Foundations of Comparable Company Valuation

Part of the ZEW Economic Studies book series (ZEW, volume 35)


Cash Flow Market Price Capital Asset Price Model Target Company Discount Cash Flow 
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  1. 5.
    See Casey (2000: 2) the terms “buyer” and “seller” include those market participants that are not actively involved in transactions but that benefit from the buyer or the seller, respectively.Google Scholar
  2. 6.
    See Bhojraj and Lee (2002: 413–414); Damodaran (2002: 11). Especially in German literature asset-based valuation is seen as the fourth general valuation approach. This approach is, however, only used under certain valuation circumstances, see section Scholar
  3. 8.
    See Moxter (1983: 27–28); IDW (2000: 829–830); with regard to listed companies in Germany the main field of applicance of the objectified value is the so-called “squeeze-out procedure”, pursuant to sections 327a et seq. of the German Stock Corporation Law (Aktiengesetz). If a majority shareholder holds at least 95% of a company, the squeeze-out procedure permits him to acquire the shares of the minority shareholders for cash compensation. The amount of this cash compensation, in turn, crucially depends on the objectified value of the company.Google Scholar
  4. 9.
    The theory of functional value emerged from the so-called „Kölner Schule“, precursors of this theory were Muenstermann (1970); Jaensch (1966); Engels (1962); Matschke (1976) and Sieben (1983).Google Scholar
  5. 10.
    The consultancy function is also called “decision function”, see Hering (1999: 3).Google Scholar
  6. 11.
    See IDW (2000: 827); Peemöller (2005a: 10—11). Regarding the problems of methodologically justifying the existence of argument values, see Drukarczyk (2003: 134).Google Scholar
  7. 12.
    See IDW (2000: 827); a major difference between the neutral referee function and the intermediation function is that the neutral referee function does not necessary require an intersection between the decision values of the buy-side and the sell-side. This is especially important in dominated valuation settings, see Drukarczyk (2003: 133). For a distinction between dominated and un-dominated valuation settings, see Matschke (1976: 26–39).Google Scholar
  8. 13.
    See Casey (2000: 141–203); for reasons of simplicity it is assumed here that the company is purely financed with equity. In literature, sometimes price and market price are seen as identical; see e.g. Herrmann (2002: 15).Google Scholar
  9. 16.
    For more information about the CAPM, see Footnote 25. For a discussion about what „believing in the CAPM” means on real capital markets considering psychological issues, see Gerke (1997).Google Scholar
  10. 18.
    See Rubinstein (1974: 225–244); Gerke and Rapp (1994: 11–12); Pesendorfer and Swinkels (2000: 499–525); see Weber and Wüstemann (2004: 6–8) for a practitioners’ support for this thesis; see also section 3.1.2 for more information about aggregation efficiency of stock markets.Google Scholar
  11. 19.
    Strategic buyers usually expect synergies from acquisitions while financial buyers consider acquisitions as investments; regarding the deviant marginal prices of such strategic buyers, see Bhagat and Hirshleifer (1996), Hietala et al. (2000).Google Scholar
  12. 20.
    See Porter (1992: 65–82); Lang and McNichols (1997); Abarbanell and Bernard (2001: 221–242); Bushee (2001: 207–246). In some cases even management behaviour seems to be myopic, see McConnell and Wahal (1997). Studies that rather support the irrelevance of the myopia-thesis are provided by McConnell and Muscarella (1985: 399–422) and Wooldridge and Snow (1990: 353–363).Google Scholar
  13. 21.
    This is consistent with the view of the US-GAAP standard setter, the Financial Accounting Standards Board (FASB): „An observed market price encompasses the consensus view of all marketplace participants about an asset or a liability’s utility, future cash flows, the uncertainties surrounding those cash flows, and the amount that marketplace participants demand for bearing those uncertainties“ (FASB, 2002: 304).Google Scholar
  14. 22.
    Financial benefits are sometimes also called “economic benefits”, see ASA (2002: 24); however, the term “financial benefits” is used throughout this study in order to clarify that the focus here is on financial inflows.Google Scholar
  15. 23.
