Analysis and Comparison of Company Valuation Methods in Germany

Based on the Discounted Cash Flow Approach and the German Income Approach

Bachelor Thesis 2015 102 Pages

Business economics - Business Management, Corporate Governance


Table of Contents

List of Figures

List of Tables

List of Abbreviations

List of Symbols

List of Equations

1 Introduction
1.1 Scope and Objectives of this Thesis
1.2 Structure of the Thesis

2 Theoretical Foundation of Valuation
2.1 Concept of Company Valuation
2.2 The Theory of Value
2.3 Reasons and Purposes of Valuation
2.4 Overview about relevant Valuation Approaches

3 Analysis of the German Income Approach
3.1 Concept of the German Income Approach
3.2 Analysis and Adjustment of Historical Data
3.3 Determination and Forecast of Financial Surpluses
3.4 Determination of Cost of Equity under Consideration of a Risk Factor
3.4.1 Determination of a Risk-free Base Rate
3.4.2 Estimation of a Market Risk Premium under Consideration of the BetaFactor
3.4.3 Application of Tax-CAPM for Risk Premium Calculation
3.5 The Treatment of Non-Operating Assets

4 Analysis of the Discounted Cash Flow Approach
4.1 Concept of the Discounted Cash Flow Approach
4.2 Weighted Average Cost of Capital Approach
4.2.1 WACC Approach Based on Free Cash Flows
4.2.2 WACC Approach Based on Total Cash Flows
4.2.3 Concept of Weighted Average Cost of Capital
4.2.4 Determination of the Cost of Debt
4.2.5 Estimating the Cost of Equity
4.3 Adjusted Present Value Approach
4.4 Equity Approach

5 Comparison of the German Income Approach and the Discounted Cash Flow Approach
5.1 Overview and Explanations of Similarities and Differences
5.2 Numerical Examples
5.2.1 Assumptions
5.2.2 Calculation Example According to the WACC Approach Based on Free Cash Flows
5.2.3 Calculation Example According to the WACC Approach Based on Total Cash Flows
5.2.4 Calculation Example According to the Equity Approach
5.2.5 Calculation Example According to the APV Approach
5.2.6 Calculation Example According to the EWV Approach
5.3 The Low Base Rate and Its Consequences for Company Valuation
5.3.1 Recent Development of Government Bond Yields
5.3.2 Consequences for Company Valuation
5.3.3 Reactions to Increasing Company Values
5.4 Recommendations

6 Conclusion


Online Sources


List of Figures

Figure 1: Growth and ROIC Drive Value

Figure 2: Characteristics of Valuation Concepts

Figure 3: Functions of Company Valuation

Figure 4: Overview about Valuation Approaches

Figure 5: Component of the German Income Approach

Figure 6: Investment Opportunities

Figure 7: Effects of Portfolio Diversification

Figure 8: Overview about DCF Valuation Methods

Figure 9: Cost of Equity at Different Debt Levels

Figure 10: European Central Bank’s Refinancing Interest Rate Development

Figure 11: Comparison of AAA-rated Euro Area Yield Curves

Figure 12: Transaction Cost in Germany Volume in bn. Euro

Figure 13: Development of the Risk Premium in Comparison the Risk-Free Base Rate and the Yield on Shares

List of Tables

Table 1: Definition of Net Income

Table 2: Determination of Cost of Equity According to the CAPM Model

Table 3: Cost of Equity Determination According to the Tax-CAPM Model

Table 4: Calculation of the Free Cash Flow

Table 5: Calculation of the Total Cash Flow

Table 6: Calculation of Flow to Equity

Table 7: Comparison of the German Income Approach and the Discounted Cash Flow Approach

Table 8: Calculation Example According to the FCF Approach

Table 9: Determination of Income Taxes on Firm Level

Table 10: Determination of Equity Value According to the TCF Approach

Table 11: Determination of Equity Value According to the FTE Approach

Table 12: Determination of Financial Components According to the APV Approach

Table 13: Determination of Equity Value According to the APV Approach

Table 14: Determination of Equity Value According to the EWV Approach

Table 15: Determination of Equity Value before the Financial Crisis

List of Abbreviations

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List of Symbols

illustration not visible in this excerpt

List of Equations

( 1 ) Present Value Formula

( 2 ) Present Value of Equity in Detailled Planning Phase (EWV Approach)

( 3 ) Terminal Value (EWV Approach)

( 4 ) Present Value of Equity ± Two Phase Model (EWV Approach)

( 5 ) Present Value of Equity ± Consideration of a Growth Factor (EWV Approach) .

