Valuation of Companies:

Theoretical and Empirical

Considerations

© Mauricio Jenkins
Valoración de Empresas 1
 Agenda

I. Introduction
II. Methodologies based on multiples
III. Methodologies based in DCF techniques
IV. Methodologies based in the book value
V. Venture capitalist methodology
VI. Final Comments

© Mauricio Jenkins
Valoración de Empresas 2
 Introduction

© Mauricio Jenkins
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 Introduction
• Valuation for what?
– Fundamental in mergers and acquisitions
– Transcendental when incorporation new shareholders
– At the end the decisions management takes should be aimed at
increasing corporate value

• To value a business correctly it is important to understand the available

methodologies, their implicit assumptions and the problems that arise when
they are applied in practice

• The most solid methodologies from a theoretical point of view are the ones
based on discounted cash flow.

• The other methodologies, although less sound from a theoretical perspective,

are used often in practice.

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 Methodologies based on Multiples

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 Methodologies based on multiples
• The idea is to relate the value of a company to a particular indicator of
financial or activity performance (like sales or net income)

• The main advantage of these methodologies is their simplicity and the

facility with which they can be applied. They are, in a sense, like rules of
thumb and can estimate value in no time

• Of course there is the problem of which multiple to use. The most widely
used is probably the P/E ratio, but there are many other potential candidates
(P/EBIT, P/EBITDA, P/Free Cash Flow, P/sales, P/book value, P/assets,
etc.).

• Choosing one particular multiple will depend on the type of business. For
example, for service companies P/sales has been used many times since
sales might be highly correlated with income and cash flow. For companies
in the cable industry, P/number of subscribers might be a good one, or
P/number of hits might be a good choice to value internet companies.

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 Methodologies based on multiples
• In theory with the P/E multiple estimates the equity value of the business.
To obtain the total value of the companies (total enterprise value) the market
value of the debt has to be added. On the contrary, P/EBIT, P/EBITDA,
P/Free Cash Flow, P/sales are computed from and should be used to estimate
the total value of the enterprise (debt + equity)

• When we use the P/E ratio (and in general any other multiple) to value a
company, we are implicitly assuming that the company from which we have
obtained the multiple and the company we wish to value have:
– Similar opportunities for future growth, similar future profitability, similar debt
levels and the same inherent business risk
– No significant differences in the liquidity of their common stock

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 Methodologies based on multiples
• The main difficulty that arises in practice with the methodologies based on
multiples is obtaining “comparable” firms along the dimensions just
mentioned from which to get the multiples. This is complicated many times
because of different accounting conventions between companies or countries.

• Even though these methodologies may seem unsophisticated, it would not be

intelligent to disregard market valuations of similar companies if they are
available.

• For these reasons, it is better to used valuations derived from multiples as a

check of the value obtained from more fundamentally sound methodologies
rather than as the sole an only estimate of company value.

• The usage of multiples to value something is better justified when what is

been valued is common and ordinary and when there are comparable
benchmarks available. Is less adequate when what's been valued is
uncommon or unique.

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 Methodologies based on DCF
techniques

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 Methodologies based on DCF techniques
• Under these methodologies, future cash flows for the company been valued
are estimated and discounted at the appropriate discount rate to obtain its
equivalent present value.

• Formally:

CF1 CF2 CFn  Vn

V  2
 ... 
1  K (1  K ) (1  K ) n

• We have then to estimate the future cash flows until year n and a terminal
(residual) value at the end of this period. We also need to estimate the
appropriate discount rate K according the inherent risks of the cash flows.

• The quality of this methodology to estimate the value of a company depends

critically on the estimation of future cash flows. Is to those estimates that we
have to dedicate time and resources.

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 Methodologies based on DCF techniques
• A common problem that arises when applying these methodologies is the
decision on what cash flow to discount. As we have seen there are three
potential ways one may follow to estimate the present value equivalent of
future cash flows. More specifically we have shown that:
Value of project =NPV (without debt) + PV of debt tax shields
Value of project =NPV (equity cash flows) + Value Debt
Value of project = NPV (WACC)

PV Tax Shields
NPV
(Debt)
NPV
(WACC)
NPV
NPV
(without debt)
(equity)

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 Methodologies based on DCF techniques
• As we have argued, one potentially big disadvantage of the WACC method is
that assumes the capital structure of the company remains unaltered through
time and that is not always the case.

• There are several ways of estimating the terminal value. One that is quite
common is to assume that company cash flows are going to stabilize at some
point in the future and then estimate the terminal value as a perpetuity (some
times as a growing one). Some times multiples are also used to get an
estimate of terminal value.

• It is not uncommon to find that the value of a company depends to a large

extent on the terminal value estimated.

• The estimation of the appropriate discount rate is always the source of much
discussion. In theory we have to get an estimate of the opportunity costs of
the funds use to finance the enterprise, but that is not always straightforward.

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 Methodologies based on DCF techniques
• In practice is common to see the use of discount rates taken from multilateral
agencies (BID, IFC) or discount rates estimated with models like the CAPM
which have to be adjusted for country and other risks.

• From a theoretical point of view these are the strongest methodologies.

However in practice they are also the most difficult to apply.

• Unfortunately there is a generalized obsession with the application and

mechanics of these methodologies which sometimes leads to a false sensation
of precision.

• Of course the final result from a valuation exercise depends critically on the
assumptions used to estimate future cash flows. Note that this is not a
financial problem per se.

