PARt 2: VALUAtIoN, RISk ANd REtURNthe company’s book value, meaning the value of the company’s equity as shown on its balance sheet. The
book value of equity reflects the historical cost of the company’s assets, adjusted for depreciation, net of
the company’s liabilities.
Liquidation value may be more or less than book value, depending on the marketability of the
company’s assets and the depreciation charges that have been assessed against fixed assets. For example,
an important asset on many corporate balance sheets is real estate. For many organisations, the value of
raw land appears on the balance sheet at historical cost, but, in many cases, its market value is much
higher. In that instance, liquidation value may exceed book value. In contrast, suppose that the largest
assets on a company’s balance sheet are highly customised machine tools purchased two years ago. If
the company carries them at historical cost and depreciates the tools on a straight-line basis over five
years, the value shown on the books would equal 60% of the purchase price. However, there may be no
secondary market for tools that have been customised for the company’s manufacturing processes. If the
company goes bankrupt, and the machine tools have to be liquidated, they may sell for much less than
book value.
Continuing with the concept of book value as a basis for equity valuation, we can note the concept
of the residual income measure (RIM). This combines the accounting and finance elements of valuation. The
RIM for each period in the future requires us first to forecast expected future earnings or income for the
company for each future period. This will be income that is owned by the equity invested in the company.
We then project the expected future book value of ordinary shares at the start of each period. Against this
book value of equity, we set the expected cost of equity: in our terms, this is the return on equity that we
require the company to earn (re). The product of the return on equity and the book value of equity gives
us an estimate of expected future required income – that is, what we need to earn on equity in order that
it continue to invest in the company.
The residual income for a given period is then the difference between the forecast expected future
income and the expected future required income. Once we have generated the expected future residual
income measures for each period, we can take a present value of them and use this as a valuation of
equity for the company.
The method is akin to the economic value added (EVA) technique of valuing projects, which we shall
meet in Chapter 9. Differences lie in the use of book value of all equity for the RIM concept, where EVA
uses invested capital for the project; and the focus on accounting earnings (profits) for the company in
RIM as opposed to the cash flows for the project in EVA. Perhaps a key value in using RIM is that it can
be applied for valuing equity even when no dividends are being paid, as we noted in section 5-2g earlier
in this chapter.5-4b MARkEt MULtIPLES oF CoMPARABLE CoMPANIES
Because of the uncertainty surrounding the inputs to any valuation model, analysts routinely
employ different methods to analyse the same company to estimate a range of plausible values.
The two most widespread valuation techniques are the discounted cash flow method, covered in
section 5-2, and the comparable multiples method. The comparable multiples method involves three
steps.
First, collect a sample of similar, publicly traded companies. By similar, we mean that these companies
should have similar lines of business and similar risk profiles, growth prospects and capital structures. OfLO5.4book value
The value of equity as shown
on the company’s balance
sheet
residual income
measure (RIM)
The present value of the
difference between the
forecast expected future
(accounting) income for
equity in a company and the
expected future required
income. The measure can be
used to value equity if the
income measures and book
values of equity are known,
even if no dividends are being
paid
comparable multiples
method
A valuation method that
calculates a valuation ratio or
multiple for each company in a
sample of similar companies,
then uses the average or
median pricing multiple for the
sample companies to estimate
a particular company’s value