Finance Essay Paper on Valuation of Companies

Valuation of Companies

Valuation methods are used to determine the prevailing fair value of a business. For an unbiased valuation of a company, it requires not only a focus on the current revenue but also the present value and potential of the company. The following is a discussion of two common valuation techniques, which are discount cash-flow approach and the price-to earnings (P/E) method. Discount cash flow technique is a direct valuation method that values a company based on its net present value (NPV), as dependent on future free cash flows after discounting the potential risks and debts. Terminal value is determined from predicted future cash flows for a given period. The discount rates are calculated using the weighted average cost of capital (WACC) or cost of equity, and discount the projected cash flows using the present value to get the net present value of the company (Petitt & Ferris, 2013).

Price-to-earnings (P/E) makes use of the ratio of current market price of a share to earnings per share to compare peer companies. P/E is an easy valuation method among the various valuation multiples methods, and has been in use since 1930 (Suozzo, 2001). It expresses the returns or earning expected from investment per share. In order to use the /E ratio, there has to be positive accounting earning, and earnings are calculated before accounting for depreciation (Petitt & Ferris, 2013).The earning multiple is expressed in years that the shareholder would get back his/her original share value. For example, if the share was bought at $15 and the earnings per share $1.5, then the earning multiple is 10, meaning it would take an average of 10 years for an investor to earn back the $15.

DCF method gives an absolute value and can be used when there are no peer companies for comparison. It uses future assumptions, such as inflation for thorough predictions. However, it is open to bias when predicting future growth in calculations of the terminal value (Steiger, 2010). On the other hand, P/E ratio is easier to use in comparing with companies that have similar accounting procedures. However, it does not take into account the risks in the financial statement and capital requirements for future growth (Suozzo, 2001).

References

Petitt, B. S., & Ferris, K. R. (2013). Valuation for Mergers and Acquisitions (2nd ed.). New Jersey: Pearson Education, FT Press

Steiger, F. (2010). The Validity of Company Valuation using Discounted Cash Flow Methods. arXiv preprint arXiv:1003.4881. Retrieved from http://arxiv.org/ftp/arxiv/papers/1003/1003.4881.pdf

Suozzo, P., Cooper, S., Sutherland, G., & Deng, Z. (2001). Valuation multiples: A primer. UBS Warburg: Valuation and Accounting (November). Retrieved from http://pages.stern.nyu.edu/~ekerschn/pdfs/readingsemk/EMK%20NYU%20S07%20Global%20Tech%20Strategy%20Valuation%20Multiples%20Primer.pdf