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This chapter is from the book

4. Valuation Process

Analysts frequently refer to five types of value: book value, break-up value, liquidation value, fundamental value, and market value.

  • Book value refers to the accounting value of a company—that is, the value reported in the balance sheet. The book value of equity, also referred to as the company’s net worth, is equal to its total assets minus its total liabilities. It represents a company’s residual value, assuming that assets can be sold for their reported values and that the proceeds are used to satisfy all liabilities at their recorded values.
  • Break-up value refers to the amount that could be realized if a company were split into saleable units that could be disposed of in a negotiated transaction. This concept is especially relevant for companies composed of a variety of individual business units, divisions, or segments.
  • Liquidation value refers to the amount that could be realized if a company were liquidated in a distress sale. A company’s liquidation value is usually lower than its book and break-up values because assets that must be disposed of quickly are usually sold at a discount.
  • Fundamental value, also called intrinsic value, refers to the value based on the after-tax cash flows that the company is expected to generate in the future, discounted at an appropriate rate that reflects the riskiness of those cash flows. It is a forward-looking concept and requires an assessment of a company’s potential future cash flows.
  • Market value refers to the value established in an orderly marketplace such as a securities market. For example, the market value of equity, also called the market capitalization, is equal to the share price multiplied by the number of shares outstanding.

Although all five types of value can be used for valuing a company, this book deals primarily with the assessment of fundamental value because it represents the “ongoing” value of a company. Thus, the value of a company is defined herein with reference to the future cash flows that a company is expected to generate.

The process of valuing a company usually involves five steps:

  1. Identify and screen potential target candidates thoroughly to ensure that the proposed transaction is appropriate from a strategic standpoint.
  2. Analyze the historical performance of the target to ensure that it is an appropriate partner from a financial standpoint, as well as to gain a thorough understanding of the target’s business model, operations, and capital structure.
  3. Forecast the future performance of the target by preparing pro forma financial statements. Nothing is more important in assessing a target’s value than a complete and accurate modeling of the company’s operations. This critical step requires a fine-grained understanding of the target’s environment, its business model (including its revenue and cost drivers) and realistic assumptions about the target’s future operations and, potentially, capital structure.
  4. Apply one or several valuation methods to get an estimate or estimates of the target’s value.
  5. Assess the sensitivity of the key pro forma and valuation assumptions on the target’s value.

Step 4 requires the analyst to select one or several valuation methods. In the next section, we present the most widely used valuation methods and give an overview of their main characteristics and uses.

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