What are the methods of enterprise value assessment

Reasonable assessment of the value of the target enterprise is one of the very important issues often encountered in the process of corporate mergers and acquisitions and inward investment. Appropriate valuation methods are the prerequisite for accurate assessment of enterprise value. In this paper, we will focus on the core methods of enterprise value assessment, and analyze and summarize the basic principles, scope of application and limitations of the methods.

I. Enterprise Value Appraisal Methodology System

Enterprise value appraisal is a comprehensive asset and equity appraisal, which is a process of analyzing and estimating the overall value of an enterprise, the value of all the shareholders' interests, or the value of some of the interests for a specific purpose. Currently, internationally recognized valuation methods are divided into three categories: the income approach, the cost approach and the market approach.

The income approach determines the value of the subject of appraisal by capitalizing or discounting the expected earnings of the appraised enterprise to a specific date. Its theoretical basis is the discounting theory in the principles of economics, i.e., the value of an asset is the present value of the future earnings that can be obtained by utilizing it, and its discount rate reflects the rate of return on the risk of investing in the asset and obtaining the earnings. The main methods of the income approach include the discounted cash flow (DCF) method, the internal rate of return (IRR) method, the CAPM model and the EVA valuation method.

The cost approach is based on the balance sheet of the target enterprise, and determines the value of the object of appraisal by reasonably assessing the value of each asset and liability of the enterprise. The theoretical basis is that any rational person will not pay more for an asset than the price of replacing it or buying a substitute for the same purpose. The main method is the replacement cost (cost plus) method.

The market approach compares the appraisal object with reference companies or companies, shareholders' equity, securities and other equity assets that have been traded in the market to determine the value of the appraisal object. Its application is premised on the assumption that similar assets in a complete market must have similar prices. Commonly used methods in the market approach are the reference enterprise comparison method, the M&A case comparison method and the price-earnings ratio method.

Figure 1 System of Enterprise Value Assessment Methods

The income approach and the cost approach focus on the enterprise's own development status. The difference is that the income approach focuses on the profit potential of the enterprise and considers the time value of future income, which is a method based on the present and looking to the future. Therefore, the income approach is more suitable for enterprises in the growth or maturity period with stable and lasting income. The cost approach takes into account the existing assets and liabilities of the enterprise, and is a true assessment of the current value of the enterprise. Therefore, when it comes to a holding enterprise that only invests or only owns real estate, and when the appraisal premise of the appraised enterprise is discontinued operations, it is appropriate to conduct appraisal using the cost approach.

The market approach differs from the income approach and the cost approach in that it shifts the focus of appraisal from the enterprise itself to the industry, accomplishing a shift in appraisal methodology from inside to outside. The market approach is simpler and easier to understand than the other two approaches. The essence of the market approach is to seek suitable benchmarks for horizontal comparison. In cases where the target enterprise is of the development potential type and future earnings are uncertain, the market approach has a significant advantage.

Second, the core method of enterprise value assessment

1, focusing on the time value of money discounted cash flow method (DCF)

Cash flows created by enterprise assets, also known as free cash flow, they are created in a period of time by the asset-based business activities or investment activities. However, cash flows in future periods have a time value, and their potential time value needs to be removed when considering forward cash inflows and outflows, so they are discounted using an appropriate discount rate.

Figure 2 Schematic cash flow diagram of DCF method As shown in Figure 2, if t0 is the starting date of the project, the discounted cash flow of the project is .

The key to the DCF method is therefore the determination of the future cash flows and the discount rate. So the application of the method presupposes the continuing operation of the business and the predictability of future cash flows.The limitation of the DCF method is that it can only estimate the value of the cash flows that can be generated from the already open investment opportunities and the future growth of the existing business, and does not take into account the various investment opportunities under the environment of uncertainty, which can largely determine and affect the value of the business.

2, the internal rate of return method (IRR), which assumes zero returns

The internal rate of return is that discount rate that makes the net present value of a business investment zero. It has some of the characteristics of the DCF method, the practice is most often used in place of the DCF method. Its basic principle is to try to find a numerical value to summarize the characteristics of business investment. The internal rate of return itself is not affected by capital market interest rates, but depends entirely on the cash flow of the enterprise, reflecting the characteristics inherent in the enterprise.

But the IRR method can only tell investors whether the business being evaluated is worth investing in, but not how much it is worth investing in. And the internal rate of return method in the face of investment-type enterprises and financing-type enterprises in its determination of the law is just the opposite: for investment-type enterprises, when the internal rate of return is greater than the discount rate, the enterprise is suitable for investment; when the internal rate of return is less than the discount rate, the enterprise is not worth investing in; financing-type enterprises is not.

Generally speaking, for enterprise investment or mergers and acquisitions, investors not only want to know whether the target enterprise is worth investing, but also want to know the overall value of the target enterprise. The internal rate of return (IRR) method cannot satisfy the latter, so it is more often applied to individual project investments.

