The Value of a Business:

What Value is, How Value is Created, and How Value is Measured

George C Currie

Introduction
“Value” is one of the most basic concepts in economics, philosophy, ethics and
sociology, yet is perhaps one of the least well-defined and most misunderstood
(Trotta 2003). This paper examines three main aspects of value as it may apply in
the business arena. It firstly provides a definition of value for business. It then
describes the how a company creates value, and the operational, financial, and
corporate governance issues involved. The paper finally introduces the main
approaches and associated methods by which the value of the company can be
measured.

What is value?
It is not only true (if somewhat trite) to say that “value” means different things to
different people, it is also necessary to recognize that value is dynamic, and that the
same person’s definition or interpretation of value varies according to changing
circumstances. The first step in exploring value must therefore be to identify the
purpose and limits of our definition of value.

Throughout this paper the definition of value will be limited to its business sense.
British Standard BS EN 1325-1: 1997: Value management, value analysis, functional
analysis vocabulary, defines value as:

“The relationship between the contribution of the function (or VA

subject) to the satisfaction of the need and the cost of the function.”

This relationship is commonly represented as:

Satisfaction of Needs
Value =
Cost
This definition applies not only to the value of the firm’s products or services to its
customers, but also the value those sales create for the company, and through the
cash flow created from them, of the firm to its owners.

The primary function of business is to sell a product or service to a customer, since

without that transaction none of the other functions of the business create value for
its owners. At this individual transaction level, the customer has needs which he
expects the product or service to satisfy, and the firm is in business to produce a
product or deliver a service and offers this to the customer at a price. The selling
price either set or negotiated for this transaction is the buyer’s cost of the satisfaction
of his need. In our definition, the value of the product or service to the buyer is the
benefit the buyer expects to obtain from it divided by its cost, and unless this is
perceived to be greater than unity (i.e. the perceived or expected benefits exceed the
selling price), there will be no sale. One of the main functions of the company’s
management is to ensure that either the selling price of the product is kept low
enough, or its benefits as perceived by the target market are high enough, that it has
sufficient value in the eyes of the buyer to ensure the sale.

The expected benefits (and hence the value) that the buyer expects to obtain are
however in most cases complex, and stem from either or both of the two
components of value identified by classical economics; “value-in-use” and “value-in-
exchange” (Smith 1776), together with the more modern concept of “esteem-value”.
All three of these components however, to a greater or lesser degree include a
subjective element. Esteem-value is the buyer’s internal answer to the question
“How much do I want it?” (SAVE 1998), and represents the amount he is willing to
pay for the perceived properties of a product or service which contribute to its
desirability in his eyes. As such it is almost entirely subjective in nature. Value-in-
exchange depends on the collective agreement of a society as to what the relative
value of things are, which varies - both over time as societal mores alter, and from
place to place between societies, and hence in any particular transaction depends
not only upon the personal circumstances and preferences of the buyer, but also on
how he may anticipate these may change or how society may come to view the
object in question. Even the direct benefit that the individual may obtain from the use
of the object or service may change over time (and sometimes dramatically and over
a short period of time) depending upon the particular circumstance1. These
variations affect the benefit that any particular individual perceives he would gain
from the ownership of the object or receipt of the service, and hence his perception
of its value-in-use at the seller’s price. When considering an individual object or
service, its value therefore lies in the eye of the buyer and, although the price in a
transaction may be set by the seller, value may only be determined by the buyer
according to his individual circumstances, preferences and expectations (Tucker
2002).

Assuming that the business has a viable product or service to offer to the market,
and that at least some of its target market perceive this to have value, the firm will
make sales and generate revenues. Each and every product or service sold by the
firm throughout its life thus makes some contribution to the cash that may be
distributed amongst the firm’s owners once it has paid all its costs and taxes. It is the
anticipated existence of this cash flow from future sales that creates the value of the
firm to its owners. The intrinsic value of the business is therefore the sum of its
expected future after-tax cash flows (i.e. the revenues expected to be generated
from its sales less the cost of the assets and other inputs used in their creation, and
of the business entity itself), adjusted by a discount rate that appropriately reflects
the relevant risk of the business, its products and its markets (McCarthy 2004).

For privately-held businesses, their shareholder value is equal to the intrinsic value,
however for publicly-listed companies their shareholder value is determined by the
capital market in which the shares are traded, and the company has a fluctuating
“market value” which is simply the share price at any time multiplied by the number
of shares outstanding at that time. In a perfect capital market, i.e. one where all
information is immediately reflected in the share price of the company, the market
value (and hence the shareholder value) equals the intrinsic value. In real life
however, the two may differ (in some cases markedly), either due to inefficiencies

1
For example, an adventurous traveler whose boat develops a serious leak when crossing a
crocodile- infested river will not place any value on the water which threatens to sink him, but would
pay almost unlimited amounts for fuel to run his boat’s pump to keep him afloat until he can be
rescued or make it safely to shore. Conversely, the same adventurer whose 4WD breaks down when
traversing a sandy desert later in his travels will value the extra fuel he carries far less than he would
a supply of drinking water. The same two products, being employed by the same person, but having
different values at different times due to different external circumstances.
where the company’s shares are traded in a small or illiquid capital market or, more
commonly in large capital markets such as those of the United States or Europe, due
to poor dissemination to the market of information affecting the intrinsic value. Whilst
these larger and more liquid capital markets may not always be efficient on an
“absolute scale”, at any given moment they are the most efficient reflection of what
the most likely future development could be, given the information available at that
time (Berendes, et al. 2001).

How Is Value Created?

The fundamental objective of the business corporation is to increase the value of its
shareholders’ investment (Rappaport 1986), particularly in “Anglo-Saxon” economies
such as the United States, the UK and Australia1. From the definition of shareholder
value and the caveat on how the company’s share price may or may not correctly
reflect its intrinsic value given above, it is apparent that increases of market value
happen when the company’s management:
a. Increases the intrinsic value of the company; AND
b. Communicates and signals with the capital markets to ensure that they
appreciate and reflect the intrinsic value in the share price.

Shareholder value is added when the resulting increase in market value exceeds net
capital inflows (i.e. new share issues and/or a conversion of convertible debentures)
less payments to shareholders in the form of dividends or share buy-backs on the
market in the period. Shareholder value is created when the shareholder value
added exceeds the required return to equity, i.e. the return that shareholders expect
to earn in order to feel sufficiently remunerated for the risk they have taken
(Fernández 2002).

As the intrinsic value of the company is the sum of its future net after-tax cash flows
discounted at a rate to reflect their uncertainty or risk (as so far as this is perceived
by its investors and debtholders), it can be increased by improving one or more of
1
In other countries, such as France, Germany and those in Scandinavia, the company’s management
may be required (or at least expected) to take into account the interests of its other stakeholders, and
in particular its employees. It has been demonstrated however, that maximizing the value of the
company for its shareholders not only serves their interests but also the economic interests of all
stakeholders over time (McTaggart and Kontes 1993), (Copeland, Koller and Murrin 2000) &
(Berendes, et al. 2001).
three main variables: the cash flows deriving from the company’s existing assets; the
expected rate and duration of growth in its cash flows; and the cost of its capital
(Damodaran 2001). The company’s intrinsic value is increased when its
management (at the corporate or business unit level) takes actions which
proportionately increase one (or preferably both) of the first two or decrease the last
one.

Increasing Cash Flows from Existing Assets

Since the cash flow from existing assets derives from income from investments
already made by the company, it is most likely to be the prime source of immediate
improvement in intrinsic value. Such improvements may involve one or more of the
following:
 improving operating efficiencies;
 divesting or liquidating investments that are earning less than the company’s
cost of capital (and hence are destroying, rather than creating, value);
 reducing the company’s tax burden;
 reducing net capital expenditures on existing assets; and
 reducing noncash working capital

Improving Operating Efficiencies

Improving operating efficiencies increases the operating margin on existing assets,
and hence generates additional value. Although promoters of business process re-
engineering will normally argue that all businesses have the potential to improve
operating efficiencies, these opportunities are particularly marked where the firm’s
operating margins are well below those of its competitors. The key issue for the
company’s management is to identify the source of the inefficiencies in the existing
business and how to fix it without sacrificing the company’s future growth.

