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Valuation and The Illusion of Precision
Why is valuation not an exact science?
Imagine two teams of experienced financial analysts being asked a question: How much is this company worth?
Both teams receive the same financial statements, have the same access to market information, understand valuation theory, and use established financial models. One team concludes the company is worth €800 million, while the other arrives at a slightly different number, so which one is wrong? Well, perhaps neither. This is one of the most fascinating characteristics of valuation. Behind spreadsheets filled with formulas, discounted rates, multiples, and financial projections lies sometimes something considerably less precise: an assumption about a foreseeable future.
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What does it mean to calculate the value of a company?
We constantly assign values to things. How much is the painting worth, a company, or even an idea worth? But for each one of us, the value of the exact same thing can differ. Therefore, it is important to settle such arguments with methods proven over time.
Companies, just like other physical and non-physical things, can be evaluated. Professional evaluation attempts to make this process systematic. Teams of analysts study financial statements, industries, competitors, economic conditions, risks, and other expectations about the future to determine whether the business will be worth something in the future. The final product of such evaluation is usually a value that we assign to a thing; in this case, we’re talking about a company. But what is important to know is that there is no single universal method capable of revealing the true value of every company. Instead, valuation can broadly be approached from three different perspectives: asset-based valuation, income-based valuation (or earnings-based valuation), and last but not least, market-based valuation.
Asset-based valuation: what does the company own?
Equity Value = Value of Assets − Value of Liabilities
The first approach looks at the company through its assets and liabilities. It is simple: the value of the equity equals the value of assets minus the value of liabilities. The analysts examine what the company owns, for example, property, inventory, cash, investments, and other assets, and then subtract its obligations, usually referred to as liabilities. The logic is intuitive. If we want to determine the value of a business today, one approach is to assess the value of its assets after accounting for its liabilities. These liabilities may include bank loans, outstanding debt, and other financial obligations that the company is required to repay.
For certain businesses, this can be an extremely useful approach. Consider a company whose value is largely represented by real estate investment holdings or other tangible assets. Looking at its underlying assets can provide an important indication of its value. But imagine the same method applied to a young technology startup with several computers, some cash in the bank, and perhaps very little else on its balance sheet. Its current revenues also might not be very large or significant, but does that mean that a company has little value? Not necessarily; its value may be in its assets maybe it’s technology, intellectual property, network, employees, brand, customer relations, or simply its potential to generate significant cash flow. In the future, many of these sources of economic value are difficult to capture through a straightforward examination of its balance sheet. Therefore, asset-based valuation might not always be the right choice for valuation of a particular company.
Be aware that asset-based valuation does not necessarily mean rewriting values reported on a company’s balance sheet. Accounting values often represent historical costs and may therefore differ significantly from what an asset is worth today. Analysts may adjust these asset and liability values to reflect current fair or economic value and paint a more realistic picture. For example, a property purchased many years ago may be recorded on the balance sheet at a value substantially different from its current market value. These adjustments will allow analysts to provide more accurate numbers for further valuation.
Income-based valuation: What could the company generate in the future?
Instead of asking what the company owns today, we can ask a different question: how much money could this business generate for investors in the future? This brings us to the income-based valuation, and the most famously used method is the discounted cash flow model. The principle behind DCF is relatively simple: money expected to be received in the future is worth less than the money received today. Therefore, analyst forecast the company's future cash flows and discount them back to their present value using a rate reflective of both the time value of money and the risk associated with those cash flows.
This method captures something that asset valuation cannot, which is the future potential of generating cash flow; for example, with a mention startup, it could be its returns. Its assets today may not be worth a lot, but suppose an analyst believes its technology could attract millions of customers and generate substantial cash flow five or 10 years from now. An income-based valuation at the moment can be incorporated for those expectations. Of course, it introduces other problems we have to predict. Both independent analysts can examine the same company and reasonably disagree about these assumptions. The further you go into the future, the less reliable the assumption you are making. In a DCF valuation, the value of a company consists of the present value of free cash flows (projected during an explicit forecast period) and the terminal value, which represents all cash flows expected beyond that period. The longer the explicit forecast period, the greater the portion of future cash flows that is valued individually and, consequently, the smaller the terminal value will generally be as a proportion of the total valuation. However, extending the forecast period does not necessarily make the valuation more accurate, as the reliability of financial projections tends to decrease as the forecast horizon becomes longer.