( 6 ) CAPM Formula

( 7 ) Beta-Factor

( 8 ) Unlevered Beta-Factor

( 9 ) Relevered Beta-Factor

( 10 ) Tax-CAPM Formula

( 11 ) Present Value of Non-Operating Assets

( 12 ) Present Value of Equity Including Non-Operating Assets (EWV Approach)

( 13 ) WACC Formula (FCF Approach)

( 14 ) Total Capital Value (FCF Approach)

( 15 ) Terminal Value - Consideration of a Growth Factor (FCF Approach)

( 16 ) Present Value of Debt

( 17 ) WACC Formula (TCF Approach)

( 18 ) Total Capital Value (TCF Approach)

( 19 ) Tax Shield

( 20 ) Present Value of Equity (APV Approach)

( 21 ) Unlevered Cost of Equity

( 22 ) Cost of Equity Determination ± Example 1

( 23 ) WACC Determination ± Example 1

( 24 ) Present Value of Equity Determination ± Example 1

( 25 ) WACC Determination ± Example 2

List of Equations VIII

( 26 ) Unlevered Cost of Equity Determination ± Example 4

( 27 ) Cost of Equity Determination - Increased Risk-Less Base Rate

( 28 ) WACC Determination ± Based on Increased Cost of Equity

1 Introduction

1.1 Scope and Objectives of this Thesis

Estimating the value of a company is an important pre-requisite for optimal decisionmaking in upper management, for example when a company prepares to acquire another firm. The significance of valuation is rooted in the fundamental difference between price and value. Both can fall apart, as buyers and sellers individually attempt to take advantage of a sale or purchase transaction. The potential buyer considers the value of a company to be the upper limit for the price that he is willing to pay, whereas the seller considers the value of the same company to be the lower limit for the price that he is willing to receive. Not surprisingly, price and value of a company can differ significantly, and this is where company valuation comes into play.

In the late 1980s, a period characterized by increasing internationalization and consolidation due to various liberalization measures, a large number of mergers and acquisitions took place, including many hostile takeovers.1 One of the reasons for this takeover wave was that investors increasingly attempted to identify companies with so-called value gaps, i.e. differences between a company’s value and its expected stock value. In order to close this gap, methods of how to valuate a company became more important to companies, investors as well as national fiscal authorities. In this context, corporate shareholders have come to be more demanding on creating a sustainable return for shareholders and maximizing the value of a company than strictly maximizing profit, a strategy which had dominated before. The shareholder value approach introduced by Alfred Rappaport included a new orientation on generating maximized returns to shareholders by dividend distribution and an increase in stock prices of the company.2 Since then, the importance and practice of valuation has increased constantly.3 Investors need to know both how much return they will receive for their invested capital. and what the alternative investment opportunities would be.

Until today, a large number of valuation approaches and methods have been invented by researchers and practitioners. Although this has given companies a larger freedom to carry out valuations, it has also led to more complexity, and a challenge to find the ‘best’ method, because as a matter of fact, some approaches are more appropriate than others - depending on the company, the available information and the concrete objective.

The most commonly used types of approaches are the cost approach, the market approach and the income approach. The ‘Institute of Public Auditors in Germany’ (IDW), a private organization representing the profession of public auditors or auditor firms, publishes requirements providing the framework for business valuation based on applicable law in Germany.4 These requirements, known as the ‘principles for the performance of business valuation’ (in short: IDW S 1), contain primary principles and suggestions of the IDW for valuation. Although certain contractual or legal situations require specific approaches for estimating a firm’s value, basically appraisers have a substantial degree of freedom to choose the approach which they think fits best to their purpose of their underlying valuation.

The IDW S 1 considers two approaches to be appropriate for valuation, both of which are sub-categories of the income approach. The first one is the German income approach (Ertragswertverfahren, EWV), which is considered to be the classical approach in Germany. However, since the passing of the revised version of IDW S 1 in the year 2000 there is a second valuation approach which fulfills the requirements of the IDW: the discounted cash flow (DCF) approach. The DCF approach, originating from the Anglo-American region, is internationally well accepted, widely used and has become especially important for international transactions. Both approaches follow the principle that the value of a company does not equal the value from its balance sheet but should be obtained from making expectations about future transactions. Both approaches also highlight the fact that capital today is worth more than capital in a future point in time and that discounting future incomes or cash flows to the present allows to compare values of different points in time. Thus, both approaches explicitly take into consideration the time value of money and the riskiness of future transactions. However, the approaches also differ when it comes to the various input variables, such as the discount rate and the value to be discounted.

Against this background, this thesis aims at pointing out the historical and theoretical background of valuation as well as reasons for valuation in the first place and in a secIntroduction 3 ond step comparing the two most commonly used valuation approaches in Germany, the EWV and the DCF approach. Since the overall calculation method is equal in both approaches, this thesis concentrates on the similarities and in particular the differences between both approaches and their impact on a company’s value. Moreover, this thesis will point out which aspects influence a company’s value and in what way. The capital asset pricing model (CAPM) will be introduced in this context because both approaches rely on it to determine an appropriate risk factor which is considered in the discounting process.

Since the beginning of the financial crisis in 2008 government bond yields in the European Union (EU) and especially in Germany have decreased constantly and are currently on an historical low of about 0.076 percent in Germany.5 As the CAPM uses government bond yields as a proxy the valuation result is influenced by these decreasing yields. Therefore, this thesis also discusses the effects and potential issues of decreasing government bond yields on a company’s value. Finally, the advantages and disadvantages of the DCF and the EWV approach are assessed in order to clarify whether the DCF approach represents a more appropriate valuation approach than the EWV approach or whether it is merely an adequate alternative to it.

