THE APPLICATION OF FINANCIAL VALUATION METHODS IN INVESTMENT DECISIONS

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1 28 VADYBA / MANAGEMENT m. Nr. 2(11) THE APPLICATION OF FINANCIAL VALUATION METHODS IN INVESTMENT DECISIONS Lina Dagilien, Ruslan Kovaliov, Jogaila Ma erinskas, Žaneta Simanavi ien In this article, value of the company is the benefit of future periods. It is important for investors to choose the optimal collection of valuation methods in order to get reliable results. Many internal and factors influence the value of the company by making investment decisions. Four groups of financial valuation methods are identified according to the analysis of scientific literature: financial reports, cash flows, market, and value methods. Several criteria are chosen in investment decisions: source of information, information user and nature of data. After performing the theoretical grouping of company s valuation methods depending on the mentioned above criteria, four hypotheses are formulated. Key words: company, value, financial methods. Company s valuation factors Valuation of companies becomes more and more independent and distant from the information registered in accounting data. According to the traditional view, value of the company is related to the size of earnings. There are other important indicators, which influence company s value. According to the analyzed scientific literature, main reasons why accounting data are not sufficient for investment decisions are presented in Table 1. Table 1. Factors influencing accounting information insufficiency by deciding about company s value Factors Investigations Influence for information disclosure R D expenditures Herbal (2000), Stern These costs influence directly the size of profit by decreasing Steward Co (2002) it in reporting period in spite of that the company s value can increase. Intangible asset Juhasz (2004) A large part of company s intangible asset is not registered in Recognition of expenditures Analysis of profitability factors Stern Steward Co (2002), Luo (2002) Rappaport (2002), Katits (2002), Dorgai (2003), Braley-Myers (1999), Copeland-Koller-Murrin (1999), Wimmer (2004) the balance sheet because of accounting rules. Accounting rules, referring acquisitions, depreciations, expenses spent on reorganization and restructure, taxes and etc. differ. Profitability indicators of asset and property do not value requirements for capital and cash value in time view. Accounting information is static. It is difficult make a decision according to unsuitable information. Qualitative parameters Horvath (2005) Loyalty of consumers and employees, creativity of organization, culture, motivation, encouragement and etc. also influence the value creation. They are not showed in accounting information. External environment Horvath (2005) General economic conditions, legal environment, technological development, forecasted changes and etc. We can group these factors as internal and factors. Internal factors are specific and appropriate to the concrete company. Internal factors can be accounting and non-accounting. Accounting internal factors influencing company s value are accounting of R D, recognition of expenditures, depreciation and amortization, expenses related with acquisition, reorganization and restructure, taxes. Accounting internal factors usually decrease the value of company, because not all asset, especially intangible asset, is registered the whole according to the accounting rules in spite of the influence of value creation. Non-accounting internal factors contain the following influencing value creation measures: loyalty of consumers and employees, organization factors. External factors influence value of all companies. External factors are related to features of the country: political stability, risk of investment, regional position, technological development, general economic

2 VADYBA / MANAGEMENT m. Nr. 2(11) 29 situation, social-cultural environment, legal environment and etc. The investor must estimate the influence of factors to company s value himself. Neufville (2004) and Terry Rigby (2003) consider that the choice of valuation methods depends on the aim of company s valuation. Valuation aims can be of two kinds (Neufville, 2004): aim of choice decision analysis methods (decision trees or lattice); aim of making decisions options analysis methods (judgment, pricing of any option). Information is very important in processes of making investment decisions. The choice of valuation method depends on available information. Usually we need the information about: dynamics of profit of several years; dividends paying history; book value of assets and obligations; transactions of shares and other changes in the shareholder s ownership; tenders of potential outside buyers; the nature of the industry; management background and experience; prices of comparable public companies shares. The choice of valuation method also depends on aims, making decisions practice of organization, analytical competencies. Company s valuation methods There are a lot of financial-accounting methods used to determine company s value. Almost all of these methods are oriented to future decisions and refer to free cash flows. Evaluating the level of uncertainty, we assume that the present value of cash is greater than its future value. The level of risk is directly proportional to the possible profit. There are three approaches to company s valuation in scientific literature. The cost (asset) approach values a company by accumulating the costs that would currently be required to replace the asset. The premise of the cost approach is that an investor would pay no more to purchase the asset than would be paid to reproduce the asset. Sometimes it is complicated to get reliable results because of high level of inflation, rapid technological changes. It is difficult to implement where accounting records are poor. The investment in the idea may not account for all of the intangible value related to the operations of start-up company. It may conclude the lowest indication of value for start-up companies. The income approach considers future earnings by calculating the present value of projected cash flows at a reasonable present value discount rate. We identify two kinds of methods of the income approach: methods of single period dividend capitalization, earnings capitalization, cash flow capitalization; methods of multiple periods analysis of discounted cash flows. The main advantage of these methods is the indication of fair market value based on the expectations of future company specific economic performance. The market approach values the company based on comparison with sales of similar companies. The value is conceivable as consumer s will to pay the concrete amount. Analogical companies of the brand are identified. The following valuation methods are used: comparable transactions: comparable asset distinguishes by similar market value; calculation of market multiplicators; capitalization of market value per one unit of resources or capitalization of market value per one unit of yearly production. These indicators are calculated by dividing the whole amount of capital from the sum of resources or yearly production volume; optional agreements, when a partner of transactions agrees to make a payment and/or to make costs of property. Our analysis of scientific literature identifies four groups of financial valuation methods: financial reports methods; cash flows methods; market methods; value methods.