Below-average operating margins may signify that the firm is attempting to compete
for customer sales on the basis of its selling prices (i.e. achieve a cost-leadership
position) but has failed to optimize its cost structure, or alternatively that it is
attempting to follow a differentiation strategy, but is failing to demonstrate the
additional benefits of its product or service to its target market, hence reducing its
pricing power and margin. In either case, by identifying the source and reasons for
the low operating margin, the business-specific value drivers required to bring about
its improvement can be identified and suitable actions developed. These may be
either revenue-side (allowing the company to generate incremental revenues in
excess of related expense and investment), or expense-side ones focussed on
decreasing costs or making operational efficiencies (Clark and Neill 2001). Generally,
firms following a differentiation strategy may be expected to focus on revenue-side
initiatives to increase operating margins whilst those aiming for a cost leadership role
may generally be expected to concentrate on expense-side ones.

Typical revenue-side initiatives may involve additional marketing research and

promotional activities to improve customer segmentation and create awareness of
the additional product benefits in the target market, or the introduction of a customer
relationship management (“CRM”) system in order to allow the company to develop
customer-specific value propositions to identify the total value created by the
sale/purchase transaction and obtain a higher proportion of this over the life of the
market, particularly by maximizing customer retention (Payne 2004). Expense-side
initiatives, such as business process re-engineering, are aimed at identifying and
removing extraneous costs from the entire value system for the production or
delivery of the firm’s product or service, however in order to increase shareholder
value it is essential that these do not involve cutting back on current expenditures
(such as marketing or R&D) to the detriment of future growth and revenues. In either
case, whether revenue-side or expense-side measures are adopted, in order to
increase intrinsic value by improving operating margins it is essential that the correct
cost management and/or pricing strategy is identified. Measures aimed at increasing
revenues and/or reducing costs may, due to their effect on the existing balance of the
market, actually adversely affect sales growth, and hence lead to reduced market
share and/or product life. Increased product differentiation, for example, whilst
affording the opportunity for higher selling prices and margins, generally does so
only at the cost of reducing the size of the potential market. In more monopolistic
markets, increasing the selling price of its product to increase revenues reduces the
value of the product to its buyers and, depending upon their price-sensitivity for the
item in question, may lead to lower sales over time as substitutes are identified and
adopted, and hence may actually reduce revenues over the product’s life (Docters,
et al. 2004). Alternatively, if the market demonstrates price-inelasticity the higher
selling price available may increase the attractiveness of the market and precipitate
the entry of more competitors, reducing the firm’s pricing power and margins
(Copeland, Koller and Murrin 2000).

Asset Divestment
Where the company has investments tied up in assets that are earning less that its
cost of capital, then its value can be increased by divesting itself of these drags on
its finances, provided that the sale or scrap value realized from the disposal is
greater than the continuing value (i.e. the present value of the cash flows that will
derive from operating the asset through its remaining life). Where the continuing
value exceeds the value that would flow from liquidation or disposal of the asset,
then its value to the firm is maximised by continuing to operate the asset as a going
concern, irrespective of whether the cash flows exceed the cost of capital
(Damodaran 2001). This is particularly relevant in the case of project-financed or
structured-financed assets, where their loans are secured alternatively against the
asset itself or the cash flows generated from its use. Events in these markets over
the past few years have shown lenders even prepared to take over assets and
operate them themselves to allow the business (if not its original owners) to continue
as a going concern rather than selling them at their liquidation value in a depressed
market.

Reduce the tax burden

Since the intrinsic value of the firm derives from its after-tax cash flows, for any given
level of operating revenue the firm’s value may increase in proportion to any
reduction achieved in the tax payable. The company’s management may reduce its
tax burden by:
 transferring its income generation to lower-tax (or even no-tax) locations, often
by manipulation of the internal pricing for the supply or consumption of internal
products and/or services within the company;
 acquiring net operating losses through the purchase of loss-making
businesses; and/or
  smoothing income to avoid exposure to higher tax rates in periods of
exceptional performance.

As will be discussed later, the firm’s choice of financing also affects its tax burden
since interest paid on debt is a tax-deductible expense under most regimes, whereas
the returns to equity holders for their financing of the firm are not. The tax burden
can therefore be reduced by substituting debt for equity in the financing mix.

