Corporate valuation

Corporate valuation Illustration of DCF approachIn this section, the DCF approach of valuation is applied to Bharat Hotels Company (BHC) which is a major hotel chain in India.The company operates 35 hotels of which 14 are owned by it and the rest are owned by others but managed by BHC.BHCs principal strategy has been to serve the high end of the international and leisure travel markets in major metropolises, secondary cities and tourist destinations.It plans to continue to develop new business and leisure hotels to take advantage of the increasing demand which is emanating from the larger flow of commercial and tourist traffic of foreign as well as domestic travelers.BHC believes that the unique nature of its properties and the emphasis on personal service distinguishes it from other hotels in the country.Its ability to forge management contracts for choice properties owned by others has given it the flexibility to swiftly move into new markets while avoiding the capital intensive and time consuming activity of constructing its hotels.

Illustration of DCF approach..BHCs major competitors in India are two other major Indian hotel chains and a host of other five star hotels which operate in the metropolises as an extension of multinational hotel chains.The foreign hotel majors are considerably stronger than the Indian hotels in terms of financial resources, but their presence in the country has historically been small.With the government committed to developing India as a destination for business and tourism, several hotel majors have announced their intention to establish or expand their presence in the country.

Illustration of DCF approach..BHCs operating revenues and expenses for the year just concluded (year 0) were as follows: Operating Revenues Rupees (in million) Room rent 1043 Food and beverages 678 Management fees for managed properties 73 Operating Expenses Materials 258 Personnel 258 Upkeep and services 400 Sales and general administration 400Illustration of DCF approach..BHCs assets and liabilities (in million rupees) at the end of year 0 were as follows: Owners Equity and Liabilities Assets Net worth 1126 Net fixed assets 1510 Debt 900 Gross Block: 2110 Accumulated Depreciation 600 Current Assets 516 2026 2026BHC had no operating assets.At the end of year 0, BHC owned 2190 rooms.It has planned the following additions for the next 7 years.Most of the land needed by the company for these additions has been already acquired.Illustration of DCF approach.. Year Rooms Investment (in million rupees) 1 90 200 2 130 300 3 80 240 4 130 500 5 186 800 6 355 1400 7 150 800For the sake of simplicity assume that the addition will take place at the beginning of the year.Illustration of DCF approach.. For developing the financial projections of BHC, the following assumptions may be made.The occupancy rate will be 60% for year 1. Thereafter, it will increase by 1% per year for the next 6 years.The average room rent per day will be Rs. 2500 for year 1. it is expected to increase at the rate of 15% per year till year 7.Food and beverage revenues are expected to be 65 per cent of the room rent.Material expenses, personnel expenses, upkeep and services expenses, and sales and general administration expenses will be, respectively, 15, 15, 18, and 18 per cent of the revenues (excluding the management fees).Working capital (current assets) investment is expected to be 30 percent of the revenues.The management fees for the managed properties will be 7 percent of the room rent. The room rent from managed properties will be more or less equal to the room rent from owned properties.The depreciation is expected to be 7 percent of the net fixed assets.The after-tax non-operating cash flows (in million rupees) will be as follows: 300 (year 2), 600 (year 5), 800 (year 6).Given the tax breaks it enjoys, the effective tax rate for BHC will be 20 percent.There will be no change in deferred taxes. Illustration of DCF approach.. Besides financial projections, the following information is relevant for valuation.The market value of equity of BHC at the end of year 0 is Rs. 17100 million. The imputed market value of debt is Rs. 900 million.BHCs stock has a beta of 0.6775.The risk-free rate of return is 12% and the market risk premium is 8%.The post-tax cost of debt is 9%.The free cash flow is expected to grow at a rate of 14% per annum after 7 years. DCF ValuationGiven the above information, the discounted cash flow approach may be applied for valuing BHC.Free Cash Flow Forecast: Based on the information provided above, the forecast for revenues and operating expenses is developed in the first three panels of the table.Illustration of DCF approach.. Table : Financial Projections

Year 1 2 3 4 5 6 7 PANEL I*A.B.C.RoomsOccupancy rateAverage room rent (in rupees)22800.60250024100.61287524900.62330626200.63380228060.64437331610.65502833110.665783 PANEL II *D.

E.

F.

G.

