Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.
Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.
One critical issue is therefore to estimate and fix the correct company value that reflects the real values in the company. In its simplest form this can be achieved through:
Budget a simple cash flow for the forecast period with fixed interest cost throughout the period, and ad the value to the booked balance.
This evaluation will be an indicator, but implies a series of simplifications that can distort the reality considerably. For instance, real balance value differs generally from book value. Proceeds/dividends are paid out according to legislation; also the level of debt will normally vary throughout the prognosis period. These are some factors that suggest that the mentioned premises opens for the possibility of substantial deviation compared to an integral and detailed evaluation of the company’s real values.
A more correct value can be provided through:
- Correcting the opening balance, forecast and budget operations, estimate complete result and balance sheets for the whole forecast period. Incorporate market weighted average cost of capital when discounting.
The last method is considerably more demanding, but will give an evaluation result that can be tested and that also can take into consideration qualitative values that implicitly are part of the forecast.
The result is then used as input in a risk analysis such that the probability distribution for the value of the chosen evaluation method will appear. With this method a more correct picture will appear of what the expected value is given the set of assumption and input.
The better the value is explained, the more likely it is that the price will be “right”.
The chart below illustrates the method.
