Revise Lecture 27. Business Valuations. What is intrinsic value? What is intrinsic value analysis? How common shares are valuated?. Business Valuations. Intrinsic Value A share’s intrinsic value is the price that is justified for it when the primary factors of value are considered.
Intrinsic Value Analysis
Intrinsic value analysis is the process of comparing the real worth of a share with the current market price or proposed purchase price.
The primary goal of intrinsic value analysis is to locate clearly undervalued or clearly overvalued firms or shares.
There are three approaches for valuing common shares?
A firm is said to be growing internally when it increases sales and profits by expanding its own operations.
It may purchase new machinery to increase its capacity to produce existing products or it may purchase machinery and train its sales force to produce and sell a new product.
In either case, management is committing itself to an expansion of existing activities.
In one case, the firm seeks a larger volume of sales with current products.
In the other, the firm begins to expand into new product areas and markets
Internal growth may be funded from sources inside or outside the firm. Internal sources include retained earnings and the funds shielded by depreciation and other noncash expenses.
If outside funds are sought, the firm may offer debt or equity shares to raise money.
External growth occurs when a firm takes over the operations of another firm. The acquiring firm may purchase the assets or stock or may combine with the second firm.
Since the second company has sales and assets of its own, the first company does not have to generate the new business from scratch.
External growth offers a number of advantages over internal growth;
Taking over the operations of another firm is the quickest path to growth. The acquiring firm eliminates the lead time for ordering and installing machinery, producing the product, and achieving sales in the marketplace.
2. Immediate Cash Inflows:
Since the firm is taking over an operating business, it will realize almost immediate inflows as customers receive their goods and pay for them.
These inflows would not be received if the firm had to begin new construction of facilities and then the production of goods.
3. Reduction of Risk
Whenever a firm enters a new market, it takes a calculated risk. Will the new products sell in sufficient volume to be profitable? Will the firm’s managers be able to make the proper decisions in the new operating environment?
The acquired firm will be operating, perhaps successfully, in an environment familiar to its managers. By entering a field through an established and experienced management, we reduce the chances for failure.
Entering a new market involves a number of start-up cost. A start-up cost is an initial expense incurred when a firm begins a new operation. It may be the cost of training a new sales force or paying the legal fees required for the new activity. Frequently, these costs can held to a minimum by purchasing an operating firm.
Example: It would be less expensive to take over a firm with a strong marketing force than to have to compete with the marketing force by building one’s own marketing department. The reduction of start-up costs offers economies from external growth
A number of reasons may be offered as to why firm’s seek to grow. Among the more important ones are the following;
Most firms recognize that diversifying their operations reduces the risk of failure. If a firm produces a single product, it is subject to the market pressures on the product.
If a competitor introduces an improved version of the product or a substitute for it, the firm may no longer be able to compete in the marketplace.
Since demand and competitive factors are difficult to predict, the only certain safeguard against a market disaster is diversification.
If the firm is operating in a variety of markets with many products, it can cope better with a cutback in a single product or market
When a firm is able to achieve a larger volume of sales, it becomes more stable than firms with smaller volumes of sales. The high level of revenues allows production economies and other cost-saving techniques, which allow a high margin of profit on sales.
Also, the high sales level allows a deep penetration of most of the firm’s markets. If a firm dominates a market, it is better able to withstand pressure and problems in the market.
3. Operating Economies
Large firms are able to achieve economies not available to small firms.
As an example, Procter & Gamble is a large producer and seller of nondurable consumer products such as soaps, paper products and food items.
4. Profits from Turnaround Situation
When a firm is operating below its potential profit levels, a new management could remove inefficiencies and solve problems, resulting in a dramatic rise in profits.
Such a firm offers a turnaround situation. When a firm is doing poorly but has strong potential for improvement, the firm will become the target of acquiring firms.