3 30 VADYBA / MANAGEMENT m. Nr. 2(11) Financial valuation methods of companies Financial reports m Cash flows meth Market method Value methods 1. Financial ratio analysis: -profitability indicators, -financial stability ratios, - turnover ratios, -ratings. 2. -Du Point analysis 1. Discounted cash flow - DCF 2. Free cash flow - FCF 3. Discounted dividends - DDM 4. Net Present Value - NPV 5. Internal Rate of Return IRR 6. Profitability index PI 7. Cash Value Added-CVA* 8.Cash flow return on investment- CFROI* 1.Dividend capitalization 2.Earnings capitalization 3.Exceeded profit calculation 4.Market multiplicators: -Price earnings ration P/E -Revenue multiples P/S -Earnings multiples P/EBIT and P/EBITDA -P/G -P/BV 5. Relational value. 1. Book value 2. True value 3. Replacement value 4. Liquidation value 5. Economic Value Added-EVA; 6.Market Value Added-MVA 7.Cash Values Added-CVA* 8.Cash flow return on investment CFROI* *-CFROI, CVA valuation methods can be in both groups, because they are calculated according to cash flows and evaluate costs of capital. Fig. 1. Classification of company s financial valuation methods Financial reports methods Financial reports give information about consumption of material, labour and financial resources; provide this information for employees of subdivisions and company s managers. Investors ( accounting users) can get the necessary information from financial reports: receivables and obligations to creditors; profit (loss) of current period; sources of profit (loss) formation; size and structure of shareholders ownership; volume and structure of liabilities. Cash flows methods The calculation basis of cash flow methods is net cash flows. The value of the company is equal to general cash flows during long-term period. Three main questions are discussed: How much do general cash flows generate? When must net cash flows appear? What is the level of uncertainty related to net cash flows? Using cash flows methods, the process of company s valuation may consist of four parts: valuation of the net cash flow; determination and valuation of disount rates; evaluation of the growth level; the final determination of company s value.

4 VADYBA / MANAGEMENT m. Nr. 2(11) 31 Market methods Market methods refer to the market approach. The essential feature of market methods is a comparable valuation. Similar companies are compared by various indicators. Similar companies belong to the same branch, produce and sell similar products and etc. Value methods The other approach related to the company s valuation could be characterized by the following question: whose interests are priory in company s value creating? Shareholders achieve to increase value of available shares. Value methods are based on calculations of economic profit. These criteria were chosen for creation methodology, which aims at selecting and adapting financialaccounting valuation methods: 1. Nature of data. The aim is to determine whether necessary and available data are internal or. Internal data are company s financial reports data; referring to them various calculations are performed. Data of financial reports contain information from balance sheet, profit (loss) sheet, cash flows sheet, ownership changes sheet. External data are market data, such as relative financial indicators of comparable company, exchange rate of stock, asset market value. 2. Number of indicators. The aim of this criteria is to determine how much indicators are needed for valuation. The number of indicators may be: 1) one integrated; 2) two or three; 3) many (more than three). 3. Object of valuation. Company, result of activity, sphere of activity, and investment project. 4. Suitability for investment decision. Yes it is possible to decide unambiguously according to valuation results. No it is impossible to decide unambiguously; the method is only an auxiliary one. 5. Complexity of calculation. Complex many data are necessary in order to evaluate a company according to the appropriate method. Simple it easy to apply the valuation method practically. 6. Complexity of interpretation. Complex high quality, experience, comparable indicators of other companies. Simple qualification of the person, valuating the company may not be very high. 7. Application sphere. For all companies (of all property types), closely held company stocks (stock companies). Financial valuation methods are classified by these criteria in Table 2. Data Table 2. Financial valuation methods Number Valuation Suitability Complexity of object for of indicators decision calculation Complexity of interpretation Relative financial Internal Many Activity Yes Simple Simple All ratio Du Point analysis Internal Many Activity No Simple Simple All Application DCF Internal One Company Yes Complex Simple Stock comp FCF Internal, One Company Yes Complex Simple Stock comp DDM Internal One Company No Complex Simple Sock comp NPV, PI, IRR Internal One Company No Simple Simple All Dividend Internal, One Comparab No Simple Complex Stock comp capitalization le value Income Internal, One Comparab No Simple Complex Stock comp capitalization le value Multiplicators Internal, Many Comparab No Simple Complex Stock comp le value Book value Internal Many Company No Simple Simple All True value External One Company Yes Simple Simple Stock comp Replacement Internal, One Company Yes Simple Simple All value Liquidation value Internal One Company No Simple Simple All EVA Internal One Company Yes Complex Simple All MVA Internal, One Company Yes Complex Simple Stock comp CVA Internal One Company Yes Complex Simple All CFROI Internal, One Company Yes Complex Complex All