Reduce maintenance capital expenditure

Net capital expenditure consists of two component parts; investment in new assets
designed to generate future growth, and expenditure on maintaining existing assets
in order to keep them productive. As with most management issues however, using
this lever to increase shareholder value must be done with the utmost care. Though
current cash flows can be increased by reducing or eliminating capital maintenance
expenditures, this may actually reduce the intrinsic value if it means that the
productive output of the asset is adversely affected (which may be in terms of the
quantity and/or quality of its product), its working life and/or residual value is
reduced, and/or it leads to higher maintenance costs being incurred in the future.

Reduce noncash working capital

Noncash working capital is the difference between the firm’s noncash current assets,
(primarily consisting of its inventory and accounts receivable) and the nondebt
portion of its current liabilities (primarily its accounts payable) (Damodaran 2001).
Since decreases in noncash working capital show up as cash inflows, improving
cash flow management in the firm to reduce its noncash working capital requirement
as a proportion of its revenues will increase its intrinsic value provided it is done in a
way that does not impair the productivity of existing assets or jeopardize future
growth.

Reduction in inventory, for example, decreases noncash current assets (and hence
noncash working capital) and thus might reasonably be expected to increase
shareholder value. It may however actually destroy value instead, if it leads to
shortages of raw materials or spare parts, adversely impacting production efficiency
and hence reducing the productivity of its existing assets. Similarly, attempting to
decrease noncash working capital by increasing accounts payable (i.e. by delaying
payments to suppliers) may often mean that the prices charged to the firm by its
suppliers will increase, or that the suppliers may give the firm lower priority during
periods of high demand from its competitors. The former clearly impacts the net cash
flows that the firm may generate unless it is able to pass these increased costs
through to its own customers without affecting the size of its market, whilst the latter
may reduce shareholder value if the non-availability of supplies jeopardizes (or is
perceived to jeopardize) its ability to serve its customers and to defend its market
share in profitable sectors (Harris and Goodman 2001). Either or both of these
responses from others in its value system to the firm’s attempt to decrease its
noncash working capital requirements would therefore result in shareholder value
being lost rather than gained. Cash management improvements targeting reduction
in accounts receivable, by contrast, are likely to have a direct and lasting positive
impact on shareholder value.

Rate and Duration of Growth

A significant component (and in many cases, particularly for industries and
companies that are based more on intangible assets, the overwhelming one) of a
firm’s value is the market’s expectation for its growth. This “future growth value”
(Stern and Hutchinson 2004) accounts for around 16 per cent of the value of
consumer durables companies, rising to 137 per cent for technology hardware and
equipment ones, and an average of 58 per cent for the US stock market as a whole
(Ballow, Burgman and Molnar 2004). Although improvements to the cash flows
deriving from the current assets of the firm are generally the most immediate source
of increase of intrinsic value, in many cases the fruitful source of more long-lasting
improvement lies in increasing the potential rate and/or duration of future growth.

The key issue relating to growth is to grow only where the return on capital is greater
than its cost, i.e. economic profit is positive, since the alternative destroys rather than
creates value (McCarthy 2004). Identifying the type or source of future growth is
therefore of critical importance to allowing the firm’s management to take correct
strategic investment decisions aimed at increasing its intrinsic value. Where a firm
has profitable investments and reinvestment opportunities (i.e. those generating
returns above its cost of capital), value is increased either by increasing the
reinvestment rate, and hence foregoing more of the free cash flow generated by the
existing assets in order to finance expansion in capacity, or by reinvesting its free
cash flow in projects or markets offering higher rates of return at the same cost of
capital. Even firms that are presently losing money however (those in the “new
economy” of the internet for example) may still create shareholder value from their
growth rate in revenues and the improvement this yields to their sales-to-capital ratio
provided this can be achieved without adversely affecting the operating margin
excessively (Damodaran 2001). The key in these cases is to identify the relationship
between these three variables, and to establish what, if any, improvement in intrinsic
value will be achieved by any strategy affecting these (noting that strong linkages
may exist between the three).

