Blog - Investing Notes

August 14, 2006 - Classic Paper: Company Valuation Methods

We have selected for retrospective review a few all-time "best selling" research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the March 2004 update of the paper entitled "Company Valuation Methods: The Most Common Errors in Valuations" (download count over 6,000) by Pablo Fernandez. In this paper, the author describes the four most widely used company valuation methods: (1) balance sheet-based; (2) income statement-based; (3) goodwill-based; and, (4) cash flow discounting-based. He also illustrates a break-up value calculation and summarizes the valuation errors he has most commonly encountered. He states that:

• Balance sheet-based methods estimate a company’s value by determining the value of its assets (book value, adjusted book value, liquidation value, replacement value). This view is static, ignoring potential company opportunities and problems. In general, book value does not match market value.
• Income statement-based methods estimate a company’s value as a multiple of its earnings, dividends, sales or EBITDA.
• Goodwill-based (mixed) methods estimate a company’s value by first valuing its assets and then adding a quantity related to future earnings, goodwill. Goodwill represents an advantage over competitors (for example, brand power). There is no consensus on how to calculate goodwill.
• Cash flow discounting-based methods (see first chart below) estimate a company’s value by forecasting its future cash flow and then discounting the flow based on its risk. The approach is conceptually like cash budgeting. Determining the discount rate is critical. Because they are the only conceptually correct valuation methods, cash flow discounting models are the most widely used.

The following chart, taken from the paper, shows the steps in valuation via cash flow discounting. It illustrates the complexities and uncertainties that analysts and investors face in guesstimating whether a company's stock is overvalued or undervalued. Few investors have the resources to attempt the process -- hence the broad investor reliance on gurus and on simple fundamental and technical indicators, and the advantage of company insiders.

In summary, the value of a company's equity depends on its future cash flows (derived from the company's growth rate and return on investment) and on the required return on equity (derived from the risk-free rate and the company's operating and financial risks). The following chart decomposes these value drivers. Investors who are stock pickers should understand how the companies they choose stand with respect to these drivers.

For related research, see Blog Synthesis: Valuation Based on Fundamentals.