What is my company worth? What are the ratios used by analysts to determine
whether a stock is undervalued or overvalued? How valid is the discounted
present value approach? How can one value a company as a
going concern, and how does this change in the context of a potential acquisition,
or when the company faces financial stress?
Finding a value for a company is no easy task -- but doing so is an essential
component of effective management. The reason: it's easy to destroy value
with ill-judged acquisitions, investments or financing methods. This article
will take readers through the process of valuing a company, starting with
simple financial statements and the use of ratios, and going on to discounted
free cash flow and option-based methods.
How a business is valued depends on the purpose, so the most interesting
part of implementing these methods will be to see how they work in different
contexts -- such as valuing a private company, valuing an acquisition target,
and valuing a company in distress. We'll learn how using the tools of valuation
analysis can inform management choices.
- Asset-Based Methods
- Using Comparables
- Free Cash Flow Methods
- Option-Based Valuation
- Special Applications
Asset-based methods start with the "book value" of a company's
equity. This is simply the value of all the company's assets, less its debt.
Whether it's tangible things like cash, current assets, working capital and
shareholder's equity, or intangible qualities like management or brand name,
equity is everything that a company has if it were to suddenly stop selling
products and stop making money tomorrow, and pay off all its creditors.
The Balance Sheet: Cash & Working Capital
Like to buy a dollar of assets for a dollar in market value? Ben Graham
did. He developed one of the premier screens for ferreting out companies
with more cash on hand than their current market value. First, Graham would
look at a company's cash and equivalents and short-term investments. Dividing
this number by the number of shares outstanding gives a quick measure that
tells you how much of the current share price consists of just the cash that
the company has on hand. Buying a company with a lot of cash can yield a
lot of benefits -- cash can fund product development and strategic acquisitions
and can pay high-caliber executives. Even a company that might seem to have
limited future prospects can offer tremendous promise if it has enough cash
Another measure of value is a company's current working capital
relative to its market capitalization. Working capital is what is left
after you subtract a company's current liabilities from its current assets
. Working capital represents the funds that a company has ready access to
for use in conducting its everyday business. If you buy a company for close
to its working capital, you have essentially bought a dollar of assets for
a dollar of stock price -- not a bad deal, either. Just as cash funds all
sorts of good things, so does working capital.
Shareholder's Equity & Book Value
Shareholder's equity is an accounting convention that includes
a company's liquid assets like cash, hard assets like real estate, as well
as retained earnings. This is an overall measure of how much liquidation
value a company has if all of its assets were sold off -- whether those assets
are office buildings, desks, old T-shirts in inventory or replacement vacuum
tubes for ENIAC systems.
Shareholder equity helps you value a company when you use it to figure
out book value. Book value is literally the value of a company
that can be found on the accounting ledger. To calculate book value per
share, take a company's shareholder's equity and divide it by the current
number of shares outstanding. If you then take the stock's current price
and divide by the current book value, you have the price-to-book ratio
Book value is a relatively straightforward concept. The closer to book
value you can buy something at, the better it is. Book value is actually
somewhat skeptically viewed in this day and age, since most companies have
latitude in valuing their inventory, as well as inflation or deflation of
real estate depending on what tax consequences the company is trying to avoid.
However, with financial companies like banks, consumer loan concerns, brokerages
and credit card companies, the book value is extremely relevant. For instance,
in the banking industry, takeovers are often priced based on book value,
with banks or savings & loans being taken over at multiples of between
1.7 to 2.0 times book value.
