Purpose and Perspective
In general, the determination of a company’s value is closely linked to the purpose and perspective of the valuation.
The determination of objective company values is relevant, for example, for accounting or tax purposes. In this context, the valuation process abstracts from subjective parameters and assumptions and is based on the perspective of a typical market participant.
However, this approach is not suitable for individual decision-making situations—such as the purchase or sale of a company or parts of a company—since it does not take into account the decision-maker’s specific circumstances. For decision-making purposes, therefore, the subjective enterprise value must be determined, which incorporates these individual assumptions and, on this basis, calculates the subjective marginal price.
Methods
Common to both valuation concepts—that is, both the objective and the subjective enterprise value—is the use of methods based on future value of success (net present value calculation) to determine the enterprise value. According to this approach, the value of the company results from the future net cash flows to the owners associated with ownership of the company—in line with the principle that “a businessman pays nothing for the past.”
The value of the company is thus calculated based on future cash surpluses and the associated required rate of return, rather than on the book value or fair value of the assets reported on the balance sheet minus liabilities. The so-called net asset value or liquidation value is therefore irrelevant (in the vast majority of cases—an exception being, for example, an actual impending liquidation of the company) in the valuation process.
In valuation practice, two methods in particular have become established for determining enterprise value as a measure of future success: the income approach and the DCF-WACC method.
In the income approach, the financial surpluses (primarily dividends) that regularly accrue to the company’s owners are discounted to directly determine the equity value. The required return on equity is used as the discount rate.
In the DCF-WACC method, the valuation is performed in two stages. In the first step, free cash flows are determined—that is, the cash surpluses available to equity and debt investors. These are discounted using the weighted average cost of capital (WACC) to determine the enterprise value. In a second step, the net financial position is then deducted to determine the equity value—that is, the value attributable to equity investors.
Information Basis
The starting point for the forward-looking valuation is, accordingly, the company’s financial projections or scenarios of future development. Based on these, future cash flows are derived. The financial projections should be based on consistent assumptions and should be plausible in light of past performance as well as the market and competitive environment. In addition to the income statement projections, balance sheet items must also be planned, such as the development of net working capital and future capital expenditure (CAPEX). The financial forecast covers the so-called detailed planning period (typically three to five years), during which specific planning of the individual components is carried out and at the end of which a so-called steady state—that is, a sustainable level—is reached. In the subsequent perpetual annuity phase, the flat-rate projection is then carried out based on this sustainable level.
The capitalization rate is used to discount future cash surpluses to the valuation date, e.g., the date of the decision. The discount rate serves two functions: on the one hand, it is intended to reflect the time value of money—that is, inflation trends—and, on the other hand, to compensate for investors’ risk aversion, i.e., the uncertainty surrounding the company’s future performance. The capitalization rate must be aligned with the earnings metric being discounted; that is, depending on the earnings metric, it reflects the required rate of return for equity investors or the weighted required rate of return for both equity and debt investors.
In the context of a subjective valuation, the required return on equity can be set as the individual required return or, for example, a hurdle rate. The market-based derivation of the required return on equity is typically based on the Capital Asset Pricing Model (CAPM) and takes into account not only the risk-free base rate (adjusted for inflation) but also a return premium consisting of the market risk premium and the company’s individual beta factor. As a rule, the beta factor is derived from a group of comparable companies (peer group).
Multiplier Approach
In addition to future value-based methods, multiplier methods are also frequently used in practice. Here, the enterprise value is determined based on a multiple of an earnings metric. The multiplier is derived from capital market data of comparable publicly traded companies or from transactions and applied to the company being valued. Common multiplier methods refer, for example, to EBIT or EBITDA; however, other earnings metrics or even revenue can also be used as a basis.
Multiplier methods are based on numerous simplifying assumptions, such as the sustainability of the relevant earnings metric, identical tax rates between comparable companies and the company being valued, and comparable investment levels. Therefore, multiplier methods should generally be used more for plausibility checks than as a standalone valuation method.
EV-to-Equity Bridge – Gross vs. Net Enterprise Value
Net financial items include all items that are fundamentally attributable to financing activities. In this context, interest-bearing financial liabilities are deducted from interest-bearing financial assets. Interest-bearing assets include, among other things, cash and cash equivalents, securities classified as fixed or current assets, loans granted, or credit balances. Interest-bearing liabilities include, among other things, current and non-current bank liabilities, loans received from third parties or shareholders, cash pool liabilities, as well as pension obligations and lease liabilities.