One of the key drivers of a company’s future growth, particularly in determining its
duration by establishing and maintaining barriers to entry to prevent competitors from
entering the market space it occupies in the minds of its customers, is its intangible
assets, such as intellectual property, corporate and brand integrity, customer loyalty,
the skills and knowledge of its workforce, and its leadership capabilities (Sussland
2001). This is particularly true of “new-economy” and services-based firms, where
tangible assets like buildings and equipment are largely peripheral to their revenue
generation. In light of this it is essential to the long-term value of the company for its
management to be able to balance operations decisions, which tend to show
immediate (or at least relatively rapid) impact on the bottom-line, with its investment
in (and eventual returns from) its intangible assets. Failure to invest sufficiently in
intangible assets such as R&D or employee training, in an attempt to improve short-
term performance measures may jeopardize the long-term revenues, or even
viability, of the business (Sussland 2001).

A key feature of value particular to firms is that, in general, they are entities having
no fixed life and which are expected by their investors to exist (and provide returns)
in perpetuity1. Growth and longevity of the existing business unit however, is finally

1
The “Special Purpose Vehicle”, or SPV, commonly adopted in project finance structures is an
exception to this requirement of the company to continuously reinvent itself, since these are created
with the express purpose of investing in a single capital asset with a single purpose and generally with
a limited life (Esty 2003).
determined by the size and life-span of the market for its particular products or
services, and further growth beyond those external constraints must come from
expansion of the range of the company’s business activities, either in terms of the
products or services offered, or the geographical markets served. Diversification is
therefore necessary to maintain and regenerate the company’s rate and duration of
growth and hence create value over the long term, as the company must find new
businesses or markets to compensate for the normal decline of prospects for
creating value in its existing ones. The key to creating rather than destroying
shareholder value by such diversification lies in understanding the company’s core
competencies and ensuring that the investment is in related industries and/or
markets where these may also apply. The capital markets generally reward
diversification into related or complementary markets but discount those which
appear unrelated to the existing businesses or skills. Total returns to shareholders of
the former may exceed even those of focussed companies whereas the capital
markets tend to discourage fully diversified companies (Harper 2002). This is
particularly true in cases of diversification through acquisitions, where unless there
are strong synergies, the value inherent in the deal more commonly flows to the
shareholder of the acquired company rather than to those of the buyer.

Cost of Capital
The cost of capital for a firm is a composite (usually a weighted average) of the cost
of its debt and that inherent in its equity. Since the intrinsic value is the sum of the
future cash flows discounted to the present at the firm’s cost of capital, it can be
increased by reducing this denominator. This may be achieved by:

 changing the operating risk, for example by strengthening the brand image
and market positioning so as to make its market less discretionary;
 reducing the operating leverage by reducing the proportion of fixed costs
(although it is imperative to note that no long term competitive advantage can
derive from any non-proprietary service or material, and so management must
ensure that the use of subcontracting or outsourcing does not diminish
margins or growth in the long-term);
 changing the financing mix; and/or
  changing the financing type
(Damodaran 2001)

Substituting debt for equity in the capital structure of the firm can give rise to an
increase in value for two main reasons. The first is that the nominal cost of debt is
less than the current cost of equity; thus the shareholders’ expected return on their
equity can be increased by the use of debt, however the cost of debt increases as
the proportion of debt in the financing mix increases due to the increased risk to the
lender of the company being unable to service the loan, and the company’s
managers must determine what this cost of debt will be for different amounts of debt.
Also, the equity return requirements must be determined since the cost of equity
capital will also change as the percentage of debt capital is changed. Only having
established both of these variables can the optimum mix of debt and equity for the
firm be determined.

The second reason for using debt is based on the tax law that allows debt interest to
be tax deductions, but recognizes no tax deduction for the return on an equity
security. The tax deductibility of interest can add significantly to the value of a firm
with the amount of value added depending on the corporate income before tax, the
corporate tax rate, and the amount of new debt. The investor tax rates also affect the
analysis.

The company’s cost of capital is also dependent on its market value (directly in the
case of its equity and, in most cases, to a somewhat lesser extent for its debt) and
hence its management’s financing decisions are inexorably linked with the need to
properly signal and communicate its intrinsic value to the capital markets.