Another use of shareholder's equity is to determine return on equity
, or ROE. Return on equity is a measure of how much in earnings a company
generates in four quarters compared to its shareholder's equity. It is measured
as a percentage. For instance, if XYZ Corp. made a million dollars in the
past year and has a shareholder's equity of ten million, then the ROE is
10%. Some use ROE as a screen to find companies that can generate large profits
with little in the way of capital investment. Coca Cola, for instance, does
not require constant spending to upgrade equipment -- the syrup-making process
does not regularly move ahead by technological leaps and bounds. In fact,
high ROE companies are so attractive to some investors that they will take
the ROE and average it with the expected earnings growth in order to figure
out a fair multiple. This is why a pharmaceutical company like Merck can
grow at 10% or so every year but consistently trade at 20 times earnings
Brand is the most intangible element to a company, but quite possibly
the one most important to a company's ability as an ongoing concern. If
every single McDonald's restaurant were to suddenly disappear tomorrow,
the company could simply go out and get a few loans and be built back up
into a world power within a few months. What is it about McDonald's that
would allow it to do this? It is McDonald's presence in our collective minds
-- the fact that nine out of ten people forced to name a fast food restaurant
would name McDonald's without hesitating. The company has a well-known brand
and this adds tremendous economic value despite the fact that it cannot
Some investors are preoccupied by brands, particularly brands emerging
in industries that have traditionally been without them. The genius of Ebay
and Intel is that they have built their company names into brands that
give them an incredible edge over their competition. A brand is also transferable
to other products -- the reason Microsoft can contemplate becoming a power
in online banking, for instance, is because it already has incredible brand
equity in applications and operating systems. It is as simple as Reese's Peanut
Butter cups transferring their brand onto Reese's Pieces, creating a new
product that requires minimum advertising to build up.
The real trick with brands, though, is that it takes at least competent
management to unlock the value. If a brand is forced to suffer through incompetence,
such as American Express in the early 1990s or Coca-Cola in the early 1980s,
then many can become skeptical about the value of the brand, leading them
to doubt whether or not the brand value remains intact. The major buying opportunities
for brands ironically comes when people stop believing in them for a few
moments, forgetting that brands normally survive even the most difficult
of short-term traumas.
Intangibles can also sometimes mean that a company's shares can trade
at a premium to its growth rate. Thus a company with fat profit margins,
a dominant market share, consistent estimate-beating performance or a debt-free
balance sheet can trade at a slightly higher multiple than its growth rate
would otherwise suggest. Although intangibles are difficult to quantify, it
does not mean that they do not have a tremendous power over a company's share
price. The only problem with a company that has a lot of intangible assets
is that one danger sign can make the premium completely disappear
IBM Balance Sheet
|Other Current Assets
|Liabilities and Equity
The Piecemeal Company
Finally, a company can sometimes be worth more divided up rather than
all in one piece. This can happen because there is a hidden asset that most
people are not aware of, like land purchased in the 1980s that has been kept
on the books at cost despite dramatic appreciation of the land around it,
or simply because a diversified company does not produce any synergies. Sears,
Dean Witter Discover and Allstate are all worth a heck of a lot more broken
apart as separate companies than they ever were when they were all together.
Keeping an eye out for a company that can be broken into parts worth more
than the whole makes sense, especially in this day and age when so many conglomerates
are crumbling into their component parts.
The most common way to value a company is to use its
earnings. Earnings, also called net income or net profit, is the money that
is left over after a company pays all of its bills. To allow for apples-to-apples
comparisons, most people who look at earnings measure them according to
earnings per share (EPS).
You arrive at the earnings per share by simply dividing the dollar amount
of the earnings a company reports by the number of shares it currently has
outstanding. Thus, if XYZ Corp. has one million shares outstanding and has
earned one million dollars in the past 12 months, it has a trailing EPS of
$1.00. (The reason it is called a trailing EPS is because it looks at the
last four quarters reported -- the quarters that trail behind the most recent
-------------- = $1.00 in earnings per share (EPS)
The earnings per share alone means absolutely nothing, though.
To look at a company's earnings relative to its price, most investors employ
the price/earnings (P/E) ratio. The P/E ratio takes the stock price
and divides it by the last four quarters' worth of earnings. For instance,
if, in our example above, XYZ Corp. was currently trading at $15 a share,
it would have a P/E of 15.
$15 share price
---------------------------= 15 P/E
$1.00 in trailing EPS
Is the P/E the Holy Grail?
