Valuation for a company - A Method

The following is a method (among many) in attempting to estimate the valuation of a company.



Proposition



Value of company =
Book Value + NPV of future stream of abnormal earnings



where

• Book Value - ie. original capital invested to start the business
  
• Abnormal earnings - ie. earnings above the cost of capital

Consequently from the above proposition, you would have 3 possible scenarios.

1. when company's earnings > cost of capital


2. when company's earnings = cost of capital


3. when company's earnings < cost of capital
   

Investors would be willing to pay MORE than the book value of the company in scenario 1. Whereas, investors should pay a price equal to the book value of company for scenario 2. In scenario 3, investors should seek a discount on the book value to justify a normal return on investment.

My view

I would recommend the use of current networth (net assets) of the company instead of just the "original capital".

For a company that has been in business for many years, it would be using the original capital invested + any retained earnings + other reserves as the current capital involved in funding the business operations today.

The above formulation is a multi-year model ie. both the investors and owners of the business are required to look at future areas of business that would generate the abnormal returns.



We can use a single-year model to be used as "rough" valuation.

Example - ABC is company with the following profile:-
- a net assets of $100
- It generated a profit of $10 ie. 10% return on net assets.
- cost of capital for this businees is 7%.

The "rough" valuation should be around,
$10/7% = $142.86 (ie. > greater than net assets of $100)

Reference - "Abnormal earnings drive a firm's value", Business Times, Teh Hooi Ling, Dec 2-3, 2006.