Signalling and Communications with Capital Markets

The "returns" that investors receive consist of dividends and realized market
appreciation. If the market’s expectations of the firm’s results or other performance
metrics are too high, and that later becomes clear, the market value of the firm will
drop. Good communication with the investment community, both of the company’s
plans and expectations and of its results, and the reason for any variance, is
therefore essential for a company, not only to reduce its cost of capital and hence
increase its intrinsic value, but also to increase its market value directly and hence
the returns available to its shareholders. The key issue involved is how the company
and its management are perceived by the capital markets and the effect that this
perception has on investors’ expectations of its future performance, and so
shareholder returns are correlated with the quality of investor relations (as judged by
the quality of annual reports, analyst conferences and other investor events)
(Berendes, et al. 2001).

Summary on How Value Is Created

In order for shareholder value to be created the company’s management has to:

1) produce continuous earnings flow through its operational decisions;

2) invest wisely for future growth; and
3) communicate with the investment community proactively and reliably.

The environment within which the company must do so is complex and dynamic, and
there is a dichotomy between the interests of the company’s shareholders on the
one part and those of its customers, suppliers, host governments, and other
stakeholders (including its management) on the other (McCarthy 2004). Increased
shareholder value only occurs where the company is able to capture a
proportionately higher share of the total value produced in the value system for its
existing product, and hence one or more of the other stakeholders must be left with a
proportionately smaller share (even though, in a growing market, the amount itself
may have increased). Most importantly many of the measures available to increase
value rely on management achieving a balance between short term results and long
term performance, and it is therefore imperative, particularly for publicly-listed
companies, to ensure that the metrics used to monitor and reward the
management’s performance includes both long-term and short-term components
designed so as to properly align their interests with those of the shareholders to
maximize the shareholder value of the business from its long term performance and
not simply to attempt to manipulate the share price for short-term personal gain.

Measuring Value
It is important to recognise that, as value is subjective and is based on the
expectations of individuals (acting singly as buyers, sellers or holders of the firm’s
shares) of future returns, cost and risk, we cannot measure it in the strict sense.
There are exact methods of calculation, but there are no exact measures of value
and the various valuation methods, all of which involve a subjective element, are
correctly seen as providing an estimate of the value of a firm. These methods can be
considered in three groups according to their basic approach; the Asset Approach,
the Income Approach, and the Market Approach (Evans 2002), with two or more
specific valuation techniques or methods falling under each of these approaches
(Abrams 2005).

Asset Approach
The Asset Approach is predicated on the assumption that the value of the firm lies in
its tangible assets, and seeks to measure value through the calculation of assets net
of liabilities. The methods within this approach are essentially the traditional
accounting measures (book value, adjusted book value, liquidation value and
substantial value), which derive their foundation from an industrial age model that is
increasingly removed and lacking in relevance with today’s businesses and ignore
the fundamental variables required to add economic value to the firm: free cash
flows investment horizon, and risk (Morin and Jarrell 2001). Most significantly these
traditional accounting metrics are primarily backward looking, and fail to reflect the
major drivers of future cash flows and hence of the firm’s value - in particular (and
most glaringly) its intangible assets (Howell 2002).

Income Approach
The Income Approach consists of methods of fundamental valuation, which aim to
directly estimate the intrinsic value of the firm or its equity, with the assumption that
markets are, at least in the long run, efficient and hence the market price will reflect
intrinsic value. These methods can be further divided into two main types: (i) those
involving discounting estimates of future cash flows to the firm or to its shareholders,
and (ii) those applying option pricing techniques to estimate its value. Selection of
the correct valuation method depends upon the form of growth opportunities
available to the firm, with the latter type being more suitable in situations where its
growth opportunities are dependent upon some form of contingent decision (Amram
2002).

Discounted Cash Flow (DCF) Methods

The main forms of discounted cash flow valuation are:
 the enterprise DCF model;
 the economic profit model;
 the equity DCF model; and
 the adjusted present value (APV) model
(Copeland, Koller and Murrin 2000)

While all four approaches discount expected cash flows and, when correctly applied,
both DCF and economic profit models will yield equivalent results of the firm’s value
(Shrieves and Wachowicz 2001), the relevant cash flows and discount rates are
different under each, and it is important when applying DCF methods to ensure that
the cash flows and discount rates used are consistent throughout (Fernández 2003).

All DCF methods share common problems in (i) forecasting the expected cash flows
for the firm; and (ii) predicting the right discount rate(s) that will be applicable to
these future cash flows. Given these informational requirements, this approach is
easiest to use for assets (firms) whose cash flows are currently positive and can be
estimated with some reliability for future periods, and where a proxy for risk that can
be used to obtain discount rates is available. The further the firm being valued
deviates from this idealized setting, the more difficult (and possibly unsuitable)
discounted cash flow valuation becomes. Particular difficulties with DCF methods are
faced when applied in the following cases (Damodaran 2002):

 Firms in trouble with negative earnings and cash flows. For these firms,
estimating future cash flows is difficult to do, since there is a higher probability
of bankruptcy. DCF valuation methods are not well suited to firms which may
be expected to fail, since the fundamental premise of these methods is that the
firm will provide positive cash flows to its investors.
 Cyclical Firms: The earnings and cash flows of cyclical firms tend to follow the
economy - rising during economic booms and falling during recessions. If
viewed during the low part of the cycle a cyclical firm may look like a troubled
one, with negative earnings and cash flows. Two alternative techniques are
used to apply DCF valuation methods to such firms, either expected future
cash flows are smoothed out, or the analyst attempts to predict the timing and
duration of economic recessions and recoveries and the resulting cash flows
generated over the cycle. In the former case the actual results of the firm will
vary from those used in the valuation throughout the cycle, making it difficult to
identify whether the firm is delivering the anticipated results and cash flows or if
there has been a fundamental change in its market or risk which might
invalidate the valuation. The latter alternative however entangles the analyst’s
estimate of the firm’s likely performance and future cash flows with his
predictions about the overall economic cycle.

 Firms with under-utilized assets: As it values the company on the basis of cash
flows generated, rather than looking at the assets the firm uses to generate
these, DCF valuation methods reflect only the value of assets that produce
cash flows. If a firm has assets that are un-utilized (and hence do not produce
any cash flows) or under-utilized then the value of these assets will not be
reflected in the value obtained from discounting expected future cash flows.
Companies that effectively use shareholder value as a parameter in
determining their executives’ remuneration more effectively incentivise their
management to dispose of non-productive assets so as to capture the value of
these (Fernández 2002).

Un-utilized patents or licenses that do not currently produce any cash flows
(and which may not indeed do so in the near future) are intangible assets that
are of particular relevance in a number of industries. Historically the value of
such assets was normally estimated using the Market Approach, however
more recently it is more common that, as their value often depends upon the
future occurrence of favourable market conditions which allow the firm to sell
the resulting product and create a cash flow from them, it may be more
accurately estimated using contingent claim valuation methods.
  Firms in the process of restructuring: Firms in the process of restructuring often
sell some of their assets; acquire other assets; change their capital structure,
dividend policy, and management compensation schemes; and may even
change their ownership structure by being taken private. Such changes make
estimating future cash flows more difficult and affect the riskiness of the firm,
since using historical data for such firms would give a misleading picture of the
firm's value. When valuing such firms using a DCF method it is important to
ensure that the future cash flows projected reflect the expected effects of these
changes and that the discount rate used reflects the new capital structure and
risk in the firm.

 Firms involved in acquisitions: Specific issues that need to be taken into

account when using DCF valuation methods to value acquisition target firms
are: the form any synergy will take, and its effect on cash flows (Evans 2002);
possible changes in management, particularly in hostile takeovers, and their
impact on cash flows and risk; and the impact of significant changes in capital
structure, since many acquisitions burden the target firm with a significant
burden of debt, and their impact on cash flows and risk.

 Private Firms: The biggest problem in applying DCF valuation methods to

private firms is the estimation of the riskiness of the investment (to use in
estimating discount rates). Most risk/return models estimate risk parameters
from historical price, but as shares in private firms are not traded this is not
possible. One solution is to look at the riskiness of comparable firms which are
publicly traded. The other is to relate the measure of risk to accounting
variables, which are available for the private firm.

