This article focuses on the tools which corporations use to determine their value. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is potential to make fatal mistakes that may be detrimental to the organization's well-being. The role of managerial accounting as well as managerial economics is discussed. There are two types of techniques utilized by decision makers in the planning process, and they are cost/value/profit (CVP) analysis and financial budgeting. These techniques are explored.
In order to effectively manage a company, it is important to know how much it is worth. If the organization does not know how much it is worth or what makes good business sense (i.e. acquisitions and mergers), there is potential to make fatal mistakes that may be detrimental to the organization's well-being.
Methods for Determining Organizational Value
There are different ways one can determine the value of an organization; some of those methods are discussed below.
Asset-based methods began with the "book value" of an organization's equity. An organization's equity is defined as the organization's assets minus its debt. Corporations are charged with two major responsibilities, they are: Acquiring financial and productive resources and combining the resources in order to create new resources. Acquired resources are called assets, and the different types of assets are called equities. Therefore, the foundation for the basic accounting equation is "Assets = Equities." However, since equities can be divided into two groups, the basic accounting equation can be revised to read as "Assets = Liabilities + Owners' Equity."
- Assets. Although assets consist of financial and productive resources, not all resources are considered assets. In order to determine if a resource is considered an asset, it must satisfy all three of the following criteria:
- The resource must possess future value for the business. The future value must take the form of exchange ability (i.e. cash) or usability (i.e. equipment).
- The resource must be under the effective control of the business. However, legal ownership is not mandatory. As long as the resource can be freely used in business activities, the resource will meet the asset criteria. An example would be a leased computer. Although the organization may use the computer, legal rights still belong to the leasing company.
- The resource must have a dollar value resulting from an identifiable event or events in the life of the organization. The value assigned to the asset must be tracked to an exchange between the organization and others (Page & Hooper, 1985).
If the resource does not meet all of the criteria, it cannot be reported as an asset.
- Liabilities. When someone other than the owner provides an organization with an asset, the claims against the business take the form of a debt. Sources of assets from someone other than the owner are referred to as liabilities. Liabilities are the debts and legal obligations that a business incurs as the result of acquiring the assets from non-owners.
- Owners' Equity. Some businesses may obtain assets via owner investment or sale of stock. When the owner supplies the organization with assets, the claim against those assets is called owners' equity (or stockholders' equity) in a financial report.
When a business accepts assets from a source other than the owner, it can be reported as a liability or owners' equity. However, there are some differences between these two sources.
Liabilities Owners' Equity Legal Status Claims by external parties are considered legal obligations of the organization. Owners' claims are not binding and legally enforceable. If the claims are not satisfied, the only recourse for the owner is to sell his/her ownership. Amount Due Amount can be defined. Owners' claim is residual because the owners' claim all assets not specifically claimed by non-owners. Due Date Due date is established. Owners' claim is open-ended because there is no specific time in the future when the claim must be satisfied by the business.
Another way to measure an organization's value is to determine its current working capital and its relationship to market capitalization. Working capital can be defined as the amount left once one has subtracted the organization's present responsibilities from its present properties. Working capital is the amount of funding that an organization has immediate admission to use in their administration of daily duties and business.
Shareholder equity helps one to determine the value of an organization when there is a need to calculate the book value. The book value of an organization is located from the accounting ledger. To measure the book value as it stands per share, the company's shareholder's equity must be divided by the present number of shares that are left outstanding. The next step is to take the stock's present worth and divide it by the present book value so that a price-to-book ratio is reached.
Using a company's earnings is the easiest and most often used form of determining its value. An earning, also referred to as the net income or net profit, is the amount of cash that is available following the organization's payment of all its bills. In order to make a valid comparison, one has to look at earnings and measure them according to its earnings per share (EPS). An accountant may evaluate the earnings per share by dividing the amount of outstanding shares it has into the cash amount of the earnings that is reported for an organization. However, it should be noted that earnings per share by themselves do not necessarily mean anything. In order to evaluate an organization's earnings relative to its price, most financial professionals will use the price/earnings (P/E) ratio. This ratio takes divides the stock price by the total of the most recent four quarters of earnings.
Free Cash Flow Methods
Cash flow is seen as the "most common measurement for valuing public and private companies used by investment bankers. Cash flow is defined as the cash that flows through a company during the course of a quarter or the year after taking out all fixed expenses. Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA)" (Giddy, n.d., "Using comparables"). Cash flow tends to be the one approach that has logical merit to it in most occurrences.
"The argument for the discounted free cash flow method is that an organization's value can be estimated by forecasting future performance of the business and measuring the surplus cash flow generated by the organization. The surplus cash flows and cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal operations of the company and its future" (Giddy, n.d., "How to use cash flow").
Steps of the Discounted Cash Flow Method
The discounted cash flow approach is often defined in six levels. Because this method is formulated on the basis of forecasts, it is crucial that the financial professionals of an organization have the proper knowledge base necessary for the company, its market and its preceding operations. The levels involved in making up the larger method of discounting cash flow are:
- Develop debt free projections of the company's future operations.
This is clearly the critical element in the valuation. The more closely the projections reflect a good understanding of the business and its realistic prospects, the more confident investors will be with the valuation its supports.
- Quantify positive and negative cash flow in each year of the projections.
The cash flow being measured is the surplus cash generated by the business each year. In years when the company does not generate surplus cash, the cash shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had no debt. In other words, interest charges are backed out of the projections before cash flows are measured.
- Estimate a terminal value for the last year of the projections.
Since it is impractical to project company operations out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be contributed to the company by the cash flows generated after the last year in the projections. Without making such assumptions, the value generated by the discounted cash flow method would approximate the value of the company as if it ceased operations at the end of the projection period. One common and conservative assumption is the perpetuity assumption. This assumption assumes that the cash flow of the last projected year will continue forever and then discounts that cash flow back to the last year of the projections.
- Determine the discount factor to be applied to the cash flows.
One of the key elements affecting the valuation generated by this method is the discount factor chosen. The larger the factor is, the lower the valuation it will generate. This discount factor should reflect the business and investment risk involved. The less likely the company is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity investors want 30% for their funds, the discount factor would be somewhere in between -- in fact, the weighted-average cost of capital.
- Apply the discount factor to the cash flow surplus and shortfall of each year and to the terminal value.
The amount generated by each of these calculations will estimate the present value contribution of each year's future cash flow. Adding these values together estimates the company's present value assuming it is debt free.
- Subtract present long term and short term borrowings from the present value of future cash flows to estimate the company's present value (Giddy, n.d., p. 2).
Many financial professionals still have issues with the amount of risk and doubt inherent in measuring investments and obtainments. "Despite the use of net present value (NPV) and other valuation techniques, these individuals are often forced to rely on instinct when finalizing risky investment decisions. Given the shortcomings of NPV, real options analysis has been suggested as an alternative approach. This approach considers the risks associated with an investment while recognizing the ability of corporations to defer an investment until a later period or to make a partial investment instead. Basically, investment decisions are often made in a way that leaves some options open. The simple NPV rule does not provide...
(The entire section is 4970 words.)