Business valuation techniques and methods of valuing a business has in recent time receive lots of attention both from the field of academic and from practitioner with many empirical tests and evidences provided. Most of these empirical evidence conflicts on what the most popular and acceptable method of valuation is. My intention in this article is not to support or disprove any of the valuation models that have been developed in the past but to clear the obvious confusion that many naïve people have about business valuation.
Not many people have taken time to educate the general public on the distinction between valuation model and asset valuation models. So, it is a good premise to start from.
WHAT IS ASSET PRICING MODEL?
Asset pricing models are mathematical tools that are used to ascertain a reasonable proxy of what the true cost of capital might be. The cost of capital of a project or an investment is what the investors or the providers of finance require in exchange for their money. Managers use asset pricing models to perform investment appraisals in order to determine the economic viability of the project. The most popular asset pricing models are:
Arbitrage pricing theory (APT)
This is an equilibrium model developed by Stephen A Ross that is based on the assumption that in competitive capital market, arbitrage force will always keep similar riskless asset at par with the expected returns. This is based on the arbitraging power of participants in the market to eliminate profits. See Stephen A. Ross (1976) “The Arbitrage Theory of Capital Asset Pricing”, Journal of Economics theory for further discussion of this theory.
Capital asset pricing theory
Unlike the APT, CAPM is a single factor model that attempts to measure expected returns with the help of beta. Beta (β) is a tool that measures the sensitivity of relationship with some identified variables. It provides a theoretical structure for factoring risk and uncertainty into the value of an asset or investment. See Fama and French (2004), “The Capital Assets Pricing Model: Theory and Evidence” Journal of Economic Perspectives for further discussion of the validity of this model. This model was first developed by William Sharp in 1964 and John Lintner in 1965.
Mean variance capital asset pricing model
This is also called the Markowitz model. Here, the model assumes that investors are risk averse, therefore only care about the mean and variance of their return in one period when choosing among portfolios.
WHAT IS A VALUATION MODEL?
Valuations are methodological processes of assessing the intrinsic value of a business or an asset. This involves the use of both quantifiable and non quantifiable variables to determine a value to attach to an asset.
Notice that while the asset pricing models are used to determine the what investors expect to receive in return for letting you make use of their money, valuation models make use of those required return to determine value of an asset.
TYPES OF BUSINESS | ASSETS VALUATION MODELS AND TECHNIQUES
Broadly speaking, there are two classes of valuation techniques in use. They are; the single period models and the multiyear models.
Single year models
These are ways of determining the value of a business or shares simply by making reference to past single year variable (Earnings, Sales, Cash flow, etc) in relation to the current price of the share. These past accounting information are found in the financial statements of the target company. Single period models includes: comparables method, asset-based methods, and screening method. The most popular comparable is the P/E method of determining the price of a share.
As the name implies, it involves getting data from more than one year. It involves what analysts or financial planners call fundamental analysis. Examples of multiyear methods of valuation are: Residual Earning (RE), Dividend Discount Model (DDM), Discounted Cash Flow (DCF), and Earnings Growth analysis (EGA).
This article will become unnecessarily too long if I start discussing each and every one of the points identified above in detail. So, I therefore encourage you to read up other materials in this blog for more information.
The most important thing that you should bear in mind is that business valuation is a dynamic process that involves the equity analyst to make some qualitative judgmental input.