Provide a narrative explaining the market capitalization method.
• Provide a narrative explaining the book value method.
• Provide a narrative explaining expected future earnings method.
• Provide a narrative on other methods.
• Provide a narrative that compares market capitalization, book value, and future earnings methods (and other methods mentioned) with each other.
• Market capitalization is the total value of a company. It’s measured by the stock price times the number of shares issued. For example, a company that has 1 million shares that are selling for $10 each would have a market capitalization of $10 million. This means you could buy that company for $10 million, if you had the money and all the current stockholders were willing to sell you their shares.
• Market capitalization is usually called market cap for short. It also refers to the total value of a stock exchange. For example, the market cap of the NASDAQ would equal the market cap of all the companies traded on the NASDAQ combined.
• Small, Medium and Large Cap
• Investors use market cap to divide the stock market into three size categories.
• Small cap companies have a market cap of less than $1 billion. They are smaller companies, many of which recently went through their initial public offering. They are riskier, because they are more likely to default during a downturn. On the other hand, they have lots of room to grow, and could become very profitable.
• Mid cap companies are less risky, but may not have the same potential for growth. They typically have a capitalization of between $1 billion to $5 billion. A recent study showed they actually outperformed both small cap and large cap stocks over the last 20 years.
• Large cap companies have the least risk, because they typically have the financial resources to weather a downturn. Since they tend to be market leaders, they also have less room to grow. Therefore, the return may not be as high as small or mid cap stocks. On the other hand, they are more likely to reward stockholders with dividends. The market cap for these companies is $5 billion or more.
• Market Cap Is a Good Way to Value Companies
• Market cap is a relatively good way to quickly value a company. That’s because stock prices are generally based on investors’ expectations of a company’s earnings. As earnings rise, stock traders will bid more for the stock price. Including the number of shares in the calculation offsets the impact of stock splits.
• Market cap would be a great way to value companies if they all had the same price to earnings ratio. But investors consider some industries to be slow growing or stodgy. Their stock prices are undervalued, and so are the market caps of companies in that industry.
• There are several other ways to determine the value of a company. One good way is to determine the net present value of its future cash flow, or income. This gives the buyer an idea of what the return on investment will be. If a company’s market cap is lower than the net present value of its cash flow, then it is undervalue, and a candidate for takeover.
WHAT IT IS:
Market capitalization refers to the value of a company’s outstanding shares.
HOW IT WORKS (EXAMPLE):
The formula for market capitalization is:
Market Capitalization = Current Stock Price x Shares Outstanding
It is important to note that market capitalization (sometimes called “market cap”) is not the same as equity value, nor is it equal to a company’s debt plus its shareholders’ equity (although that is sometimes referred to as simply the company’s capitalization).
Let’s assume Company XYZ has 10,000,000 shares outstanding and the current share price is $9. Based on this information and the formula above, we can calculate that Company XYZ’s market capitalization is 10,000,000 x $9 = $90 million.
WHY IT MATTERS:
Market capitalization reflects the theoretical cost of buying all of a company’s shares, but usually is not what the company could be purchased for in a normal merger transaction. To estimate what it would cost for an investor to buy a company outright, the enterprise value calculation is more appropriate.
Thus market capitalization is a better measure of size than worth. That is, market capitalization is not the same as market value, which can generally only be assigned when the company is actually sold.
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1. Accounting: A method where the present value of an asset is determined by discounting its future cash flows.
2. Finance: A method of portfolio building where the manager purchases highly capitalized names in the stock index in proportion to its market capitalization. For instance, if the index has three stocks with the first stock having 60% capitalization of the index and the other two with 20% capitalization each, 60% of the portfolio would be composed of the first stock and the remaining 40% would be divided equally between the other stocks.
What Are the Advantages of Using a Market Capitalization Model?
by Walter Johnson ; Updated July 27, 2017
The market capitalization method, or MCM, is the easiest and most popular form of determining the market worth of a business. It measures the size of a business by multiplying the price per share by the number of shares in existence. There is a slight variant of the MCM that is becoming more popular, and that is the “free float” version of MCM. This model multiplies the price per share by the number of shares readily available for trading. This method is the one with the most advantages.
MCM has one great advantage: it is simple and direct. Anyone can do it. It is also the most honest. Even if the share prices are distorted because of debt or media-created demand, it reflects the value of the stock as the market sees it. This is all most investors care about.