H.Room rent from owned propertiesFood and beverage revenuesRevenue from owned properties(D+E)Management fees from managed propertiesTotal revenues (F+G)1248

811

2059

8721461543

1003

2546

10826541863

1211

3074

13032042291

1489

3780

16039402867

1864

4731

20049313771

2451

6222

26464864613

2998

7611

3237934Financial ProjectionsYear 1 2 3 4 5 6 7 PANEL III*I.J.K.

L.

K.Material expensesPersonnel expensesUpkeep and service expensesSales and general admn expensesTotal operating expenses309309

371

371

1360382382

458

458

1680461461

553

553

2028567567

680

680

2494710710

852

852

3124933933

1120

1120

410611421142

1370

1370

5024Financial Projections-----Year 1 2 3 4 5 6 7 PANEL IV*L.M.N.O.P.Q.

R.

S.

T.EBDIT(H-K)DepreciationEBITNOPLATGross cash flowGross investments (Fixed assets + current assets)Free cash flow from operations (P-Q)Non-operating cash flowFree cash flow (R+S)786120666533653

302

351

351974132842674806

446

360

30066011761401036829969

398

571

5711446166128010241190

712

478

4781807210159712781488

1085

403

60010332380293208716701963

1848

115

8009152910329258120652394

1216

1178

1178*(All figures are in million rupees)Financial Projections-------Year 1 2 3 4 5 6 7A.B.

C.D.E.F.G.Current assets*Current assets addition*Gross block*Capital exp.*Acc. deprn.*Net block (C+D-E)Depreciation 516

10221102006001710120618

14623103007201890132764

15826102408521998140924

212285050098423661661134

2853350800115030002101419

44841501400136041902931867

416555080016534697329Table : Current Assets, Fixed Assets and Depreciation (in million rupees) *At beginning of yearDCF Valuation of Free Cash FlowsCost of capital : BHC has two sources of finance, equity and debt. The cost of capital for BHC is Cost of capital = (weight of equity x cost of equity) + (weight of debt x cost of debt)The weights of equity and debt, based on market values, are as follows:Weight of equity = 17100/18000 = 0.95Weight of debt = 900/18000 = 0.05The cost of debt is given to be 9 %. The cost of equity using the capital asset pricing model is calculated below:Cost of equity of BHC = Risk-free rate + Beta of BHC (Market Risk Premium) = 12 + 0.6775(8) = 17.42%Given the component weights and costs, the cost of capital for BHC is: (0.95)(17.42) + (0.5)(9) = 17.00%

DCF Valuation of Free Cash FlowsContinuing Value: The continuing value may be estimated using the growing free cash flow perpetuity method.The projected free cash flow for year 7 is Rs. 1178 million.Thereafter it is expected to grow at a constant rate of 14% per year.Hence the expected continuing value at the end of the 7th year is given by CV7 = FCF8/ (k-g) = 1174(1.14) / (0.17 0.14) = RS. 44764 million

DCF Valuation of Free Cash FlowsCalculation and interpretation of results:The value of equity is equal to Discounted FCF during the Explicit Forecast Period + Discounted Continuing Value + Value of Non- operating Assets Market Value of Debt Claims.= {351/1.17 + 660/ (1.17)2 + 571/(1.17)3 + 478/(1.17)4 + 1033/(1.17)5 + 915/(1.17)6 + 1178/(1.17)7 } + 44764 / (1.17)7 + 0 - 900 = Rs 16619 Mio DCF Valuation of Free Cash FlowsSince the discounted continuing value [44764/(1.17)7 = Rs. 14906 million] looms large in this valuation, it is worth looking into it further.Its key determinant appears to be the expected growth rate in the free cash flow beyond the explicit forecast period.This has been assumed, in the preceding analysis to be 14 years.What happens to the estimate of equity value if the growth rate happens to be different?The sensitivity of the estimate of equity value to variations in the growth rate in a range of, say, 12% to 15% is shown below: Growth rate Equity value estimate (per cent) (in million rupees) 12 10500 13 12795 14 16619 15 24269 Comparable Company ApproachThe comparable company approach involves valuing a company on the basis of how similar publicly held companies are valued.It is typically a top-down approach and involves the following steps:Analyze the economyAnalyze the industryAnalyze the subject companySelect comparable companiesAnalyze subject and comparable companiesAnalyze multiplesValue the subject company

