This paper presents a summary and a critical writing about different company valuation methods and their significance regarding the determination of the fair value. The selected methods to be analyzed are the discounted cash flow, the capital asset pricing model, the weighted average cost of capital and the market value. Below are the analyses.
The discounted cash flow techniques
The methods discussed under this technique are the payback period, the net present value, the internal rate of return and the profitability index.
Payback period method- according to this method, the feasibility of a company is measured by dividing the initial capital outlay by the periodic cash inflows. For this reason, the payback period is defined as the period a company takes to generate cash that is equivalent, in the amount, to the initial cost of investment. The traditional financial managers mostly practice this approach because it helps to identify the time a company would take to return the cost of investment. Payback period method is considered a screening tool for viable investment opportunities. For example, an investment to expand a wireless network in Buenos Aires requires an initial investment cost of $15 million. According to the cash flow projection, the project will generate $ 5million annually. Using payback period, the company would take three years to return the initial cost of investment. The decision rule based on this method is that, if the payback period of an investment lies within investors required range of duration, the investment is considered. The reverse of the statement is entirely true (Damodaran 2008, pp. 277).
Arguments for payback period method
- Simplicity- it only requires the estimation of the periodic cash inflows. Once cash inflows have been determined, it is simple to estimate the payback period.
- It helps minimize risks by identifying an investment with the earliest payback period. Investments with extended payback periods pose high risk of payback default (Damodaran 2008, pp. 280).
Arguments against payback method
- The method does not reflect the time value of money. It assumes that the value of money is the same every year. The assumption is not true since money loses value with time.
- The method does not measure the profitability of a company but the payback period of a venture.
- The method does not consider cash inflows after the payback period and therefore, ignores the concept of return on investment (Damodaran 2008, pp. 277).
Net present value- in this method, both the cash inflows and outflows are discounted. The discounted outflow is subtracted from the sum of discounted cash inflows to obtain the net present value. The discounting rate is selected based on the cost of finance. According to this method, an investment should be accepted if the net present value is greater or equal to zero. Therefore, a company with a positive net present value is considered more valuable than that with a negative net present value. Concisely, companies with positive net present values generate a higher capital gain than those with negative NPV. The proponents of this method assert that it is advantageous because it takes into account the time value of money. Secondly, it conforms to the objective of shareholder wealth maximization. Lastly, it takes into account all the cash flows. Therefore, it is realistic concerning the estimation of return on investment. On the other hand, opponents of the method assert that it is disadvantageous because it ignores the element of risk. Secondly, it ignores the concept of payback period and lastly, it uses the cost of finance whose estimation is a challenge (Schön 2007, pp. 501).
The internal rate of return- IRR is the cost of capital of a company when the net present value equals zero. IRR of an investment can be obtained using trial and error, interpolation and extrapolation method. The fair value of a company is considered high if the IRR is higher or equal to the cost of finance. The proponents of this method assert that it is advantageous because it takes into account the concept of time value of money. Secondly, it considers the cash flows over the entire life of a venture. Lastly, it is compatible with the maximization of the owner’s wealth. On the other hand, its opponents argue that it is difficult to use (Gildersleeve 1999, pp. 280-287)
Profitability index- it is the ratio obtained after dividing the sum of the present value of cash inflows by the initial cost of investment. A company whose PI > 1 is considered of high fair value and is suitable for investment. Investment is discouraged in companies whose PI < 1. Advocates of the method argue that it is easy to use and it acknowledges the time value of money. On the other hand, proponents of the method argue that it may be difficult to estimate if the economic life of an investment is long (Schön 2007, pp. 501).
Capital asset pricing model- the model states the relationship between the risk and return on assets in a diversified portfolio. Investors are risk averse and prefer assets with lower risk at a given rate of return or higher return at a given level of risk (efficient assets). According to this model, it is profitable to invest in efficient assets. The model is limited because it relies on unrealistic assumptions. Secondly, it cannot be practically experimented because it is impossible to test the investors’ expectations. Lastly, it assumes that the required rate of return of an asset is exclusively influenced by the market risk while other factors such as inflation also affects the rate of return of an asset (Giovanis 2010, pp. 97).
Weighted average cost of capital- it is the percentage cost of capital components. It is used to discount cash flows of an investment only when the risk of a project is equal to the business risk of the company. The method is disadvantageous because it assumes that the capital structure is optimal. An optimum capital structure is not feasible in reality. Secondly, it is based on the market values of capital that keep on changing and lastly, it is based on historical information (Hirschey 2009, pp. 122-127).
The asset approach
The book value
This method involves the use of the par value of capital as indicated on the balance sheet. The value of a company, using this method, equals the value of assets as indicated on the balance sheet. However, this method faces a strong criticism because the book values are historical values of assets. Therefore, historical values do not reflect the current market situation (Martin 2011, pp. 97-112).
The market approach
The market value
Is the market price of an asset. Using this method, the fair value of a company is the product of the share price and the total number of shares. This method is limited because the share prices keep on changing thus the market value can only be computed at one point in time (Martin 2011, pp. 97-112).
List of References
Damodaran, A 2008, Strategic risk taking: a framework for risk management, Wharton School Pub, Upper Saddle River, N.J.
Gildersleeve, R 1999, Winning business: how to use financial analysis and benchmarks to outscore your competition, Gulf Pub. Co. / Cashman Dudley, Houston, Tex.
Giovanis, E 2010, Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing Theory (APT) Models in Athens Exchange Stock Market, GRIN Verlag GmbH, München.
Hirschey, M 2009, Managerial economics, South-Western Cengage Learning, Mason, OH.
Martin, G 2011, How to value shares and outperform the market: a simple, new and effective approach to value investing, Harriman House, Great Britain.
Schön, D 2007, The relevance of Discounted Cash Flow (DCF) and Economic Value Added (EVA) for the valuation of banks, GRIN Verlag, München.