1.2 Structure of the Thesis

The overall structure of the thesis takes the form of six chapters, including this introductory chapter. Chapter 2 introduces the reader to the theory of valuation by explaining the differences between an objective, a subjective and an objectified value and separates three types of valuation approaches. Moreover, this chapter aims to exemplify the reasons for valuation. Chapter 3 analyses the German income approach in particular regarding its definition of net income and the discount rate. It also explains the CAPM in more detail and points out its relevance for the valuation process. Chapter 4 describes the four subcategories of the DCF approach, in particular regarding their discountable cash flows and their discount rates. Based on a number of relevant criteria, Chapter 5 provides a direct comparison of both approaches and derives their similarities and differences. Various numerical examples are given to illustrate the impact on the valuation process. Decreasing government bond yields since the financial crisis and its influences on company valuation are also discussed in chapter 5. Chapter 6 draws the conclusion of this thesis.

2 Theoretical Foundation of Valuation

The theory of company valuation is founded in the determination of a company’s value. What seems simple at first glance requires more explanations because the term ‘value’ is not self-explanatory. This chapter introduces the theory of valuation by giving an overview about the overall concept, the historical development and about different valuation approaches that exist.

2.1 Concept of Company Valuation

The theoretical background for company valuation is assigned to the area of corporate finance. Corporate finance focusses on the analytical framework for financial decision making as well as planning, organizing and controlling of all financial activities in a company, such as the acquisition or allocation of funds.

Since the seminal publication ‘Creating Shareholder Value’ by Alfred Rappaport in 1986, the shareholder value concept has gained widespread acceptance. Shareholder value describes the return of shareholders that exceeds the required return to equity that they would earn with an alternative investment. In other words, shareholder value is created by a company that outperforms the expectations.6 A stockholder considers his stocks as an investment for the purpose of generation incomes. Thus, a valuation approach that follows the shareholder value principle assesses companies on their ability of generating future incomes. According to Hostettler, the shareholder value represents the all prospective net income of the investor discounted on the present value.7 Two principles deserve special attention here: The closing date and the time value of money. The closing date influences the valuation processes because unpredictable events can happen anywhere and anytime and thus change the value of the asset from day to day. Consequently, the valuation date depicts the concrete point of time where the company is valued and every information or changes of the company which is available after this point of time is not considered in the valuation process. The determination of the valuation date can either base on a contractual basis or on legal regulations.8 The ‘time value of money’ plays a major role for financial decisions. Almost decision which is taken by managers today, influences the future wealth of the company for instance through investment decisions.9

In an efficient market10 the shareholder value equals the equity market value11 for publicly traded companies because an efficient market is characterized through stock prices that reflect all available information. Thus, a change in market prices can only occur if new information arises. However, if the market is not efficient, stocks can be over- or undervalued and the shareholder value can be calculated as part of a fundamental equity analysis based on company data. Besides this, the shareholder value may serve as an orientation of business principles, as the ability of a company’s management to increase earnings, dividends or stock prices reflects the value which is delivered to shareholders.12 The strong focus on shareholder value also mirrors the fact that a number of operating figures, such as the Return on Investment (ROI) or Return on Equity (ROE), have been subject to criticism since several decades. One aspect that has been criticized is that many managers in companies are short-term oriented and prefer a risk-averse earnings policy. The reason for this behavior is founded in a strict short-term orientation on sales and profit, which often has led incentives to underinvest or generally invest unprofitable in order to increase the ROI.13

Besides the failure of companies to take optimal investment decisions, another major point of criticism is that managers and shareholders sometimes pursue diverging interests. This can happen because the information which managers and shareholders receive is often asymmetric. The problem of different self-interests and asymmetric information has been described by the principal agent theory.14 In order to lower the influences of such distorting actions of the management on shareholders, several measures have been integrated along with the shareholder value concept. These factors, such as a large ownership position in the company or a compensation tied to the shareholder return perforV. H., Kunowski, S. (2012), p. 293. mance, induce managers to adopt a shareholder orientation in order to strive for an optimum performance of the company in connection with a maximization of the company value to ensure a long-term continued existence of the company.