Comparable Company Approach.. Analyze the economyThe first step in the comparable company approach is to analyze the economy.An analysis of the economy provides the basis for assessing the prospects of various industries and evaluating individual companies within an industry.Such an analysis calls for, inter alia, examining the following factors and forecasting their growth rates : gross national product, industrial production, agricultural output, inflation, interest rates, balance of payment, exchange rate and government budget (as well as its composition). Analyze the industryThe second step in the comparable company approach is to analyze the industry to which the subject company belongs.This analysis should focus on the following:The relationship of the industry to the economy as a whole.The stage in which the industry is in its life cycle.The profit potential of the industry.The nature of regulation applicable to the industry.The relative competitive advantages of procurement of raw materials, production costs, marketing and distribution arrangements, and technological resources.

Comparable Company Approach.. Analyze the subject companyThe third step is to carry out an in-depth analysis of the competitive and financial position of subject company.The key aspects to be covered in this examination are as follows:Product portfolio and market segments covered by the firm.Availability and cost of inputs.Technological and production capability.Market image, distribution reach, and customer loyalty.Product differentiation and economic cost position.Managerial competence and drive.Quality of human resources.Competitive dynamics.Liquidity, leverage and access to funds.Turnover margins and return on investment.Key success factor(s).

Comparable Company Approach.. Select Comparable CompaniesAfter the subject company is studied, the next step is to select companies which are similar to the subject company in terms of the lines of business, nature of markets served, scale of operation and so on.Often, it is hard to find truly comparable companies because companies are engaged in a variety of businesses, serve different market segments, and have varying capacities.Hence, in practice, the analyst has to make do with companies which are comparable in some ways.He should make every effort to look carefully at 10 to 15 companies in the same industry and select at least 3 to 4 which come as close as possible to the subject company.Understandably, a good deal of subjective judgement is involved in this process.

Comparable Company Approach.. Analyze the Financial Aspect of the Subject and Comparable CompaniesOnce the comparable companies are selected, the historical financial statements (balance sheets and income statements) of the subject and comparable companies must be analyzed to identify similarities and differences and make adjustments so that they are put on a comparable basis.Adjustments may be required for differences in inventory valuation methods, for intangible assets, fro off-balance sheet items, and so on.The purpose of these adjustments is to normalize the financial statements. Analyze the MultiplesAfter normalizing the financial statements of the subject and comparable companies the next step is to look at the multiples for these companies.The multiples commonly considered are:Price to cash flowPrice to earningsPrice to EBITPrice to EBDITPrice to salesPrice to book valueComparable Company Approach.. Value the Subject CompanyThe final step in this process is to decide where the subject company fits in relation to the comparable companies.This is essentially a judgmental exercise.Once this is done, appropriate multiples may be applied to the financial numbers (earnings, EBIT and so on) of the subject company to estimate its value.If several bases are employed, the several value estimates may be averaged (for this purpose a simple arithmetic average or a weighted arithmetic average may be employed).Comparable Company Approach.. Illustration The following financial information is available for company D, a bulk drug manufacturer:Earnings before depreciation interest and taxes (EBDIT) Rs 18 millionBook value of assets Rs 90 millionSales Rs 125 millionBased on an evaluation of several bulk drug companies, companies A, B and C have been found to be comparable to company D.The financial information for these companies is given below.Taking into account the characteristics of company D vis--vis companies A, B and C, the following multiples appear reasonable for company D.MV/ EBDIT = 17 MV/Book value = 3.0 MV/ sales = 2.2Applying these multiples to the financial numbers of company D, gives the following value estimates.

Comparable Company Approach..A B C EBDIT*Book value of assets*Sales*Market value*(MV)MV/EBDITMV/Book valueMV/Sales12758015012.52.01.9158010024016.03.02.42010016036018.03.62.3*In million rupeesMV = 17 x EBGIT = 17 x 18 = Rs. 306 millionMV = 3 x Book value = 3 x 90 = Rs. 270 millionMV = 2.2 x Sales = 2.2 x 125 = Rs. 275 million A simple arithmetic average of the three value estimates is:(306 +270+275)/3 = Rs. 283.7 million

