In the wake of the news that Apple’s valuation has reached
$1 trillion. I feel that it is an interesting time to reflect on the valuation
process that corporate managers and investors undertake. The valuation process
is important for management to understand the implication of factors on share price
(and shareholder wealth). It is also an important technique for managers to
possess for valuing merger and acquisition targets. From studying the
literature and reading articles regarding company valuations, it is evident
that there is a large degree of subjectivity involved in the valuation methods
used. Warren Buffett described valuing a business as ‘part art and part science’.
Apple is the largest company in the world, as measured by
market capitalisation (Number of Shares X Share Value). Their share price has
strengthened to just under $180 as the company has significantly improved its
position in the Chinese market. As well as this promising news, Apple is on the
verge of launching their new product category, the Apple Watch. The market has
responded positively, and as a result the firm’s market value has increased. But
is this the true value of Apple? Many would argue that this $1 tn valuation is
the minimum valuation of the firm. This method of valuation can only be truly
accurate if the market is truly efficient, however, information asymmetry
exists and management will have essential knowledge of the firm that the public
is unaware of. So how about measuring Apple by its net assets? From Apple’s latest balance sheet, an underwhelming net asset figure of around $102bn can be calculated. This discrepancy in the two calculated values is because of the Net Asset Value (NAV) method overlooking the intangible assets that Apple possess. Arguably these assets, which include human capital, brand, and goodwill, create the most value for the firm. However, their value is nowhere to be seen on their balance sheet. Valuation based on the NAV method is better suited to valuing a company in financial difficulty when a company is considering buying the firm’s asset in a liquidation situation.
A better way to measure a firm’s value would be to calculate a value based on future income…right? Gordon’s dividend growth model is one method used to calculate a share price from the present value of expected future dividends. However, there are a number of hurdles that arise when using this technique. Predicting the growth of dividend payments of a company may be difficult for firms with volatile dividend payment patterns. Even worse, Apple (until recently) have not paid dividends, making the method impossible to use.
The price-earnings ratio of companies is a popular valuation method. The historic PER compares a firm’s share price with its latest earnings (profits). Investment analysts will have an ‘appropriate’ P/E ratio level for either a share or sector, and will also consider both risk and growth factors of the company. A value for equity is then calculated by multiplying a sustainable earnings figure by the P/E ratio (Sudarsanam, 2004). Despite this method being widely used by the investment community, it still has a number of limitations. Apple is renowned for having a lower P/E ratio than expected, thus the valuation calculated may be unreliable. There is also much scepticism regarding the accuracy of earnings figures, due to the flexibility in financial reporting, allowing companies to ‘window dress’.
A Discounted Cash Flow (DCF) Valuation method would be most appropriate for Apple, in my opinion. According to Mukherjee, Kiymaz and Baker (2004), the DCF method provides the most rational framework for valuing a business. This method forecasts the future cash flows of a business (typically post-merger, calculating the effect of synergies). In the (unlikely) event that a company should pay no more than the difference between the pre- and post-acquisition cash flows.
PVa+b – Pva = Maximum
Payment
This method considers the value attributable to shareholders
created by the combined entity when working to calculate a value for a target
firm. Greater likelihood is that Apple would be valued by their future cash
flows. To incorporate the time value of money the cash flows are discounted.
Future cash flows are difficult to estimate and are influenced by many internal
and external factors. Once the subjective cash flows are calculated, a cash
flow per share is calculated and then divided by the cost of equity for the
firm. So how much is Apple worth? It is recommended that each of the valuation techniques is considered in full knowledge of the weaknesses that each approach holds. From this, management can then apply their informed judgement to produce an estimated value region for the entity in question. In my opinion the market capitalisation valuation of Apple is realistic. The market is well aware of the innovation and creativity associated with Apple, as well as the strength of their brand, reflected in the inflated value of one trillion dollars.
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http://onlinelibrary.wiley.com/doi/10.1111/j.1911-3846.1998.tb00564.x/pdf
Sudarsanam, S. (2003). Creating
Value from Mergers and Acquisitions: The Challenges. (1st ed.)
Harlow, Essex: Pearson Education
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