In order to understand what valuation means and how it works, it is important to define the term ‘value’. In the context of business valuation value describes the particular benefit an investor gains by holding in investment.15 The value depicts the potential price of a company. At this point it is essential to point out the difference between price and value, because this difference is the reason why transactions between investors occur: As price and value of a company can fall apart, a buyer and a seller both attempt to take advantage of a sale or a purchase transaction.16 The potential buyer considers the value of a company to be the upper limit that he is willing to pay for the company. In contrast, the potential seller considers the value of the same company to be the lower limit that he is willing to receive for selling the company. In a nutshell, the value represents the marginal prices of buyers or sellers which simultaneously constitute one potential subjective value for the company at a specific point of time. In contrast, the objective price depicts the monetary unit on which the two parties have agreed upon after their negotiations.17

Companies are able to create value by finding profitable investments. Whether an investment is profitable or not depends on the rates of return on their future cash flows which have to exceed their cost of capital in order to create value. As Figure 1 illustrates, the creation of value is driven by a mixture of revenue growth and Return on Invested Capital (ROIC). The sum of both represents the cash flow, from which the cost of capital have to be deducted.18

illustration not visible in this excerpt

Figure 1: Growth and ROIC Drive Value

Source: Koller, T. et al. (2010), p. 18.

With respect to the long term aim of maximizing the shareholder value these principles help managers to compare alternative investments in order to decide which investment will create a net present value greater than zero.19 For German companies, there are certain requirements relevant for business valuation, which have been published by the IDW. According to the IDW the value of a company is derived solely from its earning capacity, meaning the ability to produce financial surpluses for the shareholders.20

The term ‘valuation’ describes the process of allocating a value to an investment.21 Valuation combines risk and return in order to estimate the price at which an asset would be sold or a liability transferred between market participants in an orderly transaction and at a specific point of time under current market conditions (fair value).22

2.2 The Theory of Value

The theory of value and its underlying valuation methods have a long history and have changed several times over the course of time.23 One can distinguish between three different phases:

1. Theory of objective value (until 1960s)
2. Theory of subjective value (1960s to 1970s)
3. Theory of functional value (starting from the 1970s)

Until the 1960s, the theory of objective value dominated company valuation. According to this theory, there is only one company value which holds for all investors,24 illustrating that there is one ‘true’ price irrespective of any personal preferences, opportunities or reasons for valuation.25 The basic idea behind this valuation theory is the creation of one unbiased value to overcome conflicts of interests between parties. The objective value represents a value which is inseparably connected to the company and which simultaneously should express the potential of the company which is theoretically available for everybody. It assumes that the company continues its current business concept and considers all realistic expectations about the future which arise from market conditions or other factors around the company.26 As the resulting value is identical for all valuation subjects it represents the market price.27 The objective value is based on the assumption of a rational investor because under the same expectations the value equals for all investors. Nevertheless, this theory cannot explain why potential prices vary depending on the type of investor and the situation of valuation.28 In order to defend the objective theory it must be assumed that the objective value only depicts the negotiation basis and considers personal and strategic preferences of investors in a second step, such as synergy effects.29 One variant of the objective value is the objectified value which is of particular importance and represents a kind of stand-alone value which does not consider any planned but not realized investments and strategy changes and does not count for synergy effects. Therefore, the value is similar the value from the perspective of the potential buyers but differs from that of the potential seller.30

The theory of subjective value was established during the mid-1960s.31 It builds on the criticism raised above and explicitly assumes that any value is highly subjective. Personal interests, preferences, action alternatives or the extent of risk aversion of each investor influences the value of a company.32 It follows that every potential investor has his own subjective value. Thus, there are as many values as valuations have been done.

Determining a subjective company value explicitly considers such interests, targets and preferences, allowing a value to differ substantially from the market price. All data used for the value determination are oriented towards one subjective investor and therefore reflect the value an investor would at maximum pay for a company. In other words it represents the marginal price that a potential buyer is willing to pay or, vice versa, the minimum price that a potential seller requires for the business. However, one major point of criticism of this theory is that a third party is hardly able to reconstruct the appraisal process because of the one-sidedness of the value creation which can lead to misunderstandings. Moreover, according to this theory the negotiation process between the two parties would not always allow a successful arbitration as they usually pursue conflicting goals.33

In the 1970s the functional theory of value established as a kind of resolution between the objective and subjective theory of value. It goes back to the Cologne School (‘Kölner Schule’) and includes, among others, research from Münstermann, Jaensch, Engels, Buss von Colbe, Sieben und Matschke.34 It is based on the assumption that a value depends on the purpose of valuation, such as the objective to realize certain tax savings or to calculate a disposal value.35 The purpose is connected to a specific function and considers the decision field of each company owner or potential investor. In concrete terms, the value does not only differ between each investor and company owner but moreover it depends on respective objectives of the valuation and is thus purposeoriented.36 The theory of functional value will be explained in chapter 2.3 in more detail. The following figure illustrates the connection between subjective, objective and functional theory of value:

illustration not visible in this excerpt

Figure 2: Characteristics of Valuation Concepts

Source: Own representation based on Matschke, M. J., et al. (2010), p. 8.

