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4.8 Valuation of firms/ Shares for Mergers and acquisition Purposes- Use of Net asset basis, P/E ratio basis, Dividend growth model, Super profits model, Capital asset pricing Model and the Discounted free cash flow basis
Valuation of firms or shares for mergers and acquisition purposes involves determining the fair value of the target company or its shares. Various valuation methods can be employed to assess the worth of a company or its shares. Here are some commonly used valuation methods:
- Net Asset Basis: The net asset basis valuation method calculates the value of a company based on its net assets, which is the difference between its total assets and total liabilities. This method is commonly used when a company’s assets hold significant value, such as in asset-heavy industries.
- P/E Ratio Basis: The price-to-earnings (P/E) ratio basis valuation method determines the value of a company by comparing its earnings to the market price per share. The P/E ratio is calculated by dividing the market price per share by the earnings per share (EPS). This method is based on the assumption that companies with similar risk profiles should have similar P/E ratios, allowing for a relative valuation comparison.
- Dividend Growth Model: The dividend growth model values a company by estimating the present value of its future dividends. It assumes that the value of a share is equal to the present value of all future dividends the investor expects to receive. This method is commonly used for valuing mature companies that consistently pay dividends.
- Super Profits Model: The super profits model is used to value companies that generate excess profits above the normal rate of return. It calculates the value of a company by capitalizing the excess profits or super-normal earnings. This method is particularly relevant for industries with high barriers to entry and companies that possess competitive advantages.
- Capital Asset Pricing Model (CAPM): The CAPM is a widely used method for valuing companies based on their systematic risk and expected return. It calculates the cost of equity capital by considering the risk-free rate, market risk premium, and the company’s beta (measure of systematic risk). The valuation is determined by discounting the expected future cash flows by the cost of equity capital.
- Discounted Free Cash Flow (DCF) Basis: The DCF method values a company based on the present value of its projected future cash flows. It involves estimating the expected cash flows generated by the company, applying a discount rate (such as the weighted average cost of capital), and discounting the cash flows back to their present value. This method is widely used as it takes into account the time value of money and provides a comprehensive assessment of the company’s intrinsic value.