Adjusted Book Value ApproachThe adjusted book value approach to valuation involves determining the fair market value of the assets and liabilities of the firm as a going concern.It may be distinguished from other approaches relying on the balance sheet.For example, it is different from the conventional book values.Likewise, it is distinct from the market price to book value method, an approach that depends on the market value of securities. Value of AssetsThe first step in the adjusted book value approach is to value the assets of the firm.The key considerations in valuing various assets are discussed below: Cash Cash is cash. Hence there is no problem in valuing it.Indeed it is gratifying to have an asset which is so simple to value.DebtorsGenerally debtors are valued at their face value.If the quality of the debtors is doubtful, prudence calls for making an allowance for likely bad debts.InventoriesInventories may be classified into three categories: raw materials, work-in-process, and finished goods.Raw materials may be valued at their most recent cost of acquisition.Work-in-process may be approached from the cost point of view (cost of raw materials plus the cost of processing) or from the selling price point of view (selling price of the final product less expenses to be incurred in translating work-in-process into sales).Finished goods inventory is generally appraised by determining the sale price realizable in the ordinary course of business less expenses to be incurred in packaging, holding, transporting, selling, and collection of receivables.Adjusted Book Value ApproachOther Current AssetsOther current assets like deposits, prepaid expenses, and accruals are valued at their book value.Fixed Tangible AssetsFixed tangible assets consist mainly of land, buildings and civil works, and plant and machinery.Land is valued as if it is vacant and available for sale.Buildings and civil works may be valued at replacement cost less physical depreciation and deterioration.Plant and machinery, too, is valued at replacement cost less physical depreciation and deterioration.As an alternative, the value of plant and machinery may be appraised at the market price of similar (used) assets plus the cost of transportation and installation.

Adjusted Book Value ApproachNon-operating AssetsAssets not required for meeting the operating requirements of the business are referred to as non-operating assets.The more commonly found non-operating assets are financial securities, excess land, and infrequently used buildings.These assets are valued at their fair market value.Intangible AssetsIntangible assets pose a problem.As they cannot be ordinarily disassociated from the business and sold separately, the market approach is not very helpful in valuing them.Therefore, one may use the cost approach or the income approach.Adjusted Book Value ApproachLiabilitiesValuing liabilities is relatively easier. The key considerations in assessing the broad categories of liabilities are discussed below:Long-term DebtLong-term debt, consisting of term loans and debentures, may be valued with the help of the standard bond valuation model. This calls for computing the present value of the principal and interest payments, using a suitable discount rate.Current Liabilities and ProvisionsBroadly defined, current liabilities and provisions consist of short-term borrowings from banks and other sources; amounts due to the suppliers of goods and services bought on credit; advance payments received; accrued expenses; provisions for taxes, dividends, gratuity, pension, etc.Current liabilities and provisions are typically valued at face value.Adjusted Book Value ApproachOwnership ValueThe value of total ownership is simply the difference between the value of assets and the value of liabilities.Ordinarily there is no need to add a premium for control because assets and liabilities are valued in economic terms.On the contrary, it may be appropriate to apply a discount for the marketability factor. Why?While it may be easier to sell an entire business, it may not be easy to locate informed and willing buyers on a timely basis.Hence a discount may have to be offered.How should a minority interest in a closely-held business be assessed?For valuing such an interest a higher discount factor should be applied.The discount factor must reflect the concern for marketability as well as the weak position of minority interest.

Adjusted Book Value ApproachCash Flow return on investment (CFROI)Instead of computing the value of the enterprise as the present value of all future free cash flows, as in the DCF model, one can instead calculate a return ratio that expresses the companys current or future ability to produce free cash flow. A popular method for this is known as cash flow return on investment (CFROI).Originally designed by the Holt Value Consultants, CFROI can be defined as the sustainable cash flow a business generates in a given year as a percentage of the cash invested in the companys assets. You can think of CFROI as a weighted average internal rate of return (IRR) of all the projects within the company. Usually, it is expressed as: Gross Cash Investment = CF1 / (1+CFROI) + CF2/(1+CFROI)2 +----- + CFn /(1+CFROI)n + TV/ (1+CFROI)n

Where Gross Cash Investment is the total inflation-adjusted gross cash investment made by all lenders and investors, CF is the inflation-adjusted annual cash flow, TV is the inflation-adjusted terminal value of all future cash flows from year n to infinity, and n is the average economic life of the firms assets.The calculated CFROI can be compared with the firms current or real (inflation-adjusted) historical cost of capital or against real industry rate of returns.