MCM deals with a firm’s size as seen by the market. If you are an investor who only wants relatively safe and stable investments, then the MCM is the only model you will use. This is because what is defined as stable is generally limited to the larger-cap stocks such as Wal-Mart. The quickest way to identify the larger, more stable firms is by using MCM because it deals only in sheer bulk.
The leading business valuation associations, the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA), all agree on three major approaches to business valuation: the Income Approach, the Market Approach, and the Cost Approach. Under each of these approaches there are several methods that might be employed to determine business valuation depending on the specific nature of the company being valued.
VALUATION APPROACHES AND METHODS
The Income Approach involves valuation methods that convert future anticipated economic benefits (e.g., cash flow) into a single present dollar amount. Depending on the valuation method used, “Income” might be represented by after-tax profit, pre-tax profit, EBIT (earnings before interest and taxes), EBITDA (EBIT plus depreciation and amortization), or other cash flow measures. The two most commonly used methods under this approach are the Single Period Capitalization Method and the Multiple Period Capitalization Method.
The Market Approach involves valuation methods that use transactional data to help determine a company’s value. These methods might involve private company transactions, public company transactions, as well as public company valuation measures using current stock market data. The theory behind this approach is that valuation measures of similar companies that have been sold in arms-length transactions should represent a good proxy for the specific company being valued.
The Cost Approach, also known as the Asset-based Approach, involves methods of determining a company’s value by analyzing the market value of a company’s assets. This valuation approach often serves as a valuation floor since most companies have greater value as a going concern than they would if liquidated, i.e., the present value of future cash flows generated by the assets usually far exceed the liquidation value of those assets. This difference between the asset value and going concern value is commonly referred to as “goodwill”. An exception to this might be a low-margin business in a competitive industry that owns its real estate, which has appreciated over time due to its development value. In this case, the asset value may exceed the going concern value of the business.
The valuation methods discussed above represent some of the most commonly used by business valuation professionals to generate an opinion of value. Although considerable time and effort is involved in preparing formal business valuations, unfortunately the results may or may not reflect the “real world” value of a specific company if it were formally offered for sale.
Consulting a professional investment banker can best help you assess the true value of your company. These professionals will assess your company’s strengths and weaknesses and employ some of the commonly used valuations methods used by business valuators. They will also leverage their insight into the current marketplace to help determine financing availability and assess many other factors to determine your company’s potential value in the market place.
Book Value Method
The financial accounting term book value method refers to one of two approaches to valuing a transaction involving the conversion of bonds to common stock. The book value method uses the current book value of the company’s bonds when recording the transaction.
Companies will issue convertible securities for a number of reasons. For example, convertible bonds and preferred stock may include this feature to attract investors, since the ability to convert these securities to common stock lowers their perceived risk.
When a company issues convertible debt securities, they need to assign a value to the transaction when the holders of these securities convert them into shares of common stock. There are two accepted ways to value this transaction, the market and the book method.
The book method uses the carrying value of the bonds to record the transaction. While this approach is helpful when the market price of the company’s common stock or bonds is not readily available, proponents believe it should be the only method used. It’s argued that when the convertible securities were first issued, the value of the securities were equal to the face value of the bond or the shares of common stock, if converted.
For this reason, strict theorists believe the company should not record a gain or loss when converted. Typically, investors would not convert these securities unless the value of the company’s stock received was significantly higher than the face value of the bond. If the market value method is used, this transaction would result in a loss that flows to the income statement. For all of the above reasons, the book method is a popular approach to recording transactions involving convertible securities.
Book value method
May 19, 2018
The book value method is a technique for recording the conversion of a bond into stock. In essence, the book value at which the bonds were recorded on the books of the issuer is shifted to the applicable stock account. This shift moves the bond liability into the equity part of the balance sheet. There is no recognition of a gain or loss on the conversion transaction. The possible line item entries associated with the book value method are as follows:
• Debit the bonds payable account, which eliminates the bond liability
• Debit the premium on bonds payable account (if used), which eliminates the excess bond liability
• Credit the discount on bonds payable account (if used), which eliminates the bond liability reduction
• Credit the common stock or preferred stock account for the amount of any share par value
• Credit the additional paid-in capital for common stock or preferred stock account to record any residual stock amount
When Should You Use the Book Value Approach to Business Valuation?
I SEE BOOK value as generally a very secondary approach to valuation. For buying a very tiny business, you can probably just ignore it unless there are significant assets involved. Book value is a good way to test valuations of companies that have significant assets, such as inventory, receivables, equipment, or property.