There is a large population of individual investors who stop their entire
analysis of a company after they figure out the trailing P/E ratio. With
no regard to any other form of valuation, this group of unFoolish investors
blindly plunge ahead armed with this one ratio, purposefully ignoring the
vagaries of equity analysis. Popularized by Ben Graham (who used a number
of other techniques as well as low P/E to isolate value), the P/E has been
oversimplified by those who only look at this number. Such investors look
for "low P/E" stocks. These are companies that have a very low price relative
to their trailing earnings.
Also called a "multiple", the P/E is most often used in comparison with
the current rate of growth in earnings per share. The Foolish assumption
is that for a growth company, in a fairly valued situation the price/earnings
ratio is about equal to the rate of EPS growth.
In our example of XYZ Corp., for instance, we find out that XYZ Corp.
grew its earnings per share at a 13% over the past year, suggesting that
at a P/E of 15 the company is pretty fairly valued. Fools believe that P/E
only makes sense for growth companies relative to the earnings growth. If
a company has lost money in the past year or has suffered a decrease in earnings
per share over the past twelve months, the P/E becomes less useful than other
valuation methods we will talk about later in this series. In the end, P/E
has to be viewed in the context of growth and cannot be simply isolated without
taking on some significant potential for error.
Are Low P/E Stocks Really a Bargain?
With the advent of computerized screening of stock databases, low P/E
stocks that have been mispriced have become more and more rare. When Ben
Graham formulated many of his principles for investing, one had to search
manually through pages of stock tables in order to ferret out companies that
had extremely low P/Es. Today, all you have to do is punch a few buttons
on an online database and you have a list as long as your arm.
This screening has added efficiency to the market. When you see a low
P/E stock these days, more often than not it deserves to have a low P/E
because of its questionable future prospects. As intelligent investors value
companies based on future prospects and not past performance, stocks with
low P/Es often have dark clouds looming in the months ahead. This is not
to say that you cannot still find some great low P/E stocks that for some
reason the market has simple overlooked -- you still can and it happens all
the time. Rather, you need to confirm the value in these companies by applying
some other valuation techniques.
The Price-to-Sales Ratio
Every time a company sells a customer something, it
is generating revenues. Revenues are the sales generated by a company for
peddling goods or services. Whether or not a company has made money in the
last year, there are always revenues. Even companies that may be temporarily
losing money, have earnings depressed due to short-term circumstances (like
product development or higher taxes), or are relatively new in a high-growth
industry are often valued off of their revenues and not their earnings.
Revenue-based valuations are achieved using the price/sales ratio, often
simply abbreviated PSR.
The price/sales ratio takes the current market capitalization of a company
and divides it by the last 12 months trailing revenues. The market capitalization
is the current market value of a company, arrived at by multiplying the current
share price times the shares outstanding. This is the current price at which
the market is valuing the company. For instance, if our example company
XYZ Corp. has ten million shares outstanding, priced at $10 a share, then
the market capitalization is $100 million.
Some investors are even more conservative and add the current long-term
debt of the company to the total current market value of its stock to get
the market capitalization. The logic here is that if you were to acquire
the company, you would acquire its debt as well, effectively paying that
much more. This avoids comparing PSRs between two companies where one has
taken out enormous debt that it has used to boast sales and one that has
lower sales but has not added any nasty debt either.
Market Capitalization = (Shares Outstanding * Current
Share Price) + Current Long-term Debt
The next step in calculating the PSR is to add up the revenues from the
last four quarters and divide this number into the market capitalization.
Say XYZ Corp. had $200 million in sales over the last four quarters and
currently has no long-term debt. The PSR would be:
(10,000,000 shares * $10/share) + $0 debt
PSR = ----------------------------------------- = 0.5
$200 million revenues
The PSR is a measurement that companies often consider when making
an acquisition. If you have ever heard of a deal being done based on a certain
"multiple of sales," you have seen the PSR in use. As this is a perfectly
legitimate way for a company to value an acquisition, many simply expropriate
it for the stock market and use it to value a company as an ongoing concern.
Uses of the PSR
The PSR is often used when a company has not made money in the last year.
Unless the corporation is going out of business, the PSR can tell you whether
or not the concern's sales are being valued at a discount to its peers.
If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many
companies in the same industry have PSRs of 2.0 or higher, you can assume
that, if it can turn itself around and start making money again, it will
have a substantial upside as it increases that PSR to be more in line with
its peers. There are some years during recessions, for example, when none
of the auto companies make money. Does this mean they are all worthless
and there is no way to compare them? Nope, not at all. You just need to use
the PSR instead of the P/E to measure how much you are paying for a dollar
of sales instead of a dollar of earnings.
Another common use of the PSR is to compare companies in the same line
of business with each other, using the PSR in conjunction with the P/E in
order to confirm value. If a company has a low P/E but a high PSR, it can
warn an investor that there are potentially some one-time gains in the last
four quarters that are pumping up earnings per share. Finally, new companies
in hot industries are often priced based on multiples of revenues and not
multiples of earnings.
What Level of the Multiple is Right?
Multiples may be helpful for comparing two compnies, but which multiples
is right? Many look at estimated earnings and estimate what "fair" multiple
someone might pay for the stock. For example, if XYZ Corp. has historically
traded at about 10 times earnings and is currently down to 7 times earnings
because it missed estimates one quarter, it would be reasonable to buy the
stock with the expectation that it will return to its historic 10 times
multiple if the missed quarter was only a short-term anomaly.
When you project fair multiples for a company based on forward earnings
estimates, you start to make a heck of a lot of assumptions about what is
going to happen in the future. Although one can do enough research to make
the risk of being wrong as marginal as possible, it will always still exist.
Should one of your assumptions turn out to be incorrect, the stock will probably
not go where you expect it to go. That said, most of the other investors and
companies out there are using this same approach, making their own assumptions
as well, so, in the worst-case scenario, at least you won't be alone.
A modification to the multiple approach is to determine the relationship
between the company's P/E and the average P/E of the S&P 500. If XYZ
Corp. has historically traded at 150% of the S&P 500 and the S&P is
currently at 10, many investors believe that XYZ Corp. should eventually hit
a fair P/E of 15, assuming that nothing changes. The trouble is, things do
Key Valuation Ratios for IBM (April 2003)
| Price Ratios
|Current P/E Ratio
|P/E Ratio 5-Year High
|P/E Ratio 5-Year Low
Free Cash Flows Methods
Despite the fact that most individual investors are
completely ignorant of cash flow, it is probably the most common
measurement for valuing public and private companies used by investment
bankers. Cash flow is literally 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).
Why look at earnings before interest, taxes, depreciation and amortization?
Interest income and expense, as well as taxes, are all tossed aside because
cash flow is designed to focus on the operating business and not secondary
costs or profits. Taxes especially depend on the vagaries of the laws in
a given year and actually can cause dramatic fluctuations in earnings power.
For instance, Cyberoptics enjoyed a 15% tax rate in 1996, but in 1997
that rate more than doubled. This situation overstates CyberOptics' current
earnings and understates its forward earnings, masking the company's real
operating situation. Thus, a canny analyst would use the growth rate of
earnings before interest and taxes (EBIT) instead of net
income in order to evaluate the company's growth. EBIT is also adjusted
for any one-time charges or benefits.
As for depreciation and amortization, these are called
non-cash charges, as the company is not actually spending any money
on them. Rather, depreciation is an accounting convention for tax purposes
that allows companies to get a break on capital expenditures as plant and
equipment ages and becomes less useful. Amortization normally comes in when
a company acquires another company at a premium to its shareholder's equity
-- a number that it account for on its balance sheet as goodwill and is forced
to amortize over a set period of time, according to generally accepted accounting
principles (GAAP). When looking at a company's operating cash flow, it makes
sense to toss aside accounting conventions that might mask cash strength.
