Lesson 4- Value of A Firm PDF

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This is a relevant topic under Managerial Economics...

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Value of a Firm  

1 Value of a Firm – Definition 2 Calculating a Firm’s Value o 2.1 Book Value of a Firm o 2.2 Market Value of a Firm

VALUE OF A FIRM – DEFINITION A firm’s value, also known as Firm Value (FV), Enterprise Value (EV) is an economic concept that reflects the value of a business. It is the value that a business is worthy of at a particular date. Theoretically, it is an amount that one needs to pay to buy/take over a business entity. Like an asset, the value of a firm can be determined on the basis of either book value or market value. But generally, it refers to the market value of a company. EV is a more comprehensive substitute for market capitalization and can be calculated by following more than one approach.

CALCULATING A FIRM’S VALUE Value of a firm is basically the sum of claims of its creditors and shareholders. Therefore, one of the simplest ways to measure the value of a firm is by adding the market value of its debt, equity, and minority interest. Cash and cash equivalents would be then deducted to arrive at the net value. EV = market value of common equity + market value of preferred equity + market value of debt + minority interest – cash and investments.

One of the reasons why the concept of EV has gained more importance than market capitalization is because the former is more inclusive. Besides equity, it includes the value of debt as well as cash reserves which have an important role to play in a corporation’s valuation. A buyer would have to pay off a firm’s debt when taking over the firm and the same could be netted off from the cash and cash equivalents available with the firm. Another sound approach towards computing the value of a firm is to determine the present value of its future operating free cash flows. The idea is to draw a comparison between two similar firms. By similar firms, we mean similar in size, same industry etc. The firm whose present value of future operating cash flows is better than the other is more likely to attract higher valuation from the investors. Operating Free Cash Flow (OFCF) is calculated by adjusting the tax rate, adding back depreciation and deducting the amount of capital expenditure, working capital and changes in other assets from earnings before interest and taxes. The formula for computing OFCF is as below –

OFCF = EBIT (1-T) + Depreciation – CAPEX – working capital – any other assets Where, EBIT = earnings before interest and taxes, T = tax rate CAPEX = capital expenditure

Calculating OFCF in such a way gives a more accurate picture of cash generating capabilities of a firm. Once OFCF is computed, one can use a suitable discount rate to find the present value of OFCF. On the basis of the sum of all the present value of future operating cash flows, one can decide on whether to take over a firm or not. While the above approaches may seem cumbersome, one can also make use of business valuation calculators. Value of a Firm Calculator can help buyers and sellers in determining the true value of a firm in no time. For different industries, different business valuation calculators have been developed by finance experts.

BOOK VALUE OF A FIRM As the name implies, the book value of the firm is its value as reflected in its ‘books’ or financial statements. It is the difference between the assets and liabilities of a firm as per its balance sheet. It is recorded as shareholder’s equity in the balance sheet. This is the true worth of business when its liabilities are netted off from its assets. For example, if company ABC has total assets worth $500 million and total liabilities amounting to $450 million, the book value of the firm would be $50 million (computed by deducting the value of liabilities from that of assets). This means that if a company XYZ is to purchase company ABC, then it will have to shell $50 million out of its pocket, the actual book value of buying company ABC.

MARKET VALUE OF A FIRM The market value of a company, also known as market capitalization, is its value as reflected in the stock exchange. It is calculated by multiplying a company’s outstanding share by its current market price. For example, if company ABC has 10 million shares outstanding and the market price of each share is $50; then the market value of the company would be $500 million, assuming there are only common shares issued in the market. Market value and book value of the firm are two different concepts. There is quite a possibility of a huge difference between the book value and market value of a company at a given point of time.

Conclusion

What approach of calculating the value of a firm needs to be followed depends on the firm in question. Also, whether to consider the book value or market value of a company while making a decision to buy is a policy and strategy decision. One can engage companies that exclusively deal with estimating the true value of firms.1,2 References 1. Cherewyk P. Valuing Firms Using Present Value of Free Cash Flows. Investopedia. October 2018. [Source] 2. Gad S. Market value versus book value. Investopedia. October 2018. [Source]

Sanjay Bulaki Borad Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms"...