Book value might also be a good approach if a company has particularly low profits. For example, let’s say a company has only $10,000 in profits and little growth, but it is sitting on $1 million in book value because it has a lot of valuable assets. So, in this case, the selling price of the company might be more based on the book value than the profitability. For example, maybe the selling price would be a 20 percent discount to book value, because the profits are so low.
Book Value Is Total Assets Minus Total Liabilities
Book value, a multiple of book value, or a premium to book value is also a method used to value manufacturing or distribution companies. Book value is total assets minus total liabilities and is commonly known as net worth.
Net book value
July 16, 2017
Net book value is the amount at which an organization records an asset in its accounting records. Net book value is calculated as the original cost of an asset, minus any accumulated depreciation, accumulated depletion, accumulated amortization, and accumulated impairment.
The original cost of an asset is the acquisition cost of the asset, which is the cost required to not only purchase or construct the asset, but also to bring it to the location and condition intended for it by management. Thus, the original cost of an asset may include such items as the purchase price of the asset, sales taxes, delivery charges, customs duties, and setup costs.
The depreciation, depletion, or amortization associated with an asset is the process by which the original cost of the asset is ratably charged to expense over its useful life, less any estimated salvage value. Thus, the net book value of an asset should decline at a continuous and predictable rate over its useful life. At the end of its useful life, the net book value of an asset should approximately equal its salvage value.
Impairment is a situation where the market value of an asset is less than its net book value, in which case the accountant writes down the remaining net book value of the asset to its market value. Thus, an impairment charge can have a sudden downward impact on the net book value of an asset.
Net book value represents an accounting methodology for the gradual reduction in the recorded cost of a fixed asset. It does not necessarily equal the market price of a fixed asset at any point in time.
Capitalization of Earnings
What is ‘Capitalization of Earnings’
Capitalization of earnings is a method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flows. The capitalization of earnings estimate is determined by taking the entity’s future earnings and dividing them by the capitalization rate (cap rate). This is an income-valuation approach that determines the value of a business by looking at the current cash flow, the annual rate of return, and the expected value of the business.
BREAKING DOWN ‘Capitalization of Earnings’
The capitalization of earnings approach helps investors determine the potential risks and return of purchasing a company.
Determining a Capitalization Rate
Determining a capitalization rate for a business involves significant research and knowledge of the type of business and industry. Typically, rates used for small businesses are 20% to 25%, which is the return on investment (ROI) buyers typically look for when deciding which company to purchase.
Because the ROI does not include a salary for the new owner, that amount must be separate from the ROI calculation. For example, a small business bringing in $500,000 annually and paying its owner a fair market value (FMV) of $200,000 annually uses $300,000 in income for valuation purposes.
When all variables are known, calculating the capitalization rate is achieved with a simple formula, operating income/purchase price. First, the annual gross income of the investment must be determined. Then, its operating expenses must be deducted to identify the net operating income. The net operating income is then divided by the investment’s/property’s purchase price to identify the capitalization rate.
Drawbacks of Capitalization of Earnings
Evaluating a company based on future earnings has disadvantages. First, the method in which future earnings are projected may be inaccurate, resulting in less than expected yields. Extraordinary events can occur, compromising earnings and therefore affecting the investment’s valuation. Also, a startup that has been in business for one or two years may lack sufficient data for determining an accurate valuation of the business.
Because the capitalization rate should reflect the buyer’s risk tolerance, market characteristics, and the company’s expected growth factor, the buyer needs to know the acceptable risks and the desired ROI. For example, if a buyer is unaware of a targeted rate, he may pay too much for a company or pass on a more suitable investment.
Capitalization of Earnings
Income-based Business Valuation Method
A common income-based small business valuation method that establishes the business value by dividing the expected business economic benefit, such as the seller’s discretionary cash flow, by the capitalization rate.
What It Means
Capitalization of Earnings Method determines the business value using a single measure of the expected business economic benefit as the numerator. This is divided by the capitalization rate that represents the risk associated with receiving this benefit in the future.
We discuss the capitalization and discounting business valuation methods in the Guide and show that the two are equivalent if the business earnings grow at a constant rate.
In using this valuation method, care must be given to the proper selection of the economic benefit being capitalized and the appropriate capitalization rate.
Accurate matching of the income being capitalized and selection of the capitalization rate are the key advantages of the Multiple of Discretionary Earnings business valuation method.
Business Valuation Methods
There are several methods of appraisal for each of the business valuation approaches.