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 Methodologies based on
the book value

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 Methodologies based on the book value
• The central idea here is to estimate the market value of assets, the market
value of liabilities and as a result the market value of the equity

• The starting point of these methodologies is always the balance sheet

Assets Liabilities
Current: Current:
Cash Payables
Receivables Short term debt
Inventories
Long term:
Fixed: Long term debt
Net Plant and equipment
Capital:
Other assets Retained earnings
Common stock

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 Methodologies based on the book value
• We can distinguish at least three possible values associated with the book
value of equity for a company
– Book value
– Adjusted book value
– Liquidation value

• Book value of equity

– Book value of assets less book value of liabilities
– Quite simple and straightforward to get
– Greatly affected by accounting conventions
– Lack of theoretical underpinning and unreliable

• Adjusted book value

– Adjust the book value of assets and liabilities to their market value
– Have to consider things like inventory obsolescence, problems with
receivables, gains or losses associated with fixed assets, inventory revaluation,
etc.
– This way of estimating the value of equity is the starting point of the so-called
methodologies based on goodwill
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 Methodologies based on the book value
• Estimating the market value of all assets and liabilities is not always an easy
thing to do:
– Collection of receivables and obsolescence of inventory
– Inventory valuation
– Inflation effect of the book value of fixed assets
– Specialized equipment
– An strategic asset (e.g., a mine or an airport)
– Value of other assets
– Provisions and reserves
– Investment in other companies
– Leases, derivatives and other sophisticated instruments
– Liquidity of some of the assets
– Etc.

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 Methodologies based on the book value
• Liquidation value
– Is the value of the equity if we assume the company will be liquidated
– It starts with the estimation of the market value of all assets and liabilities
– In theory it should be equal to the adjusted book value of equity value minus all
obligations that should be paid if the company is liquidated (employee benefits,
taxes of any kind, legal costs, etc.)
– In an efficient market it should represent the minimum value the equity of a
company can have

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 Methodologies based on the book value
• The so-called methods based on goodwill can be classified here. The starting
point of these methods is the adjusted value of equity discussed above, to which
and additional value generated by the company’s goodwill is added.

• These methods are sometimes referred to as mixed because they start from a
static view of the company and then try to incorporate a dynamic view by
adding the value of future benefits accruing from the so-called goodwill.

• There are out there numerous ways to try to take into account the presumed
added value coming from the goodwill

• Classic method: assumes the goodwill can be expressed as certain number of

times the annual net benefit or sales
V  Pn B V  Pz B
where:
P: Adjusted book value of equity
B: net benefit
n: coefficient between 1.5 y 3
z: percentage of sales
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 Methodologies based on the book value
• Method of the UEC: assumes the goodwill is equivalent to a extra benefit
obtained from the difference between the actual net benefit and the benefit
that can be obtained from investing the equity value at an “appropriate” rate
P  an B
V  P  an ( B  i V )  V 
1  i an
where:
an: annuity factor at a certain rate t for n number of years (commonly
between 5 and 8 years)
i: Opportunity cost of the equity value

• It is hard to recommend these methodologies because they lack any

theoretical foundation. It is obvious that the rates used to estimate the
annuity factors, the number of years or percentages use to estimate the
goodwill are in all cases quite arbitrary.

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 Venture Capitalist Methodology

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 Método del Capitalista de Riesgo
• Venture capitalists have developed their own way to estimate (rather quickly)
the value of a company they may be interested in.
• They estimate the value of the company in the future (e.g., five years), and
later they discount that to the present using discount rates as high as 40-70%.
• The value of the company in the future is estimated frequently by multiples
(e.g., P/E, P/EBITDA, P/book value, P/EBIT).
• The proportion of the equity the venture capitalist asks for is calculated as the
ratio of the capital he would invest in the company today to the value of the
present value of company (obtained from discounting the future value by the
rates mentioned above).

• Venture capitalist give out three reasons for the use of such high rates for
discounting
– The entrepreneur's projections are always on the optimistic side
– The capitalist gives the target company other services in addition to capital
– The shares is the future may be illiquid

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 Final Comments

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 Final comments
• At the end a valuation exercise is an estimation of value. We cannot pretend to
calculate the precise and final value of a company with the simple application
of a mathematical formula. All valuation exercises involve a judgment and in
this sense they are both art and science.
• To value an economic reality it is important to understand it with some degree
of detail. In addition, all those involved in valuation exercises should
understand the methodologies available, their theoretical limitations and
practical difficulties. Without that understanding, it is hard to believe anyone
can pretend to value or be involve in the negotiation to buy or sell a company.
• Different methodologies to value a company give some times different results.
It is not a good idea to average the results, but rather to question the implicit
assumptions of each methodology and to select those that are more appropriate
according to the particular circumstances of the company been valued.
• The ability of whomever is valuing a company resides precisely in applying the
methodologies that are more appropriate given the particular circumstances of
the situation at hand.
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 Final comments
• Different individuals often obtain different results from a valuation exercise:
– Different methodologies and/or assumptions
– Seller versus buyer
– Strategic investor versus a purely financial one
– Minority interest versus control

• In reality the price of a company is what someone else is willing to pay for it.
That will depend on intrinsic value, but also in how the transaction is
presented and handled as well as on the negotiation abilities of the parties
involved. Price and value are two different things.

• Valuation in emerging markets is, of course, more complicated in the

developed ones.
– Size and specificity of the business
– Information available and estimation of future performance
– Compensation packages for owners and family members
– Minimization of tax obligations
– Illiquidity of the equity

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 Thanks!

© Mauricio Jenkins
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