FIN544:Corporate Valuation

Other Non-DCF Approaches

 Outline
 Book Value Approach
 Stock and Debt Approach
 Strategic Approach to Valuation
Learning Outcome

 Examine the shortcomings of the DCF

approach of valuation.
 Estimate value of a firm by making strategic
judgments about the current and future state
of competition in the industry & resources
invested in the company
 Strategic Approach to
Valuation
The DCF approach is widely used in valuing
companies because it is conceptually sound
and consulting firms have developed
practical methodologies for applying it.
However, it suffers from certain
limitations. To a great extent these
limitations can be overcome by using the
strategic approach to valuation along with
the DCF approach to valuation.
 
 Limitations of the DCF
Approach
1. It mixes reliable information (usually near-term
cash flow information) with unreliable
information (terminal value). It is an axiom of
engineering that a combination of good
information and bad information does not result
in information does not result in information of
average quality. Rather, the bad information.
2. It discards a great deal of information that is
relevant for calculating the value of a company.
3. It relies on assumptions that are difficult to
make but ignores assumptions that can be
made with greater confidence.
 Strategic Approach to
Valuation
The strategic approach to valuation:
 Segregates reliable and unreliable information
 Relies on strategic judgments about the current
and future state of competition n the industry
 Does take into account the resources invested in
the company.
 Strategic Approach to
Valuation
The strategic approach to valuation involves valuing a
company at three levels:

 Asset value
 Earnings power value
 Total value

The strategic approach to valuation involves decomposing

the value of a company in terms of three tranches:

 Asset value
 Franchise value
 Growth value
 Asset Value
For valuing a company, the most reliable
information is the information on its balance
sheet. Assets and liabilities are shown as they
exist presently and can be inspected, even
though some of them may be intangible.
Valuing the balance sheet items does not
generally require any projection of future
developments. For items like cash,
marketable securities, and short-term debt
there is hardly any uncertainty about their
value. For other items, the valuation may be
more complicated, involving judgments.
 Asset Value

 For Business will "Not be economically viable"

:the assets must be valued at their
"Liquidation value.“

 For Business will "Economically viable": If the

business is considered viable, the assets
should be valued at "Reproduction cost"
Process to value assets at “"Liquidation
value.“ For "Economically Non-Viable“
Business
 Cash is valued at its balance sheet value.
 Marketable securities are valued at their market
value.

 Accounts receivable may be valued at a slight

discount over their balance sheet value.

 Inventories may be valued at a larger discount,
compared to accounts receivable.
Process to value assets at "Liquidation
value” For "Economically Non-Viable“ Business

 General purpose plant and machinery as well real estate

usually have active second hand markets and hence may
be valued at what they are likely to realise in these
markets.
 Industry-specific plant and machinery may be worth only
its scrap value.
 Intangibles like brands and customer relationships, for
an economically nonviable business, may have limited or
nil value in liquidation.
 From the value of the assets, the liabilities must be subtracted in full
because in any liquidation, other than bankruptcy, they are fully paid
off.
Process to value assets at "Reproduction
cost“
For "Economically viable“ Business
 For Cash and Marketable securities: Reproduction cost is simply
accounting book value.

 For Accounts receivable , the Reproduction cost will be slighter

higher than accounting book value ( as some may not be collected
normally)

 For Inventories : the Reproduction cost is cost of producing

equivalent amount of salable inventory.
Process to value assets at "Reproduction
cost“
For "Economically viable” Business
 For Plant and Machinery : the Reproduction cost is cost
of acquiring similar plant and machinery from cheapest
source , new or second hand....

 For land and building: the Reproduction cost is cost of

buying land and constructing similar building...
Example
 If a T- shirt co has purchased some machinery at Rs 10 lakh few
years back but now similar machinery can be purchase from
cheapest source (new or second hand.)...at Rs 5 lakh then you should
take machinery value as Rs 5 lakh....
 Earnings Power
To arrive at the “earnings power” certain adjustments have
to be made to reported earnings:
 Abstract away the effects of financial leverage , so take
EBIT (rather PAT)
 Adjust for “nonrecurring items” (e.g. gain or losses from
selling assets as these are not regular for the business)
 Adjust the current earnings for cyclical factors
 ( e.g calculate average EBIT /sales for last five years to find
current “Normalized EBIT” [by multiplying with current
year sales])
 Use economic depreciation rather taking accounting
deprecation . (economic depreciation is the amount need to
spend in a year to protect productive assets of the firm).
 Apply an average sustainable tax rate to the normalised
pre-tax earnings.
 Earnings Power Value EPV
Earnings power, which represents the annual flow
of funds, has to be divided by the weighted average
cost of capital to get the earnings power value
(EPV). For example if the earnings power is Rs.
1,000 million and the weighted average cost of
capital is 12 percent, the earnings power value will
be Rs. 8,333 million (Rs. 1,000 million/0.12).
 
Note that the EPV represents the value of the
company as a whole. If you want to get the value of
equity, subtract the value of the firm’s outstanding
debt from the EPV.
e..g if EPV is 8333 mn and value of debt =200 mn
then value of equity = 8333-500= 81333 mn
 Franchise Value
 Ignoring the issue of growth, we have estimated the
value of the company as “Asset value” or “EPV”
 If EPV > Asset Value, it means that the company enjoys
“Sustainable Competitive Advantages” that enable it to
earn superior returns.
 The difference between EPV and the asset value may be
called the ‘franchise value,’ the value attributable to the
competitive advantages enjoyed by the firm.
 If EPV = Asset value, it means that the firm does not
enjoy any significant competitive advantages.
 If EPV < Asset value, it means managerial deficiency i.e.
mgt is not able to generate return more than cost of
capital
 Total Value
The total value of a company is equal to the present value of its future cash
flows.

 No sustainable Total Value = Asset Value

competitive advantage

 Sustainable competitive Total value = EPV

advantage , but can’t
leverage .. same for growth

 Leveragable sustainable Total Value = EPV + Value of growth

competitive advantage
of growth
 Value of Growth

 If asset value > EPV, growth is bad

 If asset value = EPV, growth is neutral
 If EPV > asset value and strategic analysis
confirms that the firm enjoys sustainable
competitive advantage, growth is good.
 Three Tranches of Value

Value of Growth
Only if the growth benefits TRANCHE 3
from competitive
advantages

Franchise Value
Franchise value from current competitive TRANCHE 3
advantages

Reproduction Cost of Assets

Free entry TRANCHE 3
No competitive
advantages

ASSET VALUE EARNINGS TOTAL VALUE

POWER VALUE

 
THANK YOU