The term valuation implies the estimated worth of an asset or a

security or a business. The alternative approaches to value a

firm/an asset are:

Book value,
Market value,
Intrinsic value,
Liquidation value,
Replacement value,
Salvage value
Value of Goodwill
Fair value.

The

book value of an asset refers to the amount at

which an asset is shown in the balance sheet of a
firm. Generally, the sum is equal to the initial
acquisition cost of an asset less accumulated
depreciation.
In other words, book value of an asset shown in
balance does not reflect its current sale value.
Book value of a business refers to total book value
of all valuable assets (excluding fictitious assets,
such as accumulated losses and deferred revenue
expenditures, like advertisement, preliminary
expenses, cost of issue of securities not written off)
less all external liabilities (including preference

Market value refers to the price at which an

asset can be sold in the market.
The market value can be applied with respect
to tangible assets only; intangible assets (in
isolation), more often than not, do not have any
sale value.
Market value of a business refers to the
aggregate market value (as per stock market
quotation) of all equity shares outstanding.
The market value of business is relevant to
listed companies only.

Intrinsic/Economic Value:
Intrinsic/Economic Value is the present value of incremental future cash inflows
using an appropriate discount rate.
Liquidation Value :
As

the name suggests, liquidation value represents the price at which each
individual asset can be sold if business operations are discontinued in the wake of
liquidation of the firm.
In operational terms, the liquidation value of a business is equal to the sum of (i)
realisable value of assets and (ii) cash and bank balances minus the payments
required to discharge all external liabilities.
In general, among all measures of value, the liquidation value of an asset/or
business is likely to be the least.

Replacement Value:
The

replacement value is the cost of acquiring a new asset of equal

utility and usefulness.
It

is normally useful in valuing tangible assets such as office equipment

and furniture and fixtures, which do not contribute towards the revenue of
the business firm.
Salvage Value:
Salvage

value represents realisable/scrap value on the disposal of

assets after the expiry of their economic useful life.
It

may be employed to value assets such as plant and machinery.

Salvage

value should be considered net of removal costs.

Value of Goodwill:
The

valuation of goodwill is conceptually the most difficult.

A business firm can be said to have real goodwill in case it earns a rate of return
(ROR) on invested funds higher than the ROR earned by similar firms (with the
same level of risk).
In operational terms, goodwill results when the firm earns excess (super) profits.
Fair Value:
Fair

value is the average of book value, market value and intrinsic value.
The fair value is hybrid in nature and often is the average of these three values.
In India, the concept of fair value has evolved from case laws (and hence is more
statutory in nature) and is applicable to certain specific transactions, like payment
to minority shareholders.
It may be noted that most of the concepts related to value are stock based in
that they are guided by the worth of assets at a point of time and not the likely
contribution they can make towards earnings/cash flows of the business in the
future.

There are four approaches to valuation of business

(with focus on equity share valuation):
1)
2)
3)
4)

Assets based,
Earnings based,
Market value based and
Fair value method.

Assets-based method focuses on determining the value of

Net assets = (Total assets Total external obligations)

(1)

Net assets per share can be obtained dividing total net assets by
the number of equity shares outstanding. It indicates the net
assets backing per equity share (also known as net worth per
share).
Net assets per share = Net assets / Number of equity shares
issued and outstanding
(2)

Earnings based method relates the firms value to its potential future earnings
or cash flow generating capacity. Accordingly, there are two major variants of
this approach (i) Earnings measure on accounting basis and (ii) earnings
measure on cash flow basis.
(i) Earnings measure on accounting basis
As per this method, the earnings approach of business valuation is based on
two major parameters, that is, the earnings of the firm and the capatilisation
rate applicable to such earnings (given the level of risk) in the market. Earnings,
in the context of this method, are the normal expected annual profits. Normally
to smoothen out the fluctuations in earnings, the average of past earnings (say,
of the last three to five years) is computed.
Value of business (VB) = Future maintainable profits Relevant capitalisation
factor
(4)

The P/E ratio (also known as the P/E multiple) is the method most widely used
by finance managers, investment analysts and equity shareholders to arrive at
the market price of an equity share. The application of this method primarily
requires the determination of earnings per equity share (EPS). The EPS is
computed as per Equation
EPS = Net earnings available to equity shareholders during the period/Number
of equity shares outstanding during the period.
(5)
The EPS is to be multiplied by the P/E ratio to arrive at the market price of
equity share (MPS).
MPS= EPS P/E ratio

(6)

The P/E ratio may be derived given the MPS and EPS.
P/E ratio = MPS/EPS

(7)

The

second method makes use of the discounted cash flow technique to

value the business.
According to the DCF approach, the value of business/firm is equal to the
present value of expected future operating cash flows (CF) to the firm,
discounted at a rate that reflects the riskiness of the cash flows (k0), that is,

CF to Firmt
Value of firm
0 t1
t
1k
0

(8)

To use the DCF approach, accounting earnings (as shown by the firms
income statement) are to be converted to cash flow figures as shown in
Format 1.
Format 1: Computation of Cash Flows
After tax operating earnings*
Plus: Depreciation
Plus: Other non-cash items (say, amortisation of non-tangible asset,
such as patents, trade marks, etc and loss on sale of longterm assets)
* The interest costs are included as a part of the discount rate (K 0).

Format 2 shows computation of operating free cash flows (OFCF) for the
purpose of valuation of a business.
Format 2: Determination of Operating Free Cash Flows (OFCFF)
After tax operating earnings*
Plus: Depreciation, amortisation and other non-cash items
Less: Investments in long-term assets
Less: Investments in operating net working capital**
Operating free cash flows (OFCFF)
*Exclusive of income from (i) marketable securities and nonoperating investments and (ii) extraordinary incomes or losses.
**Addition is to be made in the event of decrease of net working
capital.

Format 3: Determination of Free Cash Flows (FCFF)

Operating free cash flows (as per Format 2)
Plus: After tax non-operating income/cash flows*
Plus: Decrease (minus increase) in non-operating
Assets, say marketable securities
Free cash flows to Firm (FCFF)
* Non-operating income (1 tax rate)

The free cash flow (FCFF) is the legitimate cash flow for the purpose of
business valuation in that it reflects the cash flows generated by a
companys operations for all the providers (debt and equity) of its
capital. The FCFF is a more comprehensive term as it includes cash
flows due to after tax non-operating income as well as adjustments for
non-operating assets. Format 3 exhibits the procedure of determining
FCFF.

Another variant of cash flow approach is to discount estimated free cash flows to
the firm (FCFF) instead of operating cash flows. The FCFFs are computed by
deducting incremental investments in long-term assets as well as investment in
working capital from operating cash flows. The value of firm is

Value of Firm 0

FCFF to all investors t

1 k 0 t

t 1

(9)

Alternatively, the value of equity can be determined directly by discounting the

free cash flows available to equityholders (FCFE) after meeting interest,
preference dividends and principal payments, the discount rate being ke.

Value of Equity 0
t 1

FCFF to equityholders t

1 k e t

(10)

In Example 4, for the sake of simplicity, we have assumed the life of the corporate
firm as 5 years. In practice, firms have perpetual long-term existence/indefinite life.
Evidently, the indefinite life of business/corporate firms, in general, is an additional
aspect to be reckoned in a firms valuation.
Ideally, one approach is to forecast future FCFF for a very long period of time, say
30-40 years and ignore all subsequent years FCFF. The reason is the discounted
value of such FCFF in such distant years will be insignificant.
However, there are genuine difficulties in explicitly forecasting decades of
performance. In fact, it is virtually impossible to make reasonably accurate
forecasts of profits/cash flows beyond a certain period (say 710 years) in most of
the businesses.
To overcome the problem Copeland et al suggest that the exercise related to
valuation of business can be segregated into two periods, during and after an
explicit forecast period. The value of a business/firm is
Present value of cash flows during explicit forecast period + Present value of cash
flows after explicit forecast period
(12)
(i) PV of cash flows during explicit forecast period
In the context of cyclical businesses, the explicit forecast period can correspond to
one full business cycle; in other businesses, the period can match with the number
of years during which they are likely to perform well. The firm is said to have
attained a steady state at the end of explicit period. Subsequent to this period, the
firm grows at a steady rate (normal or less than normal) which is likely to continue
in future years.