2.3 Reasons and Purposes of Valuation

As shown in the previous chapter 2.2 the value of a company can also depend on the purpose of valuation, which in turn is determined by a specific motivation.37 There are several approaches in literature for systemizing the reasons of valuation.38 The IDW distinguish between three reasons for valuation. The first reason describes a voluntary company valuation as part of entrepreneurial initiatives, such as the purchase and sale of a company or a part of the company, mergers & acquisitions, IPO, management buy outs or new capital injection. Among these reasons, the sale and purchase of a company is the most frequent.39 The second reason depicts a valuation which is regularly done for external accounting, such as purchase price allocation or impairment tests after International Financial Reporting Standards (IFRS), United States Generally Accepted Accounting Principles (US-GAAP) or Handelsgesetzbuch (HGB) or for tax purpose for group-internal restructuring. The third reason represents a company valuation which is based on legal or contractual regulations especially stock corporation regulations for the conclusion of enterprise agreements or squeeze outs.40

The proponents of the functional valuation theory derive a variety of purposes. The functional valuation theory distinguishes between three main and three minor functions (see Figure 3), which are assigned to these purposes. The main functions represent valuations which target a change of ownership and are divided into decision function, mediation function and argumentation function. The minor functions are divided into information function, contract stipulation function and tax-assessment function.41 Minor functions represent reasons for valuations which are in particular restricted by contractual or legal regulations. Moreover, minor functions are not combined with a change of ownership. In contrast, the Cologne School, the IDW lists the function of a neutral appraiser but negated the argumentation function.42

illustration not visible in this excerpt

Figure 3: Functions of Company Valuation

Source: Based on Peemöller, V. H. (2012), pp. 7-8, IDW (2008), Para. 12.

The three main functions are explained in the following:

1. The decision function of company valuation provides assistance for buyers and seller for determining marginal prices43 and subjective decision values. The seller of a company wants to know which minimum price he has to realize to avoid being in an inferior position compared to alternative investments. On the other side, the buyer wants to determine the maximum price he should pay for the company in order to ensure that an alternative and comparable investment will not yield a higher return on the invested capital.44 The knowledge of marginal prices is an essential requirement for negotiations. The function of the appraiser is the preparation of the decision process for the decision maker. He determines the positive or negative contribution that the sale or purchase would have to the target achievement and compares it to alternative investment opportunities. Subjective preferences and future plans as well as alternative investment opportunities lead to different marginal prices for buyer and seller. Besides marginal prices also non-monetary terms, such as the demand for ongoing cooperation within the management, supply and purchase obligations, are taken into account when determining the purchase price. Therefore, marginal prices represent the subjective decision values and show the negotiating range which is highly essential for both parties. The decision function does not only apply for sale and purchase of companies but everywhere where marginal prices of decision values a necessary.45 Establishing a best case scenario for the respective party belongs to the main tasks of this function.46

2. In case the two parties are not able to agree, an independent appraiser takes the mediation function in order to balance the different preferences of buyer and seller fairly and to find an acceptable price between their subjective notions.47 The appraiser needs to have knowledge about party specific interests so that he is able to consider a resolution of the conflict. The range of agreement is limited through the decision values of both parties. Thus, the result of the valuation has to lie within the range of marginal prices and it is necessary that the appraiser has knowledge about the marginal prices of both parties. The result is called arbitration value and does not reflect a general and objective value but a value which considers the specific situation of both parties. This appropriate and fair price should allow improving the economic situation of both parties.48

3. The argumentation function is an instrument which is used to give arguments for

negotiations in order to improve the negotiation position of the arguing party. Arguments, such as little equity capital or synergistic effects are used to raise the sales price and realize a price that is as close as possible to the decision value. The argumentation value has to be flexible to allow for a negotiating range. One important aspect of this function is finding an appropriate buyer meaning the buyer who is also able to improve his economic situation with the given sale price.49

The IDW negates the argumentation function for auditors because it is not in line with their principles. These principles require an objective valuation and therefore the IDW has worked out the function of the neutral appraiser which represents the typical professional task of auditors. The neutral appraiser should estimate an objectified value of the company. This value is a standard future value which results from the company’s continued existence under an unchanged business concept and realistic future expectation regarding its opportunities and threats on the market as well as its financial opportuniTheoretical Foundation of Valuation 15

ties. There has been quite some debate in literature on this aspect. In particular, critics argue that a value that ignores personal development opportunities of potential investors cannot be considered as neutral.50

In contrast to the main functions which are geared to valuation reasons comprising a potential or actual change in ownership, the minor functions consider reasons which do not lead to a change in ownership but usually combined with legal or contractual purposes.51 The three most common minor functions are the following:

1. The information function means that a company valuation should provide information about the opportunity of the company to create future income for investors of a company.52 While the valuation principles of accounting represent the basis for information provision, their aim is to make a statement about the value of a company derived from its balance.53 The valuation process is shaped significantly by the principles of accounting, such as the caution principle to protect shareholders or creditors.54

2. The second minor function is the tax-assessment function. The core of this function is to build a basis for tax calculation and to consider the objectiveness of a valuation by the principles of equitable taxation and legal certainty dependent on rules and laws. Therefore, depending on the underlying law valuation results may distinguish.55

3. The contract stipulation function represents the third minor function. Examples include commercial agreements that contain performance fees or compensation clauses for withdrawing shareholders.56 This function constitutes a preventive character in order to avoid conflict situations which arise through incorrect or missing formulations in commercial agreements.57

The criticism of the functional business theory is based on the fact that main and minor functions cannot be absolutely separated because the viewpoint of the observer differs.

