How Importance of The Business Valuation

The primary financial goal of financial managers is to maximize the market value of their firm. It follows, then, that financial managers need to assess the market value of their firms to gauge progress.

Accurate business valuation  is also a concern when a corporation contemplates selling securities to raise long-term funds. Issuers want to raise the most money possible from selling securities. Issuers lose money if they undervalue their businesses. Likewise, would-be purchasers are concerned about businesses’ value because they don’t want to pay more than what the businesses are worth.

A General Valuation Model

The value of a business depends on its future earning power. To value a business then, we consider three factors that affect future earnings:

  • Size of cash lows

  • Timing of cash lows

  • Risk

These  three  factors  also  determine  the  value  of  individual  assets  belonging  to a  business,  or  interests  in  a  business,  such  as  those  possessed  by  bondholders  and Stockholders.

We examined how risk factors affect an investor’s required rate of return. We learned hat time value of money calculations can determine an investment’s value, given the size and timing of the cash lows. We learned how to evaluate future cash lows.

Financial managers determine the value of a business, a business asset, or an interest in a business by finding  the present value of  the future cash lows  that  the owner of the business, asset, or interest could expect to receive. For example, we can calculate a bond’s value by taking the sum of the present values of each of the future cash lows from the bond’s interest and principal payments. We can calculate a stock’s value by taking the sum of the present values of future dividend cash low payments.

Analysts and investors use a general valuation model to calculate the present value of future cash lows of a business, business asset, or business interest. This model, the discounted cash low model (DCF), is a basic valuation model for an asset that  is expected to generate cash payments in the form of cash earnings, interest and principal payments, or dividends. The DCF equation is shown in Equation 12-1:

The DCF model values an asset by calculating the sum of the present values of all expected future cash lows.

The discount rate in Equation 12-1 is the investor’s required rate of return per time period, which is a function of the risk of the investment. Recall from Chapter 7 that the riskier the security, the higher the required rate of return.

The discounted  cash low model  is  easy  to use  if we know  the  cash lows  and discount rate. For example, suppose you were considering purchasing a security that entitled you to receive payments of $100 in one year, another $100 in two years, and $1,000 in three years. If your required rate of return for securities of this type were 20 percent, then we would calculate the value of the security as follows: