The value of a firm

Table of Contents

EXECUTIVE SUMMARY

LIST OF FIGURES

1 INTRODUCTION

2 THE SHAREHOLDER VALUE APPROACH
2.1 Market value orientation
2.2 Shareholder Value as firms’ objective

3 EVALUATION OF FIRMS
3.1 Occasions of evaluation
3.2 Diversity of methods

4 METHODS OF EVALUATION
4.1 Discounted Cash-flow
4.1.1 Entity approach
4.1.2 Equity approach
4.2 Real options approach
4.2.1 Financial option price models
4.2.2 Flexibility

5 ECONOMIC ASSESSMENT

6 CONCLUSION

BIBLIOGRAPHY

ITM-CHECKLISTE

List of figures

Figure 1: Diversity of methods

Executive Summary

This paper investigates the shareholders’ possibility to evaluate firm’s value. The fact, that due to the different objectives of the shareholders and the managers, the shareholder value is a suitable figure to synchronize different interests will be shown. Having shown two approaches to calculate shareholder value, these approaches will be assessed, if they provide a suitable calculation of the shareholder value. The discounted cash-flow approach (DCF), basing on prospective cash-flows, is a suitable method to determine shareholder value. The realoption approache extends the DCF-approach by the flexibility component. Regarding the occasions of evaluation, the calculating shareholder can use both approaches, but he has to be sure about the approaches’ boundaries.

1 Introduction

Nowadays, the worldwide economic situation is characterized by globalization, mergers and acquisitions, overestimated firms’ values and strong market volatility on stock markets.¹ Consequently, this situation led to a new discussion about effective methods of evaluations to calculate the accurate value of a firm.

Furthermore, the necessity to define effective methods of evaluations is forced by the re- current discussion about owners’ interests or distribution of dividends by stock corpora- tions. Methods of evaluation should be able to calculate prices that serve different issues. On the one hand, prices have to be calculated to fix sales while the owner of the firm is changing and on the other side, prices have to be evaluated in case of tax or creditable assessment.²

Regarding the pressure of raising capital it is obvious that firms have to concentrate on the investor. In consequence, the popularity of the shareholder value approach is increas- ing.³ Maximizing the equity capital is the objective of the shareholder value approach. This approach has been highly characterized by suggestions of Rappaport⁴ and Cope- land.⁵

All these methods to evaluate firms’ value have to include current and prospective economic parameters⁶, which have impact on the firm’s value: short product lifecycles, worldwide dynamic capital markets, planning periods with negative cash-flows, intangible assets and flexible entrepreneurial spirit.⁷

The objective of this assignment is to demonstrate the impact of selected methods of evaluation to the shareholder value. The effectiveness of the methods and their expressiveness to the shareholder should be outlined, whether these methods give the shareholder the possibility to calculate a useful price.

2 The Shareholder Value approach

2.1 Market value orientation

In general, a firm is related to different interests of different groups. The closed system of a firm is broken through by plenty of different desires and different demands by other actors aside the shareholders. Beside the investing shareholders, other actors are related to the firm, who have their own preferences and try to satisfy their needs.⁸ For example the management, suppliers, customers or employees, who have different objectives concerning the firm, may be these actors. But as these preferences differ intensively, conflicts within the decision making process of the firm may occur. So, a consolidated approach has to be chosen, that meet any expectation.⁹

Beside the conflicts within the subset of stakeholders, conflicts may also occur between owner and manager. This is called principal-agent problem. The owner of the firm (princi- pal) transfers special assignments to the manager (agent) and wants him to execute these. The specialized labour force and information provided by the agent is the advan- tage of the principal. Assuming that both actors are utility maximizers, “there is a good reason to believe that the agent will not always act in the best interests of the principal”.¹⁰

As a homogenous objective is not possible to generate, the capital orientated perspective of the financial theory tries to develop an approach that fits any decision making proc- ess.¹¹

The advantage of cash-flow might be chosen independently disregarding the different preferences. The choice of specific investments¹² may only be done regarding their price or rather their market value.

Now, the decisions of the management cover the expectations of the investors and shareholders.¹³ So the conflict free market value meets the utility function of any stake- holder.¹⁴ Consequently the management has to force the enhancement of the market value. If this is not possible, investments should not be made.