Moreover, a concrete classification of the various objectives is difficult as the function of the neutral appraiser according to the IDW and the argumentation function shows. In a nutshell, the functional valuation theory does not represent an equilibrium theory but one that depends on decisions and interpersonal conflicts.58 The economic situation of a party depends on its objectives and opportunities for actions. The subjective theory of value becomes comprehensible through the classification of the functional theory. Since more than 40 years the functional theory of value serves as the basis for business valuation in Germany.59

In order to summarize the results of this chapter it should be noted that the reason for valuation can be separated into contractual or legal reasons and moreover reasons which are combined with entrepreneurship such as the sale or purchase of a company. Depending on the reason the appraiser will assume a decision function a function of a neutral appraiser or a mediation function in order to determine either a subjective or objectified company value or an arbitration value.

2.4 Overview about relevant Valuation Approaches

In theory and practice there are different valuation methods which accomplish the specific purpose of the valuation.60 Legal and contractual requirements play a significant role for the choice of the valuation method. Moreover, in its principles for business valuation the IDW suggest using the EWV or the DCF approach for valuation as they are considered to be the most appropriate method according to the IDW.61 While legally motivated valuation have to follow a predefined valuation model, non-legally motivated models are not limited in their choice of valuation model and even the suggestions of the IDW are no obligations.62 During the last decades there were several valuation approaches which have been established. One reason for this could be the support for information systems and databased which makes more information available. Besides the purpose also national circumstances, the industry of the company as well as its interests have influences on the dissemination of the different approaches.63 IFRS categorized valuation methods into three types of valuation techniques with respect to the valuation process and the source of input: cost approach (or asset), market approach and income approach.64 Within each approach there are several of methods analysts can use (see Figure 4).65

illustration not visible in this excerpt

Figure 4: Overview about Valuation Approaches

Source: Own representation based on Mandl, G., Rabel, K. (2012), pp. 53 ff.; Hitchner, J. R. (2011), p. 8.

The cost approach describes a general way of determining the net asset value of a business by using the book basis balance sheet of a company which is as close as possible to the valuation date. It calculates the value of a business by using the value of all tangible and intangible assets and subtracts the value of all liabilities.66 The valuation is performed based on the costs of reproduce existing improvements based on the principle of substitution. The reproduction value calculates the costs which are necessary to build the exact same business at the same location a second time. It is based on replacement values which are calculated with the current market price of all assets.67 A significant drawback of this approach is that intangible assets cannot be considered as they are not included in the balance sheet. The only opportunity would be an individual determination of the value of these assets, which would, however, reduce the validity of the calculated value. Moreover, this approach does not consider synergy effects, i.e. the surplus value created with the assets in possession. Furthermore, the reproduction value is backward-looking and does not consider any future cash flows of the business.68 Therefore, this valuation approach is often used for (family-owned) limited partnerships, small practices and certain pass through entities as it is relatively simple to apply.69

The market approach estimates the value of a company or asset by mark up on current stock prices or other realized market prices. This approach is based on the economic principle of substitution as a rational buyer would not pay more for a company than the current price for a comparable one.70 For publicly traded companies the determination of the value is performed directly on the basis of the equity market value. Non-publicly traded companies are valued by using comparable companies which are publicly traded as these companies are required to publish annual financial reports which can be used for finding performance indicators (Similar Public Company Method) or using the market price of purchases or sales made in the recent past (Recent Acquisition Method).71 Comparable companies or assets can either be one which operates in the same industry or which has the same size in the same region etc. The market value of comparable companies will be set against performance indicators such as sales, profit for the period or cash flows. The multiple so obtained shall be multiplied with the business to be valued. In practice, Earnings before Interests and Taxes (EBIT) or Earnings before Interests, Taxes, Depreciation and Amortization (EBITDA) belong to the most popular multiples.72 The basic idea is that under the assumption of an identical framework of the companies including uncertainties as well as expectations the company value should be identical. However, one critical aspect of this approach is that it is difficult to find a similar company and almost impossible to find one which shows absolutely the same conditions. Thus, a calculation which is based on comparables always contains a certain degree of impreciseness and is hard to perform although the calculation method itself is easily to implement.73 Since the implementation of IDW S 1 in 2000, the IDW accepts the market approach but only for examination and feasibility studies.74