    See Copeland et al. (2005: 881–883); Kothari (2001: 4); Brealy and Myers (2003: 14–18); Damodaran (2002: 11–12); Gerke and Bank (2003: 42–43); this concept is also known as the dividend discount model. Another method of directly determining the corporate value is to apply the certainty equivalent approach, where — given an investor’s utility function — the (downward adjusted) risk free amount of financial benefits, that yields the same utility to an investor as the (higher) risky amount, is discounted at the risk free rate, see IDW (2000: 833); Peemöller and Kunowski (2005: 235–236); Mandl and Rabel (1997: 218–225). However, the latter concept is not subject of the following discussions.Google Scholar
  16. 24.
    For a detailed description of the DCF-concept with its various variants see Copeland et al. (2000: 129–297); Drukarczyk (2003: 199–314); Mandl and Rabel (1997: 37–42); Baetge et al. (2005: 265–362).Google Scholar
  17. 25.
    The CAPM can be traced back to Sharpe (1964), Lintner (1965) and Mossin (1966). See also Gerke (2001, colums 1701–1703); Copeland et al. (2005: 147–176); Brealy and Myers (2003: 194–204); Gerke and Bank (2003: 242–250); for a discussion about the shortcomings and limitations of pracital applicability in the context of business valuation see e.g. Hering (2003: 289–296); Fama and French (2003). In Germany, the application of a modified CAPM in direct valuation approaches is currently being discussed, which is supposed to better account for the impact of personal income taxes when determining objectified corporate values (after tax-CAPM); see Brennan (1970); Wiese (2004); Jonas et al. (2004); Wagner et al. (2004); IDW (2005). A critical evaluation of this proposition can be found in Peemöller et al. (2005). In the USA the cost of equity is sometimes determined using a multi-factor approach in the sense of Fama and French (1992) and Fama and French (1993), see Stehle (2004: 914), or using the arbitrage pricing theory (Ross, 1976). Other approaches discussed in literature — such as the intertemporal CAPM (Merton, 1973) or the Zero-Beta CAPM (Black, 1972) — are of no major practical relevance.Google Scholar
  18. 26.
    The cost of equity can be, but does not necessarily have to be, determined using the CAPM, see IDW (2000: 834, 836–837).Google Scholar
  19. 27.
    See Peemöller and Kunowski (2005: 217); IDW (2000: 830); consequently all future profitable investments are assumed to be debt-financed.Google Scholar
  20. 28.
    See Lo and Lys (2000a); Schumann (2005: 22–23); the general opinion is that for the validity of this model, clean surplus accounting is required, see Edward and Bell (1961, 68); Peasnell (1982, 362). The clean surplus relation means that only capital contributions, dividends and the profit or loss reported in the income statement can change the amount of owners’ equity (see Footnote 58 for some more details about the clean surplus relation). Recently, however, it has been found that residual income valuation is still a reasonable valuation approach even if the accounting system is not perfectly clean surplus, see Yee (2005).Google Scholar
  21. 29.
    Lee (1999: 414) states in this context that the “essential task in valuation is forecasting. It is the forecast that breathes life into a valuation model”. See also Kothari (2001: 72–73).Google Scholar
  22. 30.
    For option pricing models in general see Hull (2003: 234–329); in most cases the basic models for financial options have to be adjusted to the specific real option; see Quigg (1993), who developed a model for valuing real estate assets by modifying the BSM model in that the exercise price is stochastic; see also Gibson and Schwartz (1990), who generated a model for the valuation of commodity related projects. They substituted a mean reverting process for the standard Brownian motion in the BSM model; see also Schwartz (1997) and Bjerksund (1991), who provided an analytical solution for this model.Google Scholar
  23. 31.
    See Mandl and Rabel (1997: 42–46). “Rule of thumb” multiples for several German industries can be found at It is important to note that value indications derived from these “rule of thumb” multiples are probably not very meaningful, see ASA (2002: 13).Google Scholar
  24. 33.
    Reproduction valuation itself can be divided into different variants. It is also sometimes used for other purposes, such as valuation of non-listed corporations, valuation for tax purposes (in Germany, e.g. as part of a combination model of reproduction valuation and earnings capitalisation — the so-called “Stuttgarter Verfahren”) or in certain disputes. From an economic perspective, however, this approach is subject to critique, see Sieben and Maltry (2005: 400).Google Scholar
  25. 34.
    See the interpretation of market prices from the FASB in Footnote 21 (FASB, 2002: 304).Google Scholar
  26. 35.