Contingent Claim Valuation Methods

Contingent claim valuation methods are variations on standard DCF methods that
adjust the valuation to account for the value of flexibility in the firm’s response to
future eventualities affecting its markets and opportunities through the application of
option pricing models. While these models were initially used to value traded options,
contingent claim valuation methods extend the reach of these models to value
strategic and operating flexibility in areas such as new product launches (through the
possession of patents or licences), opening and closing plants, or natural resource
exploration and exploitation rights (Copeland, Koller and Murrin 2000).

When analysing a company using contingent claim methods it should be noted that
the method most commonly used for valuing options, the Black-Scholes model,
correctly applies only to European-type options (which are exercisable only on
maturity), whereas strategic and operating flexibility and other corporate assets may
more correctly be viewed as American-type options (which may be exercised at any
time). Valuation of such assets using the Black-Scholes model in an unadjusted form
underestimates their value (Damodaran 2001).

Market Approach
Valuation methods within the Market Approach aim to estimate the market value of
the firm’s shares directly by comparison with other listed firms which are judged to be
sufficiently similar in their structure and in the markets they serve. Because of their
ease and speed of use, such relative valuations account for the majority of
valuations performed (Damodaran 2002). Besides being useful valuation tools in
their own right, particularly for valuing non-productive assets such as real estate,
market approach valuation methods can be a useful check for errors in DCF
valuations and may also serve to allow the company’s management to better
understand mismatches between the company and its competitors (Goedhart, Koller
and Wessels 2005).

The first stage in performing a relative valuation is for the variables to be used for
comparison of the firms to be standardized, usually by converting prices into
multiples of earnings, book values or sales, although sector-specific variables may
also be used. It is then necessary to identify similar firms, which is difficult to do
since no two firms are identical and even firms in the same business can still differ
on risk, growth potential, financing structure and mix, and cash flows. The question
of how to control for these differences, when comparing a multiple across several
firms, becomes a key one. The market value of the firm is then estimated by
comparing its multipliers with those of the selected comparable firms and with their
market value. The following types of multiples are commonly used (Damodaran
2002):

 Earnings Multiples. When buying a stock, it is common to look at the price paid
as a multiple of the earnings per share generated by the company. This
price/earnings ratio can be estimated using current earnings per share
(yielding a current PER), earnings over the last 4 quarters (resulting in a trailing
PER), or an expected earnings per share in the next year (providing a forward
PER). When buying a business, as opposed to just the equity in the business,
it is common to examine the value of the firm as a multiple of the operating
income or the earnings before interest, taxes, depreciation and amortization
(EBITDA).

 Book Value or Replacement Value Multiples. As already noted, traditional

accounting measures of value often provide a very different estimate of the
same business. The ratio of the share price and the book value of equity or the
replacement cost of the asset(s) may be a measure of how over- or
undervalued a stock is within its sector (although the price/book value ratio that
emerges can vary widely between different sectors, depending again upon the
growth potential and the quality of the investments in each).

 Sales or Revenue Multiples. Both earnings and book value are accounting
measures which are determined according to accounting rules and principles
which, as noted above, are poor metrics of economic value. An alternative
approach, which is far less affected by accounting choices, is to use the ratio of
the value of an asset to the revenues it generates. For equity investors, this
ratio is the price/sales ratio (PS), where the market value per share is divided
by the revenues generated per share. This makes it easier to compare firms in
different markets, with different accounting systems at work, than it is when
comparing earnings or book value multiples.

 Sector-Specific Multiples. While earnings, book value and revenue multiples

are multiples that can be computed for firms in any sector and across the entire
market, there are some multiples that are specific to a sector. It is common
 practice, for example, to use ratios involving annual production capacity,
number of parking spaces, and annual insurance premiums in performing
relative valuations of (respectively) cement companies, car parking firms and
insurance companies (Fernández 2003). This method may be dangerous for
two reasons; firstly, since they cannot be computed for other sectors or for the
entire market, sector-specific multiples can result in persistent over or under
valuations of sectors relative to the rest of the market, and secondly it is far
more difficult to relate sector specific multiples to fundamentals, which is an
essential ingredient to using multiples well.

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