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VALUE OF A FIRM

BY : GLADYS J. CATACUTAN
A firm’s value, also known as Firm Value
(FV), Enterprise Value (EV) is an economic concept
that reflects the value of a business. It is the value that
a business is worthy of at a particular date.
Theoretically, it is an amount that one needs to pay to
buy/take over a business entity. Like an asset, the value
of a firm can be determined on the basis of either book
value or market value. But generally, it refers to the
market value of a company. EV is a more
comprehensive substitute for market capitalization and
can be calculated by following more than one
approach.
CALCULATING A FIRM’S VALUE
Value of a firm is basically the sum of claims of its
creditors and shareholders. Therefore, one of the
simplest ways to measure the value of a firm is by
adding the market value of its debt, equity, and minority
interest. Cash and cash equivalents would be then
deducted to arrive at the net value.

EV = market value of common equity + market value of


preferred equity + market value of debt + minority
interest – cash and investments.
Another sound approach towards computing the
value of a firm is to determine the present value of its
future operating free cash flows. The idea is to draw a
comparison between two similar firms. By similar firms,
we mean similar in size, same industry etc. The firm
whose present value of future operating cash flows is
better than the other is more likely to attract higher
valuation from the investors. Operating Free Cash
Flow (OFCF) is calculated by adjusting the tax rate,
adding back depreciation and deducting the amount of
capital expenditure, working capital and changes in
other assets from earnings before interest and taxes. The
formula for computing OFCF is as below –
OFCF = EBIT (1-T) + Depreciation – CAPEX –
working capital – any other assets

Where :

EBIT = earnings before interest and taxes,

T = tax rate

CAPEX = capital expenditure


BOOK VALUE OF A FIRM
As the name implies, the book value of the firm
is its value as reflected in its ‘books’ or financial
statements. It is the difference between the assets and
liabilities of a firm as per its balance sheet. It is
recorded as shareholder’s equity in the balance sheet.
This is the true worth of business when its liabilities are
netted off from its assets.
For example,
if company ABC has total assets worth
$500 million and total liabilities amounting to
$450 million, the book value of the firm would be
$50 million (computed by deducting the value of
liabilities from that of assets). This means that if a
company XYZ is to purchase company ABC, then
it will have to shell $50 million out of its pocket,
the actual book value of buying company ABC.
MARKET VALUE OF A FIRM
The market value of a company, also
known as market capitalization, is its value
as reflected in the stock exchange. It is
calculated by multiplying a company’s
outstanding share by its current market
price.
For example,
if company ABC has 10 million shares
outstanding and the market price of each
share is $50; then the market value of the
company would be $500 million, assuming
there are only common shares issued in the
market.
Market value and book value of the firm
are two different concepts. There is quite a
possibility of a huge difference between the
book value and market value of a company at
a given point of time.
Conclusion
What approach of calculating the value of a
firm needs to be followed depends on the firm in
question. Also, whether to consider the book
value or market value of a company while
making a decision to buy is a policy and strategy
decision. One can engage companies that
exclusively deal with estimating the true value of
firms.
Thank you !!!

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