Company valuation methodsIntroductionValuing a company is normally a tricky and difficult task. Valuation dictates how equity will be divided amongst company’s entrepreneurs and investors. If a company prepares a thorough valuation of its ventures, it will gain a strong negotiation position in the stock market. This paper elucidates the various methods of company valuations and discusses the current corporate valuation methods. Valuation methods that are mostly used include: discounted cash flow models, Capital Asset Pricing Models (CAPM) and Arbitrage Pricing Model (APM). Companies need more inventive methods to discover changes in financial setting to contend with the perpetual changes as noted by (Fernandez, 2004).
Diverse corporate theories have been developed ever since 1950s. These theories explain reactions from investors to the financial and investment decisions by companies. Valuation of companies is crucial in cooperate finance (Inter Metro Business Journal Fall, 2006, p. 40). Several events change the validity of valuation models. An example is the Enron that resulted to the re-evaluation of classical and neo-classical valuation methods. It describes the basic valuation methods like models in discounted cash flow where the value of a company is expressed in terms of the net present value of future cash flow as noted by (Capiński and Patena, 2006, p. 3).
Capital Asset Pricing Model (CAPM) links the market risk with the returns from equity. Various investment decisions also contribute to company’s valuation. Discounted Cash Flow ModelsDifferent valuation models on discounted cash flow focus on assessment by reference to the anticipated cash-flow proxies which include dividends, earnings from accounting and cash flow. In ideal situations, results from these variables should be identical, but if this is not the case in real world (Revista Empresarial Inter Metro Business Journal Fall, 2006).
Experiential analysis shows the variation in the outcomes is due to different estimates of the expected future cash flow. These models are written asP = CF1 + CF2 + CF3 + ……… (1+r) (1+r)2 (1+r)3Capital Asset Pricing Model (CAPM)It postulates linear relationship between expected return rate and systematic security risk. It is considered to be an extension of portfolio theory by Markowitz’s (1952). Some of the researchers who have been credited with CAPM development are Sharpe (1964), Linter (1965) and Black (1972), hence the name SLB model as stated by (Fama and French, 2001, p36).
Portfolio efficiency concept combines risky assets, reduces return and at times maximize the returns for a specific risk. Variance for the returns expected represent the locus of certain portfolios that facilitate reduction of return risk rate. Arbitrage Pricing Theory (APT)This theory was developed by Ross (1976). According to this theory, return value is dependent upon other independent factors but not on a single systematic risk factor. When these models contains CAPM beta, they are termed as extended CAPM.
Major criticism of this theory is that there are no clear specifications on the model that should be used. Multifactor version by Fama and French (2001) is consistent with APT. CAPM is criticized of being ineffective in the prediction of the returns and instead market capitalization and book- market equity ratios are proposed in prediction of a larger variance proportion.