Real Options ValuationSince the publication of Fisher Black and Myron Scholes ground-breaking article The pricing of options and corporate liabilities in 1973, option valuation has been used frequently by investors, traders and others to calculate the theoretical value of stock options, interest rate options, and all other kinds of options traded all over the world.It is only in the last few years that option valuation has been recognized as an alternative to standard net present value calculations in the valuation of investment opportunities in real markets and as a company or project valuation tool. A financial option gives its owner the right to buy (call option) or sell (put option) a certain specified underlying asset (a stock, bond, amount of gold, etc,) at a specified price (the exercise price) within a certain period of time (the exercise period), but with no obligation to do so. For this right the owner pays a premium (the price of the option).Real Options ValuationThe idea behind real options is similar to the idea of financial options. Consider for example a company that has identified an opportunity (an option), a project with a certain required investment today and a certain additional investment in six months time (the exercise price). In six months time, if the opportunity looks promising, i.e. the expected net present value of the project is higher than the exercise price (the investment) of the option, the option is exercised and the project goes ahead. If the project does not look promising, i.e., the net present value of the project is lower than the exercise price (the investment) of the option, the option is not used and the only loss is the price of the option paid, the premium. The point of real options valuation is that it takes into consideration the flexibility that is inherent in many projects (or in entire companies) in a way that a DCF valuation does not. With real options, management possibilities to expand an investment or to abandon a project are given a correct value. Or, stated differently, real option valuation might produce positive net present values where standard net present value calculations produce negative ones. This is because the flexibility of the project or the investment is given a value. Real Options ValuationSpecifically, real options valuation is a powerful tool in investment-intensive industries where companies make investments in sequences involving a high degree of uncertainty. A small investment today that gives the opportunity to either continue with a larger investment later or abandon the project altogether is much like a stock option where a small premium is paid today in order to have the opportunity, but not the obligation, to buy the stock later. Examples of such industries include energy (particularly oil and gas), all R&D-intensive industries such as biotechnology, pharmaceutical and high-tech, as well as industries with high marketing investments. Recently, a number of financial authorities have argued that real options valuation is a valuable tool for the valuation of almost any type of company. The idea is that all unexplored avenues for future cash flow, for example possible new products, new segments or new markets, could or even would be best valued through real options valuation. They want to divide the valuation of a company in the following manner : Real Options ValuationEnterprise Value =

Value of existing operations (= value of all discounted future cash flows from present projects) + Value of the company's portfolio of Real Options (= value of future potential projects)

The value of existing operations is calculated by using one of the valuation models mentioned in this chapter, for example the DCF model. Since we lift the value of future potential operations out of the calculation, the projections for future free cash flow are easier to perform. Thereafter, the value of the companys various other business opportunities in its industry or in adjacent industries is calculated using real options valuation. The two values are then simply added together to give the total enterprise value.

Residual income model The term residual income (sometimes called economic profit) refers to the real profit a company produces in contrast to the accounting profit as decided by accounting principles. Residual income takes into consideration not only the companys cost of debt but also the companys cost for equity financing, i.e. the opportunity cost of capital for equity investors.This has the important implication that a company must not only break even but also make a profit large enough to justify the cost of capital it is using. Residual income can mathematically be expressed as :

RI = (RE CE) * BVt

Where RI is the residual income RE is the return on equity, CE is the cost of equity and BVt is the book value of the equity at the beginning of the year t.Residual income model A residual income model values a company by using a combination of the companys book value and a present value of the companys future residual income. It can be expressed as : Enterprise Value = BV + (RI/(1+CE)1 + (RI/(1+CE)2 + ------ +RI/(1+CE)t + TV/(1+CE)t

Where BV is the current book value of equity for the company and RI is the future residual income. i.e. the amounts by which profits are expected to exceed the required rate of return on equity, C is the cost of equity and t is the number of years in the explicit period.

And where TV is calculated as : TV = BVt * RIt / (CE g)

Where BV is the book value at time t, RI is the residual income in year t, C is the required rate of return on equity and g is the constant growth rate from year t to infinity.

