Author: Jim Riley Last updated: Sunday 23 September, 2012
If an important financial objective of a business is to maximise the value of the business, how can this be achieved? The answer lies in the different approaches to valuing a business.
There are two broad approaches to valuing a business:
(1) Break-up Basis: this method of valuing a business is only of interest when the business is threatened with liquidation, or when management are considering selling off individual assets to raise cash;
(2) Market Value Basis: The market value of a business is the price at which buyers and sellers will trade shareholdings in a company. This method of valuation is most relevant to the financial objectives of a business.
When shares are traded on a recognised stock market, such as the Stock Exchange, the market value of a business can be measured by the share price.
When shares are held in a private company, and are not traded on any stock market, there is no easy way to measure value. It becomes a subjective judgement on behalf of both the buyer and seller about factors such as:
• Future profits and cash flows that the buyer can expect the business to deliver;
• The “intangible” quality of the business, including the quality of management, products etc.
• The strategic position of the business – e.g. is it a market leader?
Nevertheless, the objective remains for management – to maximise the wealth of their ordinary shareholders.
The wealth of shareholders in a company comes from:
• Dividends received:
• Market value of the shares
A shareholders’ return on investment is obtained from:
• Dividends received;
• Capital gains from increases in the market value of his or her shares
If shares in a business are traded on a stock market, the wealth of shareholders is increased when the share price goes up. The share price will go up when the business makes additional profits (or is expected by the market to do so) which it pays out as dividends or re-invests in the business to achieve future profit growth. However, to increase the share price, the business should try to increase profits without taking business and financial risks which worry shareholders (thereby increasing their required rate of return).