2.2 Shareholder Value as firms’ objective

Since the 1980s, the definition of shareholder value has been gainged more importance. In the first instance, the shareholder value has been understood as a model to assess investments. Later on, the shareholder value became an evaluation standard, which was able to assess the complete performance of a firm.¹⁵ The objectives of shareholders and the capital market are internalized with the help of the shareholder value orientation. The internal firms’ objectives are deduced by these external objectives.¹⁶

The idea of the shareholder value is the combination of the economic planning process and the economic capital theory. This combination has to be oriented on entrepreneurial interests of the owners.¹⁷ This compensates the orientation on the traditional objective of profit maximizing.¹⁸ Now, the firms’ objectives have to be related to an increasing market value.¹⁹

Moreover, the orientation of entrepreneurial activities related to the shareholder value is a possibility to control the firms’ management.²⁰ A highly efficient controlling system can be installed by implementing an incentive structure which is combined with the achievement of the objectives. Now, the shareholder is able to remunerate the management regarding their performance.²¹ So, the principal-agent problem can be decreased.²²

Due to the increased importance of the capital market, it was necessity to use a value based orientated management, beside implementing an incentive structure. The efficiency of the capital market emphasizes the importance of the capital owner. Sometimes the return was as big as secure bonds. The entrepreneurial risks have not been rewarded. And the investor did not get any positive return.²³

The calculation of the shareholder value has to take the firm’s complete performance into consideration. The methods of evaluation have to focus on the specific objective of the assessing subject. An evaluation of the firm can not be processed without precise objectives given by the assessing subject.²⁴

Nowadays, there are different methods of evaluation to calculate the accurate shareholder value of a firm. One the one hand, there are complex performance measurement systems and ratio systems like Balanced Scorecard²⁵, Intangible Assets Monitor or the Skandia Navigator²⁶, which provide a system related to the causes and impacts existing within the firm. On the other hand, there are profit orientated methods of evaluation, which are based on the net present value method.

3 Evaluation of firms

3.1 Occasions of evaluation

As firm’s evaluation needs many resources, it will be done for special purpose. These purposes might be buying or purchasing decisions. But consultants, analysts or surveyors also use methods of evaluation on the capital market. Besides, different laws also intend to calculate an accurate value of a firm for further acting.

In general, the occasions of evaluations might be separated into occasions, which are influenced by the owner, and occasions, that can not be influenced by the owner of the firm.²⁷

Within the first group of evaluation occasions, which intend a change in ownership, situations have to be separated, where owners have direct impact on the evaluation. Listing on stock exchanges, buying or purchasing firms and the value orientated incentive structure for managers might be examples for ownership driven value evaluation.

The second group of evaluation occasions, which can not be influenced by the owner are e.g. checkups of financial standing or checkups of tax base.²⁸

For a long time, the combination of all these occasions to an objective value of a firm was tried to combine.²⁹ It was assumed that there is a true objective value. Nowadays, it is accepted that the value of a firm can only be evaluated regarding the evaluation subject and its specific occasion.³⁰ The business school of Cologne tries to catagorize functions of evaluation in main and additional functions.³¹ Main functions of evaluation methods are functions of arguing³², consulting and mediating.³³

The mediating function tries to fix a reference value that finds out the needs of different parties, which have opposing interests. The function of arguing tries to support one party in its individual objectives. Regarding the function of consulting, marginal prices are tried to be fixed for a potential purchaser. These marginal prices equal the individual price of the evaluation subject.³⁴

3.2 Diversity of methods

A diversity of methods is used within the theoretical and experiential evaluation of firms.³⁵ These different methods of evaluation result of different evaluation occasions and evaluation situations. The objective of these methods is to provide a model to calculate the individual utility value of the evaluating subject.

illustration not visible in this excerpt

Figure 1: Diversity of methods

The use of summarized methods is highly propagated. The execution of these methods to calculate the value of a firm is easy. Due to the one dimensional operating figures a com- parison with other firms can be done quickly. The profit orientated figures are mainly ad- justed to figures from the accountancy. Value orientated figures tend to firm’s cash-flows in the future. Methods of evaluation, which follow analytical aspects, describe the causes and impacts of firms’ value. In-house processes are mapped to complex operational fig- ures. While calculating the value of a firm, these operational figure systems also take non- monetary figures into consideration.

4 Methods of evaluation

4.1 Discounted Cash-flow

The method of the discounted cash-flow (DCF) is one of the most popular methods to evaluate firms. This method is also one of the main methods used by the German Certi- fied Public Accountants.³⁶ The concept of DCF can not be summarized in one significant method, but in different models. Objective of DCF is to synthesize the market value of equity capital. The value of the investments equals the returning cash-flows³⁷, discounted by the investor’s opportunity costs.