Residual income model Unlike models that discount dividends or cash flow, in which usually a significant portion of the estimated value comes from its so-called terminal value far away in the future, a residual income model usually derives most of its value from years in the not too distant future. This is because of its reliance on book value, which obviously can be taken directly from the balance sheet. In fact, in many cases the terminal value can be deemed to be zero since the additional value represents such a small portion of the total value. This is a significant advantage over the DCF model since forecasting and estimating errors tend to magnify over time and forecasting 10-15 years into the future can hardly be anything else than an educated guess. Another advantage is that the residual income model is entirely based on accounting standards with numbers easily available. However, the main disadvantage of the residual income model is that being based on accounting standards, it often fails to reflect the true economic value of assets and cash flows.

Economic value added (EVA)A slightly altered approach of the residual income model is the so-called Economic Value Added approach, popularly called EVA, which was developed by the consultancy Stern, Stewart & Co. According to this approach, the enterprise value equals the current capital stock plus the value of all future EVA, discounted to the present. The EVA for a given year is the excess return the company enjoys, once all operating as well as capital costs are covered. It is calculated as the difference between the return on capital and the cost of capital, multiplied by the capital stock at the beginning of the year. In other words, in order for the enterprise value to be larger than invested capital, return on invested capital (ROIC) has to exceed the cost of capital over time .EVA is a fine tuned variant of residual income or economic profit where a number of adjustments transform financial statement items into statistics suitable for valuation. Specifically, NOPAT (Net Operating Profit After Taxes) and the capital stock at the beginning of the year need adjustment.Economic value added (EVA) Generally, the adjustments fall into any of the following categories : Conversions from financial to cash accounting.Conversions from a liquidating perspective to a going-concern perspective.Removal of unusual losses or gains.

Economic value added for one year is expressed as : EVA = NOPAT (WACC x K)

Where EVA is economic value added, NOPAT is net operating profit after taxes, but before financing costs and non- cash book-keeping entries (except depreciation), WACC is weighed average cost of capital and K is the capital stock at the beginning of the year, i.e., the sum of all the firms financing apart from non-interest-bearing liabilities such as accounts payable, accrued wages and accrued taxes.

Economic value added (EVA)Alternatively, EVA is expressed as : EVA = (ROIC WACC) x K

Where ROIC = NOPAT / K

Where EVA is economic value added for year one, ROIC is the return on invested capital for year one, WACC is the weighted average cost of capital, K is the capital stock in the company at the beginning of year one and NOPAT is net operating profit after taxes for year one. The result of these calculations states whether the company has a positive or a negative EVA, in other words whether the company is creating or destroying value. Economic value added (EVA)In accordance with EVA (and as seen from the formula), a company can only create value in the following ways: Increase ROIC and hold WACC and invested capital constant.Decrease WACC and hold ROIC and invested capital constant.Increase the invested capital in projects/activities yielding a ROIC greater than WACC.Withdraw capital from projects / activities that yield a ROIC lower than WACC.Create longer periods where the company is expected to earn a ROIC greater then WACC. However the goal of the management and board of a company is not to maximize the EVA of one single year but to maximize enterprise value, where enterprise value equals the present value of all future EVA plus the capital stock invested in the company. The aggregated future EVA is generally called Market Value Added (MVA). For publicly traded companies, this can be seen as the difference between a companys market value and the total invested capital in the company. Or expressed differently, the MVA is the market expectations of future EVAs. When calculating enterprise value, the formula is :

Economic value added (EVA)EV = K0 + EVA1 / (1+WACC)1 + EVA2 / (1+WACC)2+ ------ + EVA n / (1+WACC)n + TV / (1+WACC)n Where TV = K*n + (ROICn WACC) X K*n X (1/(WACC g)

Where EV is enterprise value, EVA is economic value added, K is the capital stock in the company, WACC is the weighted average cost of capital, TV is terminal value, ROIC is return on invested capital, K* is the equilibrium value of the capital stock in the terminal year, n is the number of years that the company can enjoy a return on invested capital greater than its cost of capital, and g is the growth rate of future EVA from year n to infinity.

Economic value added (EVA)Enterprise value = present value of future cash flows

= invested capital + present value of future EVAs

While EVA has several purposes, its main use is a period-by-period performance measurement where DCF valuation usually falls short. The EVA method is particularly useful in compensation programs such as a value-based management (VBM) programmes since EVA may be computed separately for different business units, departments, product lines or geographic business segments within the organization.It is a great strength that EVA provides a link between performance measurement and corporate valuation . This ensures evaluation and rewards to management and employees in a way consistent with how financial markets actually value companies.