In a private or public market acquisition, the price-to-cash flow multiple
is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to
9.0 range, the acquisition is normally considered to be expensive. Some counsel
selling companies when their cash flow multiple extends beyond 10.0. In
a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0
times cash flow because so much of the acquisition is funded by debt. A
LBO also looks to pay back all the cash used for the buyout within six years,
have an EBITDA of 2.0 or more times the interest payments, and have total
debt of only 4.5 to 5.0 times the EBITDA.
IBM's Income Statement
|Annual Income Statement
(Values in Millions)
|Cost of Sales
|Gross Operating Profit
|Selling, General & Admin. Expense
|Depreciation & Amortization
|Other Income, Net
|Total Income Avail for Interest Exp.
|Total Net Income
Free Cash Flow goes one step further. A company
cannot drain all its cash flow -- to survive and grow is must invest in capital
and hold enough inventory and receivables to support its customers. So after
adding back in the non-cash items, we subtract out new capital expenditures
and additions to working capital. A bare-bones view of IBM's free cash flows
is given below.
IBM: Free Cash Flows
||TTM = Trailing
|Operating Cash Flow
|- Capital Spending
|= Free Cash Flow
How to Use Cash Flow
Cash flow is the only method that makes sense in many situations. For
example, it is commonly used to value industries that involve tremendous
up-front capital expenditures and companies that have large amortization
burdens. Cable TV companies like Time-Warner Cable and TeleCommunications
have reported negative earnings for years due to the huge capital expense
of building their cable networks, even though their cash flow has actually
grown. This is because huge depreciation and amortization charges have masked
their ability to generate cash. Sophisticated buyers of these properties
use cash flow as one way of pricing an acquisition, thus it makes sense for
investors to use it as well. It is also commonly used method in venture
capital financings because it focuses on what the venture investor
is actually buying, a piece of the future operations of the company.
Its focus on future cash flows also coincides nicely with a critical
concern of all venture investors, the company's ability to sustain
its future operations through internally generated cash flow.
The premise of the discounted free cash flow method
is that company value can be estimated by forecasting future performance
of the business and measuring the surplus cash flow generated
by the company. 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
The discounted cash flow method can be applied in
six distinct steps. Since the method is based on forecasts, a
good understanding of the business, its market and its past operations
is a must. The steps in the discounted cash flow method are as
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.
The following table illustrates the computations
made in the discounted cash flow method. The chart assumes a discount
factor of 13% (IBM's estimated weighted-average cost of capital)
and uses the growing perpetuity assumption to generate a residual
value for the cash flows after the fifth year.
Valuation for IBM
2-stage growth model
Executives continue to grapple with issues of risk and uncertainty
in evaluating investments and acquisitions. Despite the use of net present
value (NPV) and other valuation techniques, executives 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,
one that 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. In short, investment decisions are
often made in a way that leaves some options open. The simple NPV rule
does not give the correct conclusion if uncertainty can be “managed.” In
acquisitions and other business decisions, flexibility is essential -- more
so the more volatile the environment -- and the value of flexibility can
be taken into account explicitly, by using the real-options approach.
Financial options are extensively used for risk management in
banks and firms. Real or embedded options are analogs of these financial
options and can be used for evaluating investment decisions made under significant
uncertainty. Real options can be identified in the form of 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 abandoning the project.
The option is worth something because the future value of the
asset is uncertain. Uncertainty increases the value of the option, because
if the uncertainty is interpreted as the variance, there are possibilities
to higher profits. The loss on the option is equal to the cost of acquiring
it. If the project turns out to be non-profitable, you always have the choice
of non-exercising. More and more, the real options approach is finding its
place in corporate valuation.
Assignment: Special Applications
What adjustments to the valuation approaches discussed above would have to
me made in the following special situations?
- Valuation in an M&A context
- Valuation of a company in distress
- Valuation of a company facing corporate financial restructuring.
Acknowledgements: some material adapted from fool.com