership team. This type of organization gains profits as a result of being effective and efficient. An example would be General Electric under Jack Welch's leadership.

Wealth Maximization

Wealth maximization is a long term operational goal. Shareholders have a residual claim on the firm's net cash flows after expected contractual claims have been paid. All other stakeholders (i.e. employers, customers) have contractual expected returns. There tends to be a preference for wealth maximization because it takes into consideration (Shim & Siegel, 1998):

• Wealth for the long term;
• Risk or uncertainty;
• The timing of returns;
• The stockholders' return.

Criterion for this goal suggests that a firm should review and assess the expected profits and or cash flows as well as the risks that are associated with them. When conducting this evaluation, there are three points to keep in mind. First, economic profits are not the same as accounting profits. Second, accounting profits are not the same as cash flows. Lastly, financial analysis must focus on maximization of the present value of cash flows to the owners of the firm when attempting to maximize shareholder wealth.

When making decisions, the financial management team has to anticipate certain factors and realize that they may not have control over some of them. Factors outside of their control tend to be ones that are a part of the economic environment.

Factors under Management Control

• Product and services offered
• Production technology
• Marketing and distribution
• Investment strategies
• Employment policies and compensation
• Ownership form
• Capital structure
• Working capital management policies
• Dividend policies
• Alliances, mergers, spinoffs

Factors Not Under Management Control

• Level of economic activity
• Tax rates and regulations
• Competition
• Laws and government regulations
• Unionization of employees
• International business conditions and currency exchange rates

In order for wealth maximization to be at the optimal level, certain conditions need to be in place. The process has a good chance to be successful when:

• Complete markets are secure.

Liquid markets are needed for the firm's inputs, products and by-products.

• There is no asymmetric information.

Buyers and sellers have the same information and no information is hidden from either group.

• All re-contracting costs are known.

Managers know or anticipate the exact future input costs as a portion of the present worth of anticipated cash flows.

When one reviews the wealth maximization model, there are some basic assumptions made about how the financial management team should respond. Some recommendations include to: Develop a dynamic long term vision/outlook; anticipate and manage change; secure strategic investment opportunities; maximize the present value of expected cash flows to owners.

In order to account for timing, future cash flows must be discounted by an interest rate that represents the cost of the funds being used to finance the project. Financial analysts have found the time value of money to be an important factor when making decisions on projects. Present value is the value today of future cash flows, and the computation of present values (discounting) is the opposite of determining the compounded future value. The discounted cash flow (DCF) analysis is a tool that tends to be used to account for the timing of cash inflows and outflows.

The purpose of using the DCF analysis is to get an estimate of how much money can be gained by investing in a specific project. An adjustment for the time value of money is also taken into consideration. DCF analysis uses the weighted average cost of capital to discount future free cash flow projections in order to get the present value. Once the present value has been determined, it is used by financial examiners to decide if a project is worth of an investment. Good prospects are those projects in which the DCF analysis is higher than the current cost of the project investment. Currently, there are four different DCF methods utilized. The type of method utilized is determined based on the financing schedule of the firm. The four methods fall into two categories -- equity approach and entity approach. The flows to equity approach falls under the equity approach. There are three methods under the entity approach and they are adjusted present value approach, weighted average cost of capital approach and the total cash flow approach.

However, there are some pitfalls with using the DCF analysis. Harman (2007) pointed out three potential problems with DCF:

Operating Cash Flow Projections

"The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of problems with earnings and cash flow forecasting that can generate problems with DCF analysis. The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast -- and DCF models often use five or even 10 years' worth of estimates. Analysts may have a good idea of what operating cash flow will be for the current year and the following year. However, the ability to project earnings and cash flow diminishes rapidly starts to dwindle after a certain period. Also, cash flow projections in any given year will most likely be based largely on results for the preceding years. Small, erroneous assumptions in the first couple years of a model can amplify variances in operating cash flow projections in the later years of the model" (Harman, 2007, "Problems with DCF").