Asset Based Approach
Adjusted Net Asset Value Method – This business valuation method requires that the appraiser adjust the assets and liabilities to the fair market value as of the date of the valuation. For example, tangible assets such as machinery and equipment are valued by qualified professionals and the values are used by business appraisers in the asset approach.
Liquidation Value Method – This business valuation method used when a company will discontinue its operations or restructure. The proceeds from the liquidation are calculated under an orderly or forced liquidation premise.
Book Value Method – This method is sometimes used but has serious flaws. Since book value is only an “accounting” number, it has little to do with the actual value of the assets. Companies can take advantage of accelerated depreciation to reduce taxes. This in effect reduces the value of the equipment to zero in the first year when the normal useful life may be much longer. Likewise, equipment could be depreciated over a longer span of years when it is no longer useful. Financial accounting depreciation is very different from equipment depreciation. Using the book value in a business valuation can provide misleading results.
Excess Earnings Method – This business valuation method calculates earnings that are considered above the reasonable return on the tangible assets. It is often used in measuring goodwill or intangible value of a business. It contains some components of the Income Approach.
Capitalization of Earnings Method – This business valuation method is used to convert a normalized ongoing benefit stream into a present value based on a single period. It is most appropriate when a company has a stable level of cash flow that is increasing at a relatively constant rate over a period of time.
Discounted Earnings Method (Discounted Cash Flow Method) – This method of business valuation is appropriate when a company is experiencing an unstable level of earnings or cash flow or is experiencing inconsistent growth rates. The discounted earnings method calculates the present value of all the future benefits.
Guideline Public Company Method – This valuation method uses financial data from publicly traded companies. These valuations are based on the actual price investors have paid for minority interests in companies in the same or similar line of business as the company being valued.
Guideline Company Transactions Method – This method is a calculation of value of closely held companies in the same or similar line of business as the company being appraised. Companies are selected that have similar characteristics to the subject such as industry, size, products or services, and location. Transaction dates are also examined with more recent transactions being more meaningful than dated business sales.
Multiple of Discretionary Earnings Method – Small company financial statements can be adjusted to represent an owner-operated business entity. This business valuation method compares the adjusted earnings of small business transactions. The transaction value is divided by the discretionary earnings for the comparable company. The subject’s discretionary earnings is calculated and then multiple by the multiple.
Gross Revenue Multiple Method – Used sometimes for small businesses, this method divides the transaction price by the company’s revenue. Comparable companies are researched to formulate a multiple of gross revenue. This multiple is then multiplied by the subject’s revenue to calculate the business value. Though this method is easy to calculate, it fails to take into account profitable versus unprofitable businesses of similar revenue.
Business Valuation Methods:
What Do You Need for the Valuation?
• Financial statements: present, past (minimum 2 years but 5 to 10 years are better since they should show trends, hopefully growth trends), and the forecast for future.
• Market value: of real estate, equipment, inventory and other assets that would be transferred in a sale of the operation.
• Value of intangible assets and goodwill: employees, management team, years in operation, brand reputation, sales book and type of customers, length of relationships.
The income approach to valuation bases value on a company’s income potential. This type of valuation is most appropriate for businesses that do not carry inventory or substantial tangible assets, such as consultancies and other service-oriented businesses. It looks at cash flow, and uses a capitalization rate to estimate the present value of income the business will likely generate in the future.
The benefit valuation approach is a simple model that looks to the tangible benefit the business generates for the current owner in terms of cash flow. It uses a multiplier to extrapolate the value of future earnings. The multiplier is a rate that takes into account a standard return on investment, living wage and debt service.
Perhaps the most reliable type of valuation is the market approach. This economic model bases its valuation on industry standard sales figures, or comparable sales. If the business to be sold is a hair salon, for example, the market approach looks at the sale of other hair salons that have similar gross sales. The industry publishes standard multipliers that are used to determine the current value of similar businesses.
Private Versus Public
The value of a public corporation is directly related to its stock price. Stock price is the actual amount the market thinks the business is worth at a particular point in time. Although stock price isn’t the sole component of the value of a public corporation, it is a major part. Privately-held companies do not have the benefit of a market value for ownership interests. Each private company is unique. Without a market-based equalizer to establish actual value, experts have to use economic models that estimate value based on a number of assumptions.
An asset-based approach to valuation is typically used with businesses that have substantial tangible assets, usually in the form of inventory and equipment. This type of business valuation is appropriate for retail and manufacturing companies. Experts using this approach take the fair market value of fixed assets and add the value of any improvements, plus the wholesale value of inventory, to arrive at a value approximation.