The DCF approach as well as the EWV approach belong to the income approach. Both

approaches estimate the value of a company or an asset by computing the present value of all future incomes which the company is expected to generate and able to distribute to the investors.75 These future cash flows are discounted on the present value of the valuation date using a discounted rate.76 This discount rate represents the required return of investors and depicts a kind of opportunity cost because investors required a return which they would receive for a comparable investment on the market. Therefore, the discount rate is an objective capital market oriented rate. Income approaches compare different cash flows which occur at various points in time. In order to ensure a rational and appropriate comparison, the appraiser has to consider the aspect of time because cash inflows are worth the less the further they occur in the future. Vice versa, cash outflows are more debiting the closer the date of payments comes. With reference to this the calculation of the present value enables the appraiser to compare cash flows which differ in their amount, their occurrence and duration. The present value is the most flexible declaration of value and only describes the value of an investment for a specific point of time.77 The income approach represents a total valuation method because the value of the company is not calculated through the balance of assets, liabilities and shareholder’s equity but through the benefit the owner receives from the future values of the company. According to the general formula the present value (PV) is calculated by discounting future values (FV) which arise from the operating business of the company. Moreover, it is assumed that non-operating assets do not exist or are disposed of and the liquidation proceeds increase the present value. If there are no non-operating assets the present value is calculated as follows:

illustration not visible in this excerpt

Where (r) represents the interest rate per period and n claims the number of compounding periods.78

With reference to this formula it becomes clear that the appraiser needs to make some estimations namely about the discount rate and the future cash flows.79 These expectations are combined with difficulties because future cash flows are always combined with uncertainties. Moreover, the determination of an appropriate discount rate is highly essential because as the formula illustrates the discount rate has a high influence on the present value. Both methods are explained and analyzed in the next chapters in detail.


1 Vancea, Marina (2013), p. 272.

2 Rappaport, A. (1998), pp. 2 ff.

3 Cf. Pellens, B. et al. (1997), pp. 1933 f.

4 Cf. IDW (2008).

5 Cf. Bloomberg (2015).

6 Cf. Koller, T. et al. (2010), p. 4.

7 Cf. Hostettler, S. (1997), p. 23.

8 The valuation date is often the end of the year for example for annual reports of publicly traded companies. However, the valuation date can also be quarterly or an individual specified date, see: Peemöller,

9 Cf. Khan, M. Y., Jain, P. K. (2007), p. 339.

10 Fama E.F. (1970), p. 383.

11 Equity market value reflects the current stock price times the number of all stock.

12 Cf. Hostettler S. (1997), p. 27; Rappaport, A. (1986), p. 1.

13 ROI is determined through profit divided by total capital.

14 The principal agent theory refers to asymmetric relationship between one authority party (e.g. shareholders) who have an imperfect control about the other party that has the information advantage (e.g. managers of a company), see: Miller, G. J. (2005), pp. 203 ff.

15 Cf. Smart, W. (2007), pp. 2 ff.

16 Cf. Hering, T. (2000), p. 449.

17 Cf. Casey, C. (2000), p. 2; Moxter, A. (1991), p. 13.

18 The increase in stock prices is not always combined to cash flows but can result only from expectations.

19 Cf. Koller, T. et al. (2010), p. 17.

20 Cf. IDW (2009), Para. 4-5.

21 In Germany this allocation is legally regulated by § 9 BewG.

22 Fair value estimates the intrinsic value through discounting future cash flows to the present value, see: IFRS (2014), pp. 704-739; Khan, M. Y., Jain, P. K. (2007), p. 339.

23 The answer of the question what a company is worth goes back until 2000 before Christ. In the Middle Ages net proceeds multipliers had been used which were characterized through the mathematical knowledge of this time and the prohibition of interests which is prescribed by the bible, see: Henselmann, K. (2012), pp. 100-101.

24 Cf. French, N. (2013), pp. 208 ff.

25 Cf. Mandl, G., Rabel, K. (1997), p. 6.

26 Cf. IDW (2009), Para. 29.

27 Cf. Peemöller, V. H. (2012), p. 4; Helbling, C. (2012), p. 288.

28 Proponents of this theory announced that the reason for varies in potential prices is a lack of valuation competence of some investors, see: Jaensch, G. (1966), p. 7.

29 Cf. Mandl, G., Rabel, K. (1997), p. 7; Peemöller, V. H. (2012), pp. 4-6.; Hering, T. (2000), p. 441.

30 Cf. Meitner, M. (2006), pp. 10-11.

31 Cf. List, S. (1987), p. 11.

32 Cf. Peemöller, V. H. (2012), p. 6.

33 Cf. Mandl, G., Rabel, K. (1997), p. 8; Peemöller, V. H. (2012), pp. 6-7.

34 Cf. Peemöller, V. H. (2012), p. 7.

35 Cf. Matschke, M. J., et al. (2010), p. 5; Mandl, G., Rabel, K. (1997), p. 9; Peemöller, V. H. (2012), p. 7.

36 Cf. Matschke, M. J., Brösel, G. (2007), p. 973.

37 In the following called reason; Cf. Moxter, A. (1991), p. 26; Mandl, G., Rabel, K. (1997), p. 12; Peemöller, V. H. (2012), p. 19; Drukarczyk, J., Schüler, A. (2009), p. 87; Matschke, M. J., Brösel, G. (2007), p. 59.

