9+ Unique Approaches to Valuation
Determining the true value of a company is not always straightforward.
Beyond the mainstream methodologies are various unique approaches to valuation, each offering a distinct perspective on a company’s worth.
We look at techniques that may not be as widely recognized, but are equally viable in the right context and application.
From the classic fundamentals-based valuation, which is based on hard accounting data, to the Graham Number that provides a safety margin for defensive investors/traders, we provide a broad spectrum of unique valuation methodologies to consider.
Some methods, like the T-Model, offer simplicity, while others, such as the excess earnings method, cater specifically to businesses with higher levels of intangible assets.
Key Takeaways – Unique Approaches to Valuation
- Diversity in Valuation: Beyond traditional fundamental approaches (e.g., DCF, comps), there are various unique valuation methods, each tailored to specific business contexts.
- Simplicity to Specificity: From the straightforward T-Model to the intangible-asset focused excess earnings method, the range of valuation tools caters to varied needs.
- Past vs. Future: While historical earnings valuation leans on past performance, future maintainable earnings focus on projected growth, highlighting the importance of context. Situations vary widely, requiring different approaches to valuation.
Fundamentals-Based Valuation
The fundamentals-based approach to valuation is a traditional and commonly utilized method.
It relies heavily on accounting information such as what’s reported on financial statements.
These statements provide an overview of a company’s financial position, allowing traders/investors to make educated assessments about the company’s worth.
T-Model
The T-Model is a framework designed to analyze a company’s value from two perspectives: operating and non-operating components.
The operating component represents the firm’s business activities while the non-operating component encompasses financial activities.
Residual Income Valuation
Residual income valuation is a method of equity valuation that revolves around the concept of economic profit or economic value added (EVA).
Essentially, it gives a valuation based on the premise that the value of a company is equal to its book value plus the present value of future residual incomes, discounted at the appropriate cost of equity.
Residual income, in this context, refers to the economic profit the firm earns over the required return on its equity capital.
For example, if a company is funded with a 7% cost of equity it needs to earn net income margins at least on par with that.
Clean Surplus Accounting
Clean surplus accounting is often used when traditional valuation models are unsuitable, often for capital budgeting purposes.
This method involves only two inputs: return on equity and cost of equity, which simplifies the valuation process significantly.
The principle behind it is that the change in a company’s book value in any given period, excluding any new equity issues, is equal to the company’s net income minus the equity dividends.
Net Asset Value Method
The Net Asset Value (NAV) method is a technique often used to value a company with a simple business model.
This valuation approach considers the net value of the company’s assets, subtracting liabilities to determine the company’s inherent value.
It’s essentially like a net worth calculation.
This method is useful for investment or real estate companies where the value is primarily determined by the assets held.
Excess Earnings Method
The excess earnings method is suitable for valuing businesses with substantial intangible assets (e.g., brand name, goodwill).
This method determines a business’s value by adding the value of tangible assets and the present value of excess earnings.
Excess earnings are those that exceed a specified reasonable return on the company’s tangible assets.
Historical Earnings Valuation
Historical earnings valuation is an approach that bases a company’s value on its past financial performance.
This approach assumes that past performance is an accurate indicator of future performance.
Although it’s relatively simple, it can be beneficial for businesses that have demonstrated steady and predictable growth over time.
This is generally a reasonable approach for mature companies that tend to produce consistent levels of cash flow over time.
It is generally not the best approach for fast-growing companies or those without earnings, which brings us to the next valuation approach…
Future Maintainable Earnings Valuation
In contrast to the historical earnings valuation, the future maintainable earnings valuation focuses on projecting future earnings.
This method is particularly useful for growth companies that are expected to increase their earnings significantly in the future.
It involves estimating the maintainable earnings of a company and applying an appropriate capitalization rate.
Graham Number
The Graham Number, named after Benjamin Graham, one of the initial popularizers of value investing, is a conservative method of valuation.
It involves calculating a company’s fair value based on its earnings per share (EPS) and book value per share (BVPS) – i.e., earnings, which are based on its assets.
The Graham Number is considered an upper limit to the price a defensive investor should pay for the stock, providing a margin of safety.
Conclusion
Each of these unique valuation approaches has its unique perspective and application.
Understanding the context and situation of a business can help investors and analysts select the most appropriate method.
As with any financial model, these approaches have their pros and cons and should be used in conjunction with other valuation methods to triangulate when appropriate.