11 - Valuation issues

Abstract

Closely held companies can be valued basically by three methods—discounted income approach, comparative analysis, and capitalized earnings. In the case of high probability of bankruptcy, the estimation of liquidation value is the best estimate of valuation of distressed firms. The life cycle of a firm is also a determinant of negative earnings for firms. Cyclical firms are subject to significant swings in profitability. Cyclical companies can be valued using modified discounted cash flow approach involving scenario analysis. The earnings of the cyclical firms must be normalized for the economic cycle covering 5 or 10 years. In the life cycle stage of firms, startup firms highlight the initial stage of the life cycle of firms. The value of startup firms depends on its future growth potential. Venture capital firms estimate the exit or terminal value of startup firms at the time of the initial public offerings. The discount rate for estimation of discounted cash flow valuation for emerging market firms must factor in additional risk factors like high levels of inflation and macroeconomic volatility. To take into account inflation impact on cash flows, the estimation of future cash flows in discounted cash flow valuation must be done in both nominal and real terms. Cash flow valuation, relative valuation, and real option valuation methods can be used to value high growth firms. High growth companies offer higher rate of return to shareholders.