Market-based evaluation: How much are others willing to pay?
There is another way to approach the problem of valuation. Instead of trying to calculate value entirely from within the company, we can look outside: how are comparable companies valued in the market? This is the logic behind relative valuation and valuation multiples such as price-to-earnings (P/E), enterprise value to EBITDA (EV/EBITDA), and enterprise value to sales (EV/Sales). An example of such multiples is usually presented like this: similar publicly traded companies are valued around 10 x EBITDA. If the company we are analyzing generates 50 million in EBITDA, that market evidence can help us estimate what investors might be willing to pay for it. Analysts can also examine precedent transactions, actual acquisitions of a business. Rather than asking how the stock market currently values similar companies, we ask: what have buyers actually paid for a business like this?
This can be particularly valuable in mergers and acquisitions because transaction prices may incorporate factors such as control premiums and expected synergies, but once again there is no perfect answer. No two companies are completely identical. They may have different growth prospects, profitability, depth, level, competitive advantages, geographic exposure, management quality, or risk. Even the same company can command very different multiples depending on whether markets are optimistic, fearful, experiencing a recession, or moving through a speculative boom. The market provides evidence of value, but it does not provide unquestionable truth.
So now imagine you are trying to evaluate the same company, and you use all three approaches to evaluate the same company: the asset approach produces a value of $500 million, DCF produces $850 million, and finally comparable companies suggest $780 million. Which number should we use?
This is precisely why professional evaluation rarely relies on a single method; an analyst may construct several evaluation models and compare their results. They might perform a DCF, examine trading multiples, analyze precedent transactions, and, where appropriate, consider the company's underlying assets. Worth mentioning is the fact that all three approaches can not always be used. To understand better, we can use market size as an example. In a market such as the USA, there is a large number of publicly traded companies that provide analysts with a broad pool of potential comparables. But what if we are present in a growing economy in which only a few companies are listed on the stock market? Although there are many other businesses operating of different sizes, industries, and stages of development within the economy, the limited number of publicly traded companies may not provide a sufficiently representative sample for completing a comparison. Relying solely on these companies could therefore produce an incomplete or potentially misleading picture of real value.
But just geographical limitations do not make market-based valuation impossible. Analysts may expand their search to comparable companies operating in other countries or examine previous transactions involving similar businesses in other countries. However, doing so introduces another layer of necessary adjustments and limitations to take into account. Companies operating in different markets may face different levels of geographical risk, regulation, taxation, economic growth, liquidity, and investor expectations. Consequently, finding a truly comparable company or transaction is often considerably complicated.
More importantly, the objective of valuation is not necessarily for all three methods to produce the same number. In fact, if all three approaches arrived at precisely the same result, it might be worth examining whether some of the underlying assumptions have been constructed to force that convergence. Instead, each method should be approached from a different angle: What do the company’s assets tell us about its value? What do its expected future cash flows suggest? And what does the market tell us about what investors are currently willing to pay for comparable businesses? Is there a future for the company on the market in the upcoming years? Is it worthwhile for the company to operate further, or is it better to sell or complete a restructuring? By considering all the approaches together, rather than looking for a single method to reveal one “correct” number, analysts can develop a more complex and well-supported picture of a company’s value.
Price and value are not the same!
One final distinction is worth making: a company may have an estimated value of €1 billion, but that does not mean someone is willing to pay €1 billion for it. A seller might refuse anything below €1.2 billion; a strategic buyer expecting substantial synergies might be willing to pay even more, and another investor might be too. On the other hand, someone may conclude that paying more than €800 million is unreasonable. Eventually, if a transaction occurs, there will be a finalised price. Price (the amount that was finalised by both parties in this particular transaction) is what was paid by the buyer. Value is something we believe the asset is worth. The distinction explains why evaluation matters so much. If a price and value were always identical, there would be little reason to analyze companies in the first place.
The illusion of precision is still present. Financial evaluation has become extraordinarily sophisticated. Analysts use powerful databases, detailed financial statements, and models capable of processing enormous amounts of information. They can even conduct interviews to better understand the company. Yet no model can remove the fundamental problem of the fact that the future has not happened yet. Therefore, if you come to a different conclusion while completing a valuation, you might not have made a mistake, but you should be prepared to explain why and how you made your predictions.
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