38 Henselmann distinguishes transaction related and non-transaction related reasons for company valuation. Transaction related reasons comprise a potential change in ownership whereas non-transaction related reasons might be a valuation which is carried out for tax assessment for example to determine the

impacts of different strategies on the company value. Transaction related reasons can be subdivided into dominating and non-dominating situations. A dominating situation describes a situation where one party is able to change the structure of ownership without the approval of the counterparty, such as the right of withdrawal from the company in return for cash compensation. A non-dominating situation, in turn, represents a situation where no party is able to change the structure of ownership by his own decision, such as a purchase and sell of a company or the admission and withdrawal of partners, see: Henselmann, K. (2000), p. 393; Cf. Mandl, G., Rabel, K. (1997), p. 13; Baetge, J., et al. (2012), p. 353.

39 Cf. Seiler, K. (2004), p. 1.

40 Squeeze-out describes a technique were shareholders who hold a majority of shares are able to force the minority shareholders to transfer their shares to the major shareholders and receive in an appropriate compensation in cash or in stocks of other companies in return, see: IDW (2009), Para. 8-11; § 305,

§327a AktG.

41 Cf. Brösel, G. (2006), pp. 134 ff.; Peemöller, V. H. (2012), pp. 7-8.

42 Cf. IDW (2009), Para. 12.

43 Marginal price depicts the price which lays above the lowest price limit of the seller so that the sale of the company becomes advantageous for him. Consequently, it depicts the price which is below the upper price limit of the buyer, see: Helbling, C. (2012), pp. 266-267.

44 Cf. Peemöller, V. H. (2012), p. 8; Moxter, A. (1991), p. 9; IDW (2009), p. 5.

45 Cf. Peemöller, V. H. (2012), pp. 8-9; Hommel, M., Dehmel, I. (2013), pp. 35-36.

46 Cf. Meitner, M. (2006), p. 12.

47 Cf. Hommel, M., Dehmel, I. (2013), p. 36, IDW (2009), p. 5.

48 Cf. Hommel, M., Dehmel, I. (2013), p. 36, §327AktG.; Peemöller, V. H. (2012), pp. 9-10.

49 Cf. Peemöller, V. H. (2012), pp. 10-11; Mandl, G., Rabel, K. (1997), p. 22.

50 Cf. Peemöller, V. H. (2012), pp. 11-12.

51 Cf. Matschke, M. J., Brösel, G. (2007), pp. 59-60.

52 Cf. Ibid, p. 76.

53 The balance and the income statement depict the only opportunity to receive information about a company which can be used to derive future expectations.

54 Cf. Peemöller, V. H. (2012), p. 13; Matschke, M. J., Brösel, G. (2007), p. 76.

55 Cf. Matschke, M. J., Brösel, G. (2007), p. 74.

56 The valuation is not always mandatory but its aim is to keep the compensation fee low to ensure the maintenance of a company.

57 Cf. Matschke, M. J., Brösel, G. (2007), pp. 69-70; Peemöller, V. H. (2012), p. 13.

58 Cf. Matschke, M. J., et al. (2010), pp. 6-7.

59 Cf. Peemöller, V. H. (2012), p. 14.

60 Cf. Mandl, G., Rabel, K. (2012), pp. 52-53.

61 Cf. IFRS (2014), pp. 704-739 ; IDW (2009), Para. 12.

62 Cf. Lucks, K. (2005), p. 347.

63 Cf. Damodaran, A. (1994), pp. 11 ff.

64 Cf. Ballwieser, W. (2011), pp. 8 ff., IFRS (2014).

65 Cf. Hitchner, J. R. (2011), p. 8.

66 Cf. Hitchner, J. R. (2011), p. 309; Mandl, G., Rabel, K. (2012), p. 82; Beck, R. (2003), p. 11.

67 Cf. Beck, R. (2003), p. 11; Mandl, G., Rabel, K. (2012), p. 82; IFRS (2014), pp. 704-739.

68 Cf. Mandl, G., Rabel, K. (2012), p. 82.

69 Cf. Hitchner, J. R. (2011), p. 311.

70 Cf. Ibid, p. 259.

71 Cf. Hitchner, J. R. (2011), pp. 295 ff.; Aschauer, E., Purtscher, V. (2011), pp. 106-108.

72 Cf. Löhnert, P. G., Böckmann, U. J. (2012), p. 686.

73 Cf. Meitner, M. (2006), p. 1.

74 Cf. IDW (2008), Para. 144.

75 Cf. Fackler, M., Schacht, U. (2008), p. 22.

76 Cf. French, N. (2013), p. 208.

77 Cf. Baum, A. E., et al. (2011), pp. 6-7. 78 Cf. Hoge Fenton Attorneys (2015).

79 Usually it is assumed that the company will operate for unlimited time. For this case, there is no assumption about the life expectancy of the company required. Otherwise the appraiser needs to make assumptions about the life expectancy as well, see: Hoge Fenton Attorneys (2015).


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analysis comparison company valuation methods germany based discounted cash flow approach german income




Title: Analysis and Comparison of Company Valuation Methods in Germany