Chapter: 10 Stock Valuation

Section: 10 Reasons for Valuation

Companies are usually valued for the following reasons:


  1. Listing on the stock exchange

  2. Initial public offering (IPO)

  3. Divestiture

  4. Mergers

  5. Acquisitions

  6. Taxation purposes

  7. Issue long term debt instruments

  8. Investment purposes

  9. Liquidation

  10. Investment Advising 


Earnings Multiple Approach

An easy, yet effective, method of arriving at a fair market value for the stock is through the use of multiples. In this case, the average P/E of the sector is calculated by dividing total sector market cap by the aggregate net profit of the sector entities. The ratio (expressed in ‘times’) is then multiplied by the company’s most recent earnings per share. For example, if the sector P/E is 15X and the most recent EPS was SR 4.5, then the fair value of the stock should be around SR 4.5 X 15 = SR 67.5. The same method can be used with Price to book value and price to sales ratios. There are also other useful multiples like EV/EBITDA (where EV is the Enterprise Value and EBIDTDA is Earnings before Interest, Tax, Depreciation and Amortization) and Price/Operating Cash flow that can be derived with complete financial statements.


Book Value Approach

Assets are recorded in the books at cost. This approach takes depreciated historical cost into account when valuing the company. It assumes that all the assets are disposed at the book value and the value of the firm is equivalent to sales proceeds less all liabilities including the preferred stock. However, this valuation is not very representative of the value of the firm as the market value of assets may be different from the book value. Moreover, it ignores the future earnings potential of the business.


Liquidation Value Approach

In this approach it is assumed that all assets are disposed at market value, the value of the company is equal to the remaining sum after settling all liabilities including the preferred stock. This value is more realistic than book value as the assets are fairly valued at market prices. However the major weakness in this model is that it ignores totally, the earnings potential of the company.