(ii) PV of cash flows after explicit forecast period.

The value determined after the explicit forecast period (T + 1) is referred to as the
continuing value. Its value can be determined as per the following equation:

Continuingvalue

NOPLAT T 11 g/ROICI
k0 g

(13)

Where NOPLATT+1 = The normalised level of net operating profits less adjusted
taxes in the first year after the explicit forecast period.
g = The expected growth rate in NOPLAT in perpetuity.
ROICI = The expected rate of return on the net new investment.
The derivation of the formula as per Equation 13 to compute continuing value is as
follows:

Continuing value

FCFFT1
k0 g

(13.1)

Where FCFFT+1 refers to the normalized level of free cash flow in the first
year after the explicit forecast period.

(ii) PV of cash flows after explicit forecast period

Free cash flows (FCFF) can be defined in terms of NOPLAT and investment rate, IR
(that is, the percentage of NOPLAT reinvested in the business each year).
FCFF

= NOPLAT (1IR)

(13.2)

We know, growth rate, g is the product of return on invested capital, ROICI and IR, ie,

or

= ROICI x IR

(13.3)

IR

= g/ROICI

(13.4)

Incorporating value of IR in FCFF definition

FCFF NOPLAT (1 g/ROIC I )
Continuing value

NOPLAT 1 g/ROIC I
k0 g

(13.5)

Equation 13 is termed as a value driven formula. Since Equations 13 and 13.1

provide the same answer of continuing value, it is logistically more convenient to
compute continuing value based on Equation 13.1.
1.

The major simplifying assumptions made in determining continuing value are:

(i) the firm earns a constant return on the existing invested capital;

2.

the firms NOPLAT grows at a constant rate and it invests the same proportion
of its gross cash flow in business each year and

3.

the firm earns a constant return on all new investments.

All the items in equation 13 are self explanatory, except the term adjusted taxes.
Adjusted taxes is the increase in the estimated tax liability due to the exclusion of the
tax shield provided by interest charges. This is illustrated in Example 5.

3. Market Value Based Approach to Valuation

The

market value (reflected in the stock market quotations) is the most

widely used approach to determine the value of a business, in particular of
large listed firms.
The market value indicates the price the investors are willing to pay for the
firms earning potentials and the corresponding risk.
This method is particularly useful in deciding swap ratios in the case of
merger decisions.
4.Fair Value Method
Fair

value method is not an independent method of share valuation.

The method uses the average/weighted average of two or more of the
above methods.
Therefore, such a method helps in smoothening out wide variations caused
by different methods and indicates the balanced figure of valuation.

The market value added (MVA) approach measures the change

in the value of the firm from the perspective of all the providers of
funds (i.e., shareholders as well as debenture holders).
MVA = [Total market value of the firms securities (Equity
shareholder funds + Preference share capital + Debentures)].
(14)
The MVA from the point of view of equity shareholders is =
(Market value of firms equity Equity funds
(15)

The EVA method measures economic value added (or

destroyed) for equity-owners by the firms operations in a
given year. The underlying economic principle in this
method is to determine whether the firm is earning a
higher rate of return on the entire invested funds than the
cost of such funds.
EVA = [Net operating profits after taxes (Total invested
funds WACC)]
(16)

Thank You