    See Casey (2000: 19–20). The degree of subjectivity might even be higher for earnings capitalisation methods like the IDW-“Ertragswert” approach since it allows the discount rate to be based on investor’s preferences and degree of risk aversion, see IDW (2000: 837). That is why they are usually not seen as means of estimating market prices; see Drukarczyk (2003: 130); Herrmann (2002: 33). However, under certain conditions the use of the CAPM is also acceptable to determine discount rates, see IDW (2000: 836–837 in conjunction with p. 834).Google Scholar
  27. 36.
    The determination of a value from the perspective of an individual investor would require using a discount rate that mirrors the individual risk aversion and investment situation (degree of diversification of the portfolio, planned holding period, etc.), see Hering (2003: 289–292, 343–344).Google Scholar
  28. 37.
    It is important to note that direct valuation approaches and CCV are similar in their methodology, too. Direct valuation approaches also require the existence of a (at least virtual) comparable investment to determine the discount rate, see Gerke and Bank (2003: 100–101); Schultze (2003: 63–70); e.g., if the CAPM is used for determining the cost of equity, the comparable investment consists of two securities, the riskless asset and the beta weighted market portfolio. As a consequence of this methodological similarity, literature sometimes calls the problems of investment comparability that are associated with direct valuation approaches at least as severe as those associated with CCV, see Richter (2003: 312).Google Scholar
  29. 41.
    See Damodaran (2002: 457); Stowe et al. (2002: 225, 229–230); refer to section for a more detailed presentation of differences between equity valuation and enterprise valuation.Google Scholar
  30. 42.
    The majority of all these models are described in-depth in Stowe et al. (2002: 179–237). In practical settings non-financial variables also sometimes serve as basis of reference, e.g. page views for valuing internet companies, or the number of customers for the valuation of telecommunication companies, see Coenenberg and Schultze (2002: 699); Schwetzler and Warfsmann (2005: 54–56). However, this thesis focuses on accounting reference variables.Google Scholar
  31. 43.
    An exception to this is the price-earnings-growth ratio (PEG) where the adjustment process proceeds by successively dividing the comparable companies’ value by earnings and the growth rate; see Damodaran (2002: 487); Peemöller et al. (2002: 207); Schwetzler (2003: 81–82) and section Scholar
  32. 44.
    See Ross (1976); Burmeister et al. (1994); Copeland et al. (2005: 176–185). The major difference between the arbitrage pricing theory and other multi-factor models is that the arbitrage pricing theory is an equilibrium model, i.e. it is derived from an equilibrium theory.Google Scholar
  33. 45.
    See Friedlob and Schleifer (2003: 146); Penman (2001: 596). For financial statement analysis purposes the conservativeness of accounting figures is often seen as a determinant of accounting quality, too; see White et al. (2003: 637). However, this opinion does not apply for CCV since conservativeness often implies a downward bias of accounting numbers. Financial appraisers are rather interested in how well accounting describes the reality in an unbiased manner, see Palepu et al. (1996: chapter 3; 13); IDW (2002: 51–52).Google Scholar
  34. 46.
    For an in-depth discussion about accounting quality, see Penman (2001: 594–642); Palepu et al. (1996: chapter 3, 5–14); for a discussion about the problems of manipulating accounting figures in the context of valuation, see Gerke (2002:1); note: this section does not deal with the necessity for accounting choices from a pure accounting or auditing point of view. Neither does it deal with an assessment of different accounting principles. The main goal is to show which requirements the bases of reference have to fulfil so that CCV can be performed accurately. Additionally, most theoretical parts of this work are based on the assumption that accounting figures exhibit a very high quality in the sense of CCV.Google Scholar
  35. 48.
    For a more detailed discussion of the accounting challenges in the context of financial statement analysis and CCV, see White et al. (2003); Bernstein and Wild (1998); Peemöller (2003); Krolle et al. (2005).Google Scholar
  36. 49.
    Another aggregation method is the value weighted mean, see Herrmann (2002: 105). However, because of its low practical relevance it is not discussed in details here.Google Scholar
  37. 50.
    This is a problem because the “central limit theorem”, which postulates that the probability of data being normally distributed increases with the number of observations, cannot be applied here; see Hogg and Craig (1995: 246–253).Google Scholar
  38. 54.
    See Schwenker (2001: 9). Franks et al. (1988) reported an average premium of about 30 % for cash-financed deals and of about 15 % for stock-financed deals in the UK-market.Google Scholar

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