What is my company worth? What are the ratios used by analysts to determine whether a stock is undervalued or overvalued? How valid is the discounted present value approach? How can one value a company as a going concern, and how does this change in the context of a potential acquisition, or when the company faces financial stress? Finding a value for a company is no easy task -- but doing so is an essential component of effective management. The reason: it's easy to destroy value with ill-judged acquisitions, investments or financing methods. This article will take readers through the process of valuing a company, starting with simple financial statements and the use of ratios, and going on to discounted free cash flow and option-based methods.
How a business is valued depends on the purpose, so the most interesting part of implementing these methods will be to see how they work in different contexts -- such as valuing a private company, valuing an acquisition target, and valuing a company in distress. We'll learn how using the tools of valuation analysis can inform management choices. Outline * Asset-Based Methods * Using Comparables * Free Cash Flow Methods * Option-Based Valuation * Special Applications Asset-Based Methods Asset-based methods start with the "book value" of a company's equity. This is simply the value of all the company's assets, less its debt. Whether it's tangible things like cash, current assets, working capital and shareholder's equity, or intangible qualities like management or brand name, equity is everything that a company has if it were to suddenly stop selling products and stop making money tomorrow, and pay off all its creditors.The Balance Sheet: Cash & Working Capital Like to buy a dollar of assets for a dollar in market value? Ben Graham did. He developed one of the premier screens for ferreting out companies with more cash on hand than their current market value. First, Graham would look at a company's cash and equivalents and short-term investments. Dividing this number by the number of shares outstanding gives a quick measure that tells you how much of the current share price consists of just the cash that the company has on hand. Buying a company with a lot of cash can yield a lot of benefits -- cash can fund product development and strategic acquisitions and can pay high-caliber executives. Even a company that might seem to have limited future prospects can offer tremendous promise if it has enough cash on hand.
Another measure of value is a company's current working capital relative to its market capitalization. Working capital is what is left after you subtract a company's current liabilities from its current assets . Working capital represents the funds that a company has ready access to for use in conducting its everyday business. If you buy a company for close to its working capital, you have essentially bought a dollar of assets for a dollar of stock price -- not a bad deal, either. Just as cash funds all sorts of good things, so does working capital. Shareholder's Equity & Book Value Shareholder's equity is an accounting convention that includes a company's liquid assets like cash, hard assets like real estate, as well as retained earnings. This is an overall measure of how much liquidation value a company has if all of its assets were sold off -- whether those assets are office buildings, desks, old T-shirts in inventory or replacement vacuum tubes for ENIAC systems.
Shareholder equity helps you value a company when you use it to figure out book value. Book value is literally the value of a company that can be found on the accounting ledger. To calculate book value per share, take a company's shareholder's equity and divide it by the current number of shares outstanding. If you then take the stock's current price and divide by the current book value, you have the price-to-book...