Net Asset ValuationThis is perhaps the simplest form of company valuation. Basically, Net Asset Valuation is the difference between the assets and liabilities based on their respective balance sheet values, adjusted for certain accounting principles. In other words, it is the adjusted value of the equity on the balance sheet.The reason why Net Asset Values are generally lower than market values is that many value-creating items are not accommodated in the balance sheet for accounting reasons. For Example, investments in marketing, education of employees, R&D, etc, are generally not activated on the balance sheet but they all create value. The most extreme example is consultancy; it may have very few tangible assets but can still be very valuable due to its people, brand name, process, etc. Net Asset ValuationIn addition, accounting generally estimates asset values with caution. For example, computers are often written off in three years but they may still hold a value after that. However, the main source of the discrepancy between book values and market values is that the former do not take into account all future excess returns the management should be able to generate on these assets.There are, however, certain industries where the Net Asset Value method does give an accurate estimate of corporate value. Typically, this is when the companys future cash flows stem from squeezing a margin off the collective value of assets such as securities or real estate. Consequently, it can make sense to value banks, real estate and investment companies using the net asset value approach.

Venture Capital (VC) valuationA specific form of valuation often used when valuing young firms is called VC valuation or target ownership approach.The approach starts from the end by estimating an exit valuation and then calculating a value today based on the required returns for the investor.In its simplest form, the approach uses the following formula:

Post-money valuation = Terminal value at exit year n / Required ROI

Where Post-money valuation is the company value after the investment is made (Post-money valuation = Pre-money valuation + the capital invested), Terminal value is the expected value of the company at an exit date at some point in the future and Required ROI is the return investor demands from investing in the specific company at the specific time.

Venture Capital (VC) valuationThe terminal value is the value you could expect the company to be worth at exit (an IPO or trade sale) in a few years from now.The terminal value can, in theory, be calculated using any valuation approach but in practice, one or several multiples are often used and applied to the companys sales, earnings, etc.Let us say that a company is expected to have sales of 30 mio in five years time (usually, the investors discount the revenues forecasted by management by 40-70%) and that well-managed companies in the same industry have net margins of 10%.If we assume the company will be able to reach the same margins then this would give net earnings of 3mio in five years time.If the most similar company has an earnings multiple ( P/E) of 20 and if we apply this to the company being valued, we get a terminal value in five years time of 60mio (P/E 20 X 3mio). Venture Capital (VC) valuationWhen applying another companys multiple, it is important to understand the circumstances surrounding the companys valuation:Is the multiple from a listed company? Typically, a discount of approximately 30% will be put on non-listed company valuations.Is the valuation multiple based on an industrial acquisition of a company? If so, there might be a synergy component specific to that acquisition that cannot be applied to your company.Venture capitalists and other early-stage investors generally demand very high returns on their investments.This is because early-stage investing is highly risky and many companies never even come close to revenues or earnings predicted in the business plan.Accordingly, investors never come close to the returns hoped for and in some companies might lose the entire investment.In a typical portfolio of 10 start-up companies, investors can expect 3 to 5 to fail completely and another 3 to 4 to give the investor his or her money back.Hence, the return for the entire portfolio typically comes from 1 or 2 companies that need to be very successful in order for the portfolio return to be reasonable.Venture Capital (VC) valuationGenerally, the risk decreases as the company matures.Depending on when the investment is considered, the discount rate in the early stages can vary between 30 to 70%, or put differently, investors want a return of 10 to 30 times their investment capital at exit.Using 20 X invested capital and our terminal value of 60 mio / 20 = 3mio.If the entrepreneur were looking at raising 1m, this means that the investor, in order to meet the required ROI, would need to own 33% of the company ( 1m invested / 3m valuation ).In this example, we simplified matters by assuming that one financing round was all it was needed to bring the company to an exit.In reality, companies will often take several rounds of financing and each round dilutes the ownership of existing shareholders.Also, options might be offered to incentivize key employees which will further dilute the ownership at exit.Both these factors will affect the VC valuation but the basic concept remains the same.This type of valuation which is purely from a VC investors perspective, needs to be complemented with other types of valuation.