The second approach is based on the idea that the value of a company is determined by two components: net asset value and earnings that exceed the “normal” return of the assets (economic profit is then the difference – when positive – between realized returns and “normal” industry returns).
The third approach is empirical: valuations are performed through a comparison with comparable assets traded on the market.
Finally, the fourth approach determines value from the estimation of the assets (tangible and intangible) that, net of the liabilities, constitute the net invested capital of the firm.
1.2.1 Common Practices in the Accounting and Financial Communities
Often, professionals separate methodologies into two main approaches to valuation: the first is the standard practice adopted by the financial community; the second one is the most widely used by accounting professionals.
The common practice in the financial community can be traced back to the methodologies adopted by investment and merchant banks – in particular:
● The DCF method based on the discounting of future cash flows derived from the company's business plan or assumed by the analyst
● Stock market multiples or multiples derived from comparable transactions
In other professional fields, the other methods set forth in Exhibit 1.1 seem to be preferred, partly because of cultural affinities and partly because of the specific goal of the valuation.
Indeed, some methods (particularly those based on excess earnings):
● better fit into some economic and accounting environment;
● follow, therefore, a logic more understandable to the actors for whose benefit the valuation is performed; and
● allow one to effectively and convincingly deal with special valuation problems, such as third-party interests or tax benefit valuations.
1.2.2 Approach of This Book
Despite the widespread use of alternative methodologies, most of this book will be devoted to the DCF analysis.
The reason for this choice is that DCF valuation processes allow a clear focus on the fundamental principles underlying valuation conditions that need to be met, and also when the professional believes a different methodology to better fit the final valuation objective.
In this chapter, we introduce, following a logical order that teaching experience has shown to be effective, the basic principles and themes that form the pillars of the DCF valuation approach:
● The net present value (NPV) principle
● How to deal with uncertainty
● The relationship between uncertainty and value
● The need for preventing, when possible, subjective judgments in value determination
1.3 THE TIME VALUE OF MONEY
Irving Fisher is considered the founding father of modern finance theory, not only for his market equilibrium model, which explains investment and consumption decisions, but also because of his almost-obsessive insistence on the need to determine any asset value exclusively as a function of its expected discounted cash flows.
Thanks to Fisher, since the early 1920s the main building block of valuation has been identified as follows: any asset value (financial or real) is a function of the cash flows it can generate and of the time distributions of the cash flows.2
Through Fisher's contribution, the concept of time value of money became solidified, thus building the rationale for the universally agreed need for a present value approach to valuation.
So, without uncertainty, or, as it is often said, in a deterministic framework, an investment, firm, or more generally any asset value can be obtained by the following:
● Calculate the asset relevant cash flows and their time distributions.
● Discount any cash flows at a rate expressing the time value of money.
Typically, this rate is the return rate of investments whose issuers are virtually free of any insolvency risk, such as government bonds (so-called risk-free rate). Exhibit 1.2 shows the concept.
Exhibit 1.2 Investment cash flow profile and mechanics of discounting
1.4 UNCERTAINTY IN COMPANY VALUATIONS
In order to set forth in an organized fashion the crucial problem of every evaluation, it is necessary to understand the reasoning that guides the process of valuation in a context in which the results of an investment, or of a business, cannot be certainly determined in advance, but can only be estimated.
In order to introduce the problem of uncertainty with the pragmatic approach more suitable to the needs of a business or financial analyst, it is useful to start from some basic concepts:
● The performance of industries is characterized by different degrees of predictability and, therefore, uncertainty. For example, trend in demand in the public utilities sector shows a significant correlation with the trend in the GDP, or the total family income. In other sectors, demand is a function of different macroeconomic variables, such as industrial investments, interest rates, etc. Generally, though, these correlations are more weak because some factors, such as lifestyle evolution or consumer behaviour, can have a great influence on the demand. Further, some other industries are extremely sensitive to economic trends (typically, the intermediate sectors, investment goods sectors for which demand is formed by other industries). Finally, some industries are less cyclical (e.g., some food sectors, and the pharmaceutical industry).
● New ventures, or firms that develop innovative strategies, face a different kind of uncertainty than traditional or consolidated industries. In fact, in traditional industries historical information helps to identify systematic correlations between the economic environment and a firm's expected results. In innovative ventures lacking significant historical comparisons, uncertainty can be associated with the idea of probability as an expectation of future events: therefore, estimates are largely subjective (uncertainty = belief).3 Such a concept of uncertainty, in general, is contrasted by academics with the notion of probability that past events repeat themselves (in such case, the concept of probability is associated with that of frequency).
● Firms, as organizations of individuals competing on the market, generate evolutionary phenomena that constitute risk factors for other firms, which in turn react by generating new changes. Therefore, we must abandon the idea, implicitly accepted by finance theorists, that uncertainty is a situation passively faced by firms. In the real world, uncertainty is managed by firms that seek to exploit favorable opportunities and limit the downside of unfavorable events. Management, indeed, by its own decisions continuously molds the risk profile characteristic of its core activity. That is, management style, interaction with the economic environment, and adopting innovative approaches rather than passive adaptation are fundamental factors in adjusting the degree of uncertainty associated with external factors, common to all the firms belonging to the same strategic business area.
In the valuation of investments, acquisitions, or businesses, different forms of uncertainty can coexist – although, generally, one form tends to prevail over the others.
On the one hand, there are valuations of companies that operate in highly stable macroeconomic contexts, in highly predictable industry, and whose future performance is characterized by high visibility. Such cases of “easy” valuations become less and less frequent in the current context of erratic economies