V Valuemaximization is the central theme in

financial management. Hence, all managers

must understand what determines value and
how to measure it.

FAIR MARKET VALUE:

V IRS of the US has defined fair market value as
´the price at which the property change
hands between a willing buyer and a willing
seller when the former is not under any
compulsion to buy and the latter is not any
compulsion to sell, both the parties having
reasonable knowledge of relevant facts.
V Adjusted book value
V Stock and debt approach
V Direct comparison approach
V Discounted cash flow approach
r The simplest approach to valuing a firm is to
rely on the on formation found on its balance
sheet.
r The accuracy of the book value approach
depends on how well the net book values of
the assets reflect their fair market values.
r THERE ARE THREE REASONS WHY BOOK
VALUES MAY DIVERGE FROM MARKET
VALUES:
1. Inflation drives a wedge between the book value of an asset
and its current value.
2. Thanks to technological changes some assets become
obsolete and worthless even before they are fully
depreciated in books.
3. Organizational capital, a very valuable asset, is not shown on
the balance sheet.
r Kash
r Debtors
r Inventories
r Other current assets
r Fixed tangible assets
r Non-operating assets
Adjusting book value to reflect liquidation values
The most direct approach for approximating
the fair market value of the asset on the
balance sheet of a firm is to find out what they
would fetch if the firm were liquidated
immediately.
r When the securities of a firm are publicly
traded its value can be obtained by merely
adding the market value of all its outstanding
securities. This approach is called the stock
and debt approach.
r The efficient market hypothesis has two
important implications for appraisal practice:
1. Where stock and debt approach can be
applied, it will produce the most reliable
estimate of value.
2. The securities of the firm should be valued at
the market price obtaining on the lien date.
Averaging of prices over a period of time is
not correct. It reduces the accuracy of
appraisal.
V Thedirect comparison approach involves
valuing a company on the basis of how
similar companies are valued in the market
place.
V— Œ
— . Vc


V—  appraised value of the target firm (asset)

— Œ observed variable for the target firm that
supposedly drives value
Vc Πobserved value of the comparable firm

 Πobserved variable for the comparable
firm
1. Analyze the economy
2. Analyze the industry
3. Analyze the subject company
4. Select comparable companies
5. Analyze subject and comparable
companies
6. Analyze multiples
7. Value the subject company
V The relationship of the industry to the
economy as a whole
V The stage in which the industry is in its life-
cycle
V The profit potential of the industry
V The nature of regulation applicable to the
industry
V The relative competitive advantages of
procurement of raw materials, production
costs, marketing and distribution
arrangements, and technological resources
r ÿroduct portfolio and market segments
covered by the firm
r Availability and cost of inputs
r Technological and production capabilities
r Market image, distribution reach, and
customer loyalty
r ÿroduct differentiation and economic cost
position
r Managerial competence and drive
r Quality of human resources
r Kompetitive dynamics
r Liquidity, leverage and access to funds
r Turnover margins and return on investment
V Firm value to sales
V Firm value to book value of assets
V Firm value to EBDIT (also called ÿBDIT)
V Firm value to EBIT
V Equity value to equity earnings (price-
earnings multiple)
V Equity value to net worth (market to book
ratio)
V Valuing a firm using the discounted cash flow
approach calls for forecasting cash flows over
an indefinite period of time for an entity that is
expected to grow.
V The value of the firm is separated into two time
periods:
Value of the firm Œ
present value of cash flow during an explicit
forecast period
+
present value of cash flow after that explicit
forecast period
1. Forecast the cash flow during the explicit
forecast period
2. Establish the cost of capital
3. Determine the continuing value at the end
of the explicit forecast period
4. Kalculate the firm value and interpret
results
V Selecting the explicit forecast period
V Defining the free cash flow to the firm
V Getting a perspective on the drivers of free
cash flow
V Developing the free cash flow forecast
V The FKFF is the sum of cash flows to all investors of the
firm, both creditors and shareholders. It can be broken
down into two components : operating free cash flow plus
non-operating cash flows.
V The operating cash flow is the post-tax cash flow
generated from the operations of the firm after providing
for investments in fixed assets plus net working capital
required for the operations of the firm.
V Non-operating cash flow arises from extraordinary or
exceptional items like profit from sales of assets,
restructuring expenses, and payments for setting legal
disputes. Such items, of course, be adjusted for taxes.
FKF Œ NOÿLAT ² Net investment
FKF Œ (NOÿLAT + Depreciation) ²
(Net investment ² Depreciation)
FKF Œ Gross cash flow ² Gross investment
NOÿLAT stands for net operating profit less
adjusted tax.
NOÿLAT Œ EBIT ² Taxes on EBIT
EBIT Œ profit before tax + interest expense ²
interest income ² non-operating
income
Taxes on EBIT Πtax provision from income
statement
+ tax shield on income expense
² tax on interest income
² tax on non-operating income
Net investment Œ Gross investment ² Depreciation

NON-OÿERATING KASH FLOW Œ

Non-operating income × (1 ² tax rate)
Therefore, FKFF Œ NOÿLAT ² NET INVESTMENT
+ NON-OÿERATING KASH FLOW
 Thus, the FKFF equals the total funds
available to investors, which is also referred
to as financing flow. The financing flow
comprises the following elements:
Financing flow Πafter-tax interest expense
+ cash dividend on equity
and preference
capital
+ redemption of debt
- new borrowings
+ share buybacks
- share issues
+ excess marketable
securities
- after-tax income on excess
market
securities
V THERE ARE TWO STEÿS IN ESTIMATING
KONTINUING VALUE:
(i) Khoose an appropriate method
(ii) Estimate the valuation parameters and
calculate the continuing value
V KASH FLOW METHODS
(i) Growing free cash flow perpetuity method
KV— Œ FKF —

KV— Œ continuing value at the end of year T
FKF — Œ expected cash flow for the first year
after the explicit forecast period
k Πweighted average cost of capital
g Πexpected growth rate of free cash flow
for ever
(ii) Value driver method
KV— Œ NOÿLAT — ( 1 ² 
)

KV— Œ continuing value at the end of year T
NOÿLAT — Œ expected NOÿLAT for the first
year after the explicit forecast period
k Πweighted average cost of capital
g Œ constant growth rate of NOÿLAT after
the explicit forecast period
r Πexpected rate of return on net new
investment
V NON-KASH FLOW METHODS
(i) Replacement cost method
- The continuing value is equated with the
expected replacement cost of the fixed
assets of the compan
(ii) ÿrice-earnings method
- The expected earnings in the first year
after the explicit forecast period is
multiplied by a ¶suitable· price-to-earnings
ratio
(iii) Market-to-book ratio method
- The continuing value of the company at
the end of the explicit forecast period is
assumed to be some multiple of its book
value.
The following parameters have to be
estimated:
V Net operating profit less adjusted taxes
(NOÿLAT)
V Free cash flow (FKF)
V Return on investment capital (ROIK)
V Growth rate ()
V Kost of capital ()
V The value of the firm is equal to the sum
of the following three components:
1. ÿresent value of the free cash flow
during the explicit forecast period
2. ÿresent value of the continuing value
(horizon value) at the end of the explicit
forecast period
3. Value of non-operating assets (like
excess marketable securities) which
were ignored in free cash flow analysis.
V Understand how the various approaches
compare
V Use at lest two different approaches
V Work with a value range
V Go behind the numbers
V Value flexibility
V Blend theory with judgment
V Avoid reserve financial engineering
V Beware of possible pitfalls
V Adjust for control ÿremia and non-
marketibility factor
V Debunk the Myths surrounding valuation