3. CAPM Model for Valuing Risky Assets under Complete Markets

The Capital Asset Pricing Model (CAPM) was initially designed to value risky assets (such as stocks). However, the value of a stock depends to a large extent on the degree of risk involved in obtaining a return on its acquisition. It is similar in nature to risky investments, both of which discount future returns at the risk reward rate. Therefore, the CAPM model can be used to determine the discount rate for venture capital projects while valuing stocks.

Under the framework of general economic equilibrium, assuming that all investors make decisions based on a utility function with return and risk as independent variables, the specific form of the CAPM model can be derived:

What seems to be behind the complex formula is actually a very simple truth. The expected return on an asset depends on the risk-free rate of return, the market portfolio return and the size of the correlation coefficient. The risk-free rate of return is the rate of return when investing in the safest assets such as deposits or purchasing treasury bonds; the market portfolio yield is the weighted average yield of all securities on the market, representing the average level of return in the market; the correlation coefficient represents the size of the correlation between the assets purchased by the investor and the overall level of the market. Therefore, the essence of the method is to study the correlation between a single asset and the market as a whole.

The derivation and application of the CAPM model has strict prerequisites, and there are harsh regulations on the market and investors. Under the premise that China's securities market needs to continue to improve, the application of the CAPM model is subject to certain limitations, but its core idea is worth learning and promoting.

4, adding capital opportunity cost of EVA assessment method

EVA (Economic Value Added) is more popular in recent years in foreign countries for evaluating the status of business management and management performance of important indicators, the core idea of EVA into the field of value assessment, can be used to assess the value of enterprises.

In the EVA-based enterprise value assessment method, the enterprise value is equal to the invested capital plus the present value of EVA in the future years, i.e.: enterprise value = invested capital + present value of expected EVA.

According to Sten? Sten's explanation, EVA is the difference between the return on a firm's capital and the opportunity cost of capital. That is:

EVA = net operating profit after tax - total cost of capital = invested capital x (return on invested capital - weighted average cost of capital rate).

The EVA valuation method takes into account not only the profitability of a company's capital, but also provides insight into the opportunity cost of applying a company's capital. By incorporating opportunity cost into the system, it examines the ability of corporate managers to select projects from the best. However, grasping the opportunity cost of the enterprise becomes the focus and difficulty of this method.

5. Replacement cost method conforming to the law of "1+1=2"

Replacement cost method treats the appraised enterprise as a combination of various factors of production, and assesses each identifiable asset one by one on the basis of an inventory of the various assets and confirms the existence of goodwill or economic depletion of the enterprise, and then adjusts the appraisal value of each identifiable asset to the value of the individual asset, which will be determined by the appraisal value of the individual asset. The appraised value of each individual identifiable asset is summed up and then added to the goodwill of the enterprise or subtracted from the economic depletion, and the appraised value of the enterprise value is obtained. That is: overall enterprise asset value = ∑ individual identifiable assets appraisal value + goodwill (or - economic depletion).

The most basic principle of the replacement cost method is similar to the equation "1+1=2", which assumes that the value of the enterprise is the simple sum of the individual assets. Therefore, one of the major flaws of this method is that it ignores the synergy effect and scale effect between different assets. That is to say, in the process of business operations, often "1+1>2", the overall value of the enterprise is greater than the sum of the individual assets appraisal value.

6. Reference enterprise comparison method and M&A case comparison method focusing on industry benchmarking

Reference enterprise comparison method and M&A case comparison method analyze the financial and operating data by comparing the benchmarking object with the appraised enterprise in the same or similar industry and status, and multiply them by the appropriate ratio of value or economic indicator, so as to arrive at the value of the appraised object.

But in reality, it is difficult to find a benchmarking object with the same risk and the same structure as the appraised enterprise. Therefore, the reference enterprise comparison method and the M&A case comparison method generally split the different aspects of the enterprise's value performance according to multiple dimensions and determine the weights according to the relevance of each part to the overall value. That is, the assessed enterprise value = (a x assessed enterprise dimension 1 / benchmark enterprise dimension 1 + b x assessed enterprise dimension 2 / benchmark enterprise dimension 2 + ...) x benchmark enterprise value.

7. Price-earnings ratio multiplier method for market value assessment of listed companies

The price-earnings ratio multiplier method is specialized for the assessment of the value of listed companies. The stock price of the assessed company = the average price-earnings ratio of the same type of company × earnings per share of the assessed company's stock.

The use of the price-earnings ratio multiplier method to assess the value of an enterprise requires a relatively complete and developed stock exchange market, as well as a sufficient number of listed companies in a complete range of industry sectors. Because China's securities market is still a certain distance from the complete market, while domestic listed companies in the equity settings and structure and other aspects of the larger differences, at this stage, the price-earnings ratio multiplier method is only as an auxiliary system for enterprise value assessment, is not suitable for the time being as a stand-alone method of the overall value of the enterprise assessment. However, in foreign markets, the application of this method is more mature.