Capital Expenditure Projections

"Free cash flow projection involves projecting capital expenditures for each model year. The degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary. In a down year, a firm may elect to reduce capital expenditure plans since they tend to be risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation" (Harman, 2007, "Problems with DCF").

Discount Rate & Growth Rate

"There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = R_f + β (R_m -- R_f) or the weighted average cost of capital of the firm as the discount rate in the DCF model. Both approaches are quite theoretical and may not work well in real world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. This format allows all investments to be evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there usually are no easy answers" (Harman, 2007, "Problems with DCF").

Conclusion

In order to effectively manage a company, it is important to know how much it is worth. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is a potential to make fatal mistakes that may be detrimental to the organization's well-being.

There are two types of techniques utilized by decision makers in the planning process, and they are cost/value/profit (CVP) analysis and financial budgeting. An organization's income and profit is based on the structure of its revenues and costs as well as the volume of activity that it achieves. The CVP analysis is the decision making model that most managerial accountants utilize when predicting future actions, which is crucial in determining a corporation's value. Decisions, such as pricing products and services, selecting the appropriate advertising strategies, and deciding on which markets to enter, can be determined using this model.

Managerial economics highlights how financial professionals make decisions with regard to resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. These professionals use a series of techniques in order to find the most efficient way to reach the best decisions for the firm, which assists in determining the value of a corporation. The crucial and most prominent emphasis is to offer access to the evaluation tools and administrative knowledge necessary to the evaluation and resolution of those problems that have important financial consequences, both for the corporation and for the world economy.

Terms & Concepts

Accounting Profits: The difference between the total revenue and the cost of producing goods or services.

Accounting Systems: An organization's chronological list of debits and credits.

Assets: An asset of financial value purchased by an individual or company, specifically that which could be exchanged for cash.

Discounted Cash Flow Analysis: A valuation method used to estimate the attractiveness of an investment opportunity.

Liabilities: Total assets minus total owners' equity.

Managerial Accounting: Financial reporting that is aimed at helping managers to make decisions.

Managerial Economics: The branch of economics applied in managerial decision making.

Owners' Equity: Total assets minus total liabilities.

VisiCalc: One of the first spreadsheet programs designed for microcomputers; created by Dave Bricklin and Bob Frankston.

Wealth Maximization: In an efficient market, it is the maximization of the current share price.

Bibliography

Giddy, I. (n.d.). Methods of corporate valuations. Retrieved December 14, 2007, from http://pages.stern.nyu.edu/~igiddy/valuationmethods.htm

Harman, B. (2007, July 9). Top three DCF analysis pitfalls. Retrieved July 28, 2007, from http://www.investopedia.com/articles/07/DCF%5Fpitfalls.asp

Ionescu, L. (2012). The valuation impact of firm-level corporate governance mechanisms. Economics, Management & Financial Markets, 7(4), 233-238. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86434016&site=ehost-live

Page, J., & Hooper, P. (1985). Microcomputer accounting and business applications. Reston: Reston Publishing Company, Inc.

Ruenrom, G., & Pattaratanakun, S. (2012). Corporate brand success valuation: an integrative approach to measuring corporate brands. International Journal of Business Strategy, 12(3), 100-108. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84406145&site=ehost-live

Shim, J., & Siegel, J. (1998). Managerial economics. New York: Barron's Educational Series, Inc.

Singh, J.P. (2013). On the intricacies of cash flow corporate valuation. Advances in Management, 6(3), 8-19. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86112096&site=ehost-live

Suggested Reading

Chen, F., Yee, K.K. & Yoo, Y.K. (2007). Did adoption of forward-looking valuation methods improve valuation accuracy in shareholder litigation? Journal of Accounting, Auditing & Finance, 22(4), 573-598. Retrieved December 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27157517&site=bsi-live

Gray, R.P. (2007). Valuing intangible assets-a fast-growing, demanding niche. Journal of Accountancy, 203(5), 68. Retrieved December 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25737643&site=bsi-live

Mellen, C.M. & Sullivan, D.M. (2007). Preparing for and conducting a business valuation. Financial Executive, 23(9), 20. Retrieved December 17, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27424658&site=bsi-live