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¹ Cp. Unknown (2005): Selbst in den USA macht man sich Sorgen, p. 960 - 962.

² Cp. Drukarczyk (2001), p. 2.

³ Cp. Drukarczyk (2001), p. 1.

⁴ Cp. Rappaport (1986); Rappaport (1997). Also cp. Rappaport (2006).

⁵ The shareholder value approach is also known as „Aktionärsnutzenansatz“, „wertorientierte Strategieplanung“ or „Wertsteigerungsanalyse“. Cp. Taetzner (2000), p. 27.

⁶ Cp. Kußmaul (1999), p. 335.

⁷ According to Sullivan the „focus of this New Economy is on knowledge and relationships, with a pre- mium awarded to firms demonstrating a capability for speed, flexibility, innovation, and the ability to connect.“ Cp. Sullivan (2000), p. IX and p. 115. Also cp. Edvinsson/ Brünig (2000); Stewart (1998).

⁸ Cp. Günther (1997), p. 42.

⁹ Cp. Schmidt/ Terberger (1999), p. 55.

¹⁰ Cp. Jensen/ Meckling (1976), p. 308.

¹¹ Cp. Schmidt/ Terberger (1999), p. 55.

¹² Ballwieser emphasizes that the returns of these investments should cover the capital costs. Cp. Ball- wieser (1995), p. 121.

¹³ For a general discussion about utility maximization cp. Schmidt/ Terberger (1997), p. 44.

¹⁴ Wilhelm describes the orientation of the market value as a firm’s objective without conflicts. Cp. Wilhelm (1983), p. 531. Similar Ballwieser (1994), p. 1404.

¹⁵ Cp. Rappaport (1997), p. XI. Cp. Becker (1998), p. 1104.

¹⁶ Cp. Ballwieser (1994), p. 1383. Ballwieser imputes that the owner tries to maximize his own financial return.

¹⁷ Cp. Bühner (1992), p. 418.

¹⁸ Kürsten describes the market value as the „element one“, that fixes the welfare of the shareholder. Kür- sten also critizises the objective of rising market value, because firms are not able to act fully for their shareholders. Cp. Kürsten (2000), p. 362.

¹⁹ Richter/ Furubotn see the implementation of market mechanism as an important factor to discipline the management. Cp. Richter/ Furubotn (1999), p. 218.

²⁰ Cp. Ballwieser (1994), p. 1383. „When performance evaluation and incentives differ from measurement standards employed in planning, decision making will be motivated by the performance evaluation -

²¹ system and not the planning system.” Cp. Rappaport (1986), p. 171.

²² For further information about the principal-agent theory see Jensen/ Meckling (1976); Richter/ Furubotn (1999); Sappington (1991).

²³ Cp. Pape (1996), p. 34.

²⁴ See also Barthel (1996), p. 150, who understands the evaluation of a firm as a process. This means that each evaluation is also a part of decision making regarding different economic methods.

²⁵ The Balanced Scorecard was invented by Norton/ Kaplan, who compare its multi dimensions to a cock- pit of an airplane: „For the complex task of navigating and flying an airplane, pilots need detailed infor- mation about many aspects of the flight. They need information on fuel, air speed, altitude, bearing, destination, and other indicators that summarizes the current and predicted environment.“ Cp. Kaplan/ Norton (1992), p. 72.

²⁶ For further information see Edvinsson/Brünig (2000).

²⁷ For an assigning enumeration of different occasion cp. Schultze (2001), p. 6 or Kussmaul (1996), p. 264.

²⁸ Cp. Schultze (2001), p. 6.

²⁹ Cp. Schultze (2001), p. 7.

³⁰ See also Ballwieser (1999), p. 23, who emphasizes that only evaluations with a specific purpose are useful to evaluate firms.

³¹ Cp. Schildbach (1998), p. 305. Also see Kussmaul (1996), p. 262.

³² Ballwieser sees the function of arguing not as an accurate function. The agreement of a method is not useful, because the evaluating subject does not know if this method supports the argumentation. Cp. Ballwieser (1997), p. 185.

³³ The values calculated within the function of mediating and consulting will be calculated using the method of “objective values” in two steps. Cp. Schultze (2001), p. 9.

³⁴ Cp. Schultze (2001), p. 8.

³⁵ For enumeration of methods see Barthel (1995), p. 345 or Bauer et al (1999), p. 5.

³⁶ Cp. Taetzner (2000), p. 73.

³⁷ The reader has to notice that there are plenty of cash-flow definitions around.