Thomas Sonntag

Company assessment by means of the cash-value method – A brief critique

In the M&A business, no one project is identical to another, which is one of the many reasons our work is so exciting. Despite all the differences between the projects, there is however one process without which none of our transactions would work, that is, company assessment. No matter whether a company is for sale or a client wants to expand by means of acquisition, the question of what the object is actually worth must be answered.

There are many different methods used to calculate the value of a business. Over the years, the mathematical finance method of business assessment by means of the so-called cash-value method has prevailed. Here, expected future cash flows are discounted against the expected average capital costs of all investors.

This, in theory very simple procedure presents considerable problems in practice. For instance, so-called equity costs need to be known for the calculation. These are not actual costs incurred, rather this is the minimum required return required by the business owners (e.g. shareholders). If the returns of the business are not met, it would be more beneficial for the owners to invest their capital in other assets, e.g. in government bonds. They would therefore have to take their capital out of the company. These equity costs however cannot be directly determined, which is why more or less accurate models are to be used. A widespread method is the determination of these costs with the aid of the capital asset pricing model (CAPM). With this method, the equity costs are comprised of a basic interest (a return that is to be expected with certainty, such as secure government bonds) and a risk premium.

It’s exactly in this combination that the greatest weakness of the cash-value assessment method can be found, as the basic interest rate can only be predicted in the short-term. A few years ago, e.g. no one would have seriously thought that investors would have to pay negative interest for German government bonds. Considering the strong influence a change of the basic interest rate of just a few tenths of a percent can have on the assessment results, one can see the difficulty in the prognosis of the basic interest rate.

The situation is similar for the risk premium. It gives an indication of how willing investors are to take risks as long as they receive the corresponding return. The CAPM calculates this premium by multiplying the expected market return with the risk factor (called beta). The beta factor describes the risk of the overall market, i.e. to which extent the return of a company correlates with the overall market. Here it is ascertained as to how the share price of a company behaves in comparison to the overall market. The unsystematic risk, i.e. the individual business risk, is not even taken into consideration. It is assumed that an investor acts perfectly rationally and has invested his money evenly in the overall market. If this is transferred into practice, this would mean that we would have to assume that an average investor has shares of every company in the entire market. In reality, one does not need any advanced financial knowledge to realize that this assumption is entirely unrealistic in the real market.

This is aggravated by the fact that even under the assumptions made with the CAPM, the beta factor can only be calculated for stock companies. For companies whose shares are not traded publically, no share price can be determined. This is why comparative values are used when assessing a private company. It is however also unrealistic in practice that two similar companies would have an entirely identical risk structure. It gets even worse for the validity of the CAPM: even if you accept all of these restrictions, studies and research have shown that the actual risk (and the return) of a company depend on entirely different factors, such as business size.

We feel that the value of a company is predominantly comprised of future growth opportunities, future risk as well as the earnings structure of the company in question.  A reduction of the business value to a pure risk assessment, for which several assumptions that are impossible in reality would have to be made, does not meet our requirements of a serious company assessment. Mathematical finance assessment methods are not too complicated for us, and we do not avoid them because they are too elaborate. Rather, the past has shown that our market-based company assessment, with which we very accurately predict the actual purchase price (and thus the value of the company) is far superior to conventional theoretical calculation methods.