5 32 VADYBA / MANAGEMENT m. Nr. 2(11) The actual problem for investors is the suitability information disclosure. The information disclosure depends on valuation subject strongly. We grouped all investors as internal and. These definitions are used. External investors investors who achieve to purchase the concrete business unit. Internal investors possess the concrete business unit and try to identify the potential use of available investment. Internal investors are director of the company, managers responsible for investments, owners of the company. Regarding to the kind of an investor, financial valuation methods can be divided by the source of information and nature of data. Source of information: internal methods. Internal methods refer to financial reports data and other internal information. Data of financial reports contain information from balance sheet, profit (loss) sheet, cash flows sheet, ownership changes sheet. External methods refer to market data, such as relative financial indicators of comparable company, exchange rate of stock, asset market value and etc. Nature of data: accounting flow methods. Accounting (primary) methods are calculated according to the financial reports data: sales, cost, profit, asset, equity. Calculations of flow (secondary) methods evaluate more variables, such as costs of capital, free cash flow. Accounting financial valuation methods use available financial reports data. Applying flow financial methods, first of all we have to count the free cash flow. Determinated versus non-determinated. Determined methods show the relation of results with the sum of investment. Non-determined methods do not show the connection between company s results and invested capital. After performing the theoretical grouping of company s valuation methods depending on the source of information and nature of data, the following hypotheses were formulated: External investors by making decisions for valuation of present situation refer to accounting, (market) valuation methods. External investors by making investment decisions refer to flow, (market) valuation methods. Internal investors by making decisions for valuation of present situation refer to accounting, internal valuation methods. Internal investors by making investment decisions refer to flow, internal valuation methods. The theoretical model was created showing the application of financial valuation methods depending on investors. It is presented in Figure Relative financial ratios 2. DU Point analysis 3. Book value 4. Liquidation value 5. Replacement value Internal investors 1. Net present value NPV 2. Internal rentability rate IRR 3. Profitability index - PI 4. Dicounted dividends - DDM Accounting Flow 1. Market multiplicators 2. Dividends and earnings capitalization 3. True value 4. Relative value 5. Exceeded profit calculation 6. Economic value added - EVA External investors 1. Market value added - MVA 2. Discounted cash flow - DCF 3. Free cash flow - FCF 4. Cash value added - CVA 5. Cash flow return on investment - CFROI Fig. 2. The application of financial valuation methods depending on investor type

6 VADYBA / MANAGEMENT m. Nr. 2(11) 33 Conclusions According to the scientific literature, factors influencing the creation of value can be grouped as internal and factors. Internal factors are specific and appropriate to the concrete company. External factors influence value of all companies. External factors are related to features of the country. Four groups of valuation methods were identified: financial reports methods, cash flow methods, market methods and value methods. The choice of valuation methods depends on aims (valuation object), available information, source of information, nature of data, application sphere. Internal and investors have different aims in valuating the company. External investors prefer to market accounting methods valuating the company at present time. They prefer to market flow methods for making future investment decisions. Internal investors prefer to internal accounting methods valuating company at present time. For future investments it is better to apply internal flow methods. Empirical researches should be performed in the future in other to check the created theoretical model. REFERENCES 1....:, -, 2004 I, c., c.; 2....:, -, 2004 II, c., c.; 3. Galinien Birut. Turto ir verslo vertinimo sistema. Formavimas ir pl tros koncepcija. Monografija: Vilniaus universiteto leidykla, 2004, ISBN , p.; 4. Kancerevy ius G. Finansai ir investicijos.: Kaunas, Smaltijos leidykla, 2004, p.; p.; 5. Rutkauskas A.V., Damašien V. Finans valdymas.: Šiauliai, šiauli universiteto leidykla, 2002, ISBN , p.; 6. Collins Michelle, King Julie. Valuation Formulas: The Income Method // prieiga prie Interneto: 7. Gustafsson Janne. Portfolio optimization models for project valuation. Dissertation, 2005 August, Helsinki University of Technology // prieiga prie Interneto: 8. Horvath A. Non-quantitative measures in company evaluation // European Integration Studies, Miskolc, Volume 4., Number 1 (2005), p.61-72; 9. Markku V.J. Maula. Corporate Venture Capital And The Value-Added For Technology-Based New Firms. Dissertation. Helsinki University of Technology, 2001 // prieiga prie Interneto: Methods for Valuing Assets // prieiga prie Interneto: Milne Bruce. Valuations: What s Your Company Worth?, 1994 // prieiga prie Interneto: Richard de Neufville. Choice of Valuation Methods // prieiga prie Interneto: Scot D., Levine. Business Valuation Issues Related to Start-Up Companies // prieiga prie Interneto: Shrieves Ronal E., Wachowicz John. M. Free Cash Flow (FCF), Economic Vale Added (EVA TM ), and Net Present Value (NPV): A Reconsilation of Variations of Discounted-Cash-Flow (DCF) Valuation, 2000 // prieiga prie Interneto: Venkateshwarlu M. Valuation of Entrepreneurial Firms // prieiga prie Interneto: