Shinzato 1

Ryu Shinzato
Professor Richard Haskell
Finance 309-01
12th December 2015
Final exam
How do firms value assets?
As a corporations management is responsible for increasing the value of the firm
to its shareholders, it is crucial for a firm to decide what kind of approach it is going to
take in order to grow and maximize the firms value in long-term rather than giving in to
temptation of short-term profits. Asset valuation is important and can be utilized in those
situations to help a firm make decisions of whether the firm should pursue an acquisition
of another firm or another firms specific operations. Asset valuation is not only
important from the viewpoint of firms and investors, but also from economy as a whole
to avoid another economic crisis like the one occurred in 2007.

1. Asset Valuation: Book

Book Value is the theoretical value of a firm derived from the firms balance
sheet. Book value tells how much a firms net assets are. The book value of a firm is the
amount of the firms assets that will be left if the firms liabilities are fully paid to its
creditors. That amount left is also called shareholders equity that indicates how much
shareholders would receive if a firms all debts were paid off.
Book value of a firm does not fluctuate as often as market value does; though a
firm may increase book value by selling new shares to obtain capital resources although

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this will result in a decrease in Earnings Per Share since the number of share that is used
to calculate EPS increases. However, it is important to note that how much goes into new
shares will cause different consequences. If a firm pursued buybacks above the book
value per share, its book value would see a decline since the firm used its assets to
purchase its shares. Moreover, Buybacks tends to delude a firms book value, EPS, and
Return on Equity although they can increase the value of those models, making the firm
more attractive because the firm is now with more attractive figures of valuation. Overall,
Buyback does not always have a negative impact on book value. Buybacks can be a good
idea if a firm runs successfully and done at reasonable prices.
The book value is a useful and helpful tool that investors use to determine
whether a firm is overvalued or undervalued by comparing it with market value. This can
give investors an idea of when to buy or sell a firms security. On the other hand, book
value does not reflect important factors that influence the value of a firm, such as
trademarks, goodwill, and future growth expectation. For that reason, the book value of a
firm may not indicate a true value of a firm.

2. Asset Valuation: Market

Market value is the current price of a firm. Market value is important because it is
the price investors pay and receive. It can be calculated by multiplying the current stock
price by the number of shares outstanding. Marker value is in line with demand, so if the
demand of a firm increased, market value of the firm would also rise, and vice versa.
Market value tends to be greater than book value if a firm has a sound management as the
firm is building intangible assets through operations.

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Unlike book value, market value fluctuate everyday. This is because the price
reflects supply and demand. In other words, market value changes as expectations to the
future of a firm vary. Chipotle, for example, can be used to explain how market value
fluctuates. The recent outbreak of norovirus at the Mexican chain has not only forced to
close certain locations of its business, but also caused a decline in the market value by
approximately 30 percent. That decline in the market value indicates that expectations by
investors to the firm dropped. Market value involves so many intangible assets into it;
thus it is impossible to predict unless you have any insider information.

3. Asset Valuation: Production

When a firm attempts to grow its business, there are two possible ways the firm
could take. Either initiating a new business that would help add value or acquiring an
existing business so that the firm could cut any additional costs that are expected to incur
from acquiring offices, establishing a management structure, and hiring employees. In
general, the latter will not only have less opportunity cost the firm would incur, but also
the risk it would face. This is because the existing business possibly has a sound
management team, physical structure, organization structure, or intangible assets like
brand name. In addition, the existing firm may have everything set up for the firm to
function already, which could be utilized in forecasting since it has historical data as well
as customers that know what experience they would receive from the existing firm.
As we learned in class, Internal Growth Rate and Sustainable Growth Rate of a
firm are also helpful tools that can indicate a firms production level when those growth
rates are compared to each other. If SGR exceeded IGR, that would imply that only

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additional external funding can maintain the firms growth and the firm would be willing
to negotiate to outside funding.

4. Interaction between the valuation types

Book value and market value of a firm varies considerably in general. In looking
at an interaction between book value and market value, Price to Book ratio could give a
good understanding of a firms current situation since P/B ratio compares a reflection of
the firms value that the market and investors believe today with what it was originally
worth at the beginning.

Price to Book ratio = Market Value per Share/Book Value per Share

P/B ratio of less than 1 gives investors an idea to find reasonable stock price of a
firm that could potentially grow and in return it would generate a large gain. Though you
have to keep in mind that it is important to check other ratios that can provide even
clearer pictures of the value of a firm since there are some other ratios that can be
powerful when used in a good combination. In this case, a combination of Return on
Equity and P/B ratio will assure investors whether a growth firm is overvalued or not.
ROE itself tells how much profit the firm generates each dollar invested into the firm.
Those two ratios should have a positive correlation when either one is growing because if
huge buybacks were done, book value would decrease whereas ROE would increase
significantly and look too attractive to be real.

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Since ROE can increase not only from an improvement in a firms management
efficiency, but also from a rising debt proportion in the assets, DuPont identity will give
investors even deeper understanding of what part a firm does well and what part of a firm
needs to be improved.

DuPont ROE = (Operating Profit Margin)*(Total Asset Turnover)*(Equity Multiplier)

Donaldson Brown who worked for DuPont Corporation invented the DuPont
equation in his report in 1912. The DuPont equation looks at a firms return on equity by
dividing into three parts: profit margin, total asset turnover, and equity multiplier. Profit
margin shows how efficient a firms operations are. Asset turnover implies how efficient
a firms assets are used. And equity multiplier tells how much leverage a firm takes.
When first two part of the equation, which is profit margin and asset turnover, increases,
it indicates a firm is doing well whereas if only equity multiplier increased, it would
imply that firm is taking more debt to sustain ROE, adding more risk to its operations.
Value investors often look for firms with book value greater than market value.
What this means is that the firm today is not worth the value as it is described on the
balance sheet. This tells that the firm has a potential to do well, but bad management
team or a declining expectations of the firms future are two most probable reasons why
book value of a firm is greater than market value. This also indicates that the firm is not
generating an enough return on its assets despite the fact that the firm has a sound
management. This usually brings down market value of the firm even further since the
core issue lies in the business model itself rather than management team.

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Price to earnings ratio is another ratio that is well used among investors to
determine expectations of a firms future, reflecting market value of a firm. P/E ratio
shows how much investors are willing to pay in order to obtain one dollar of gain.

Price to Earnings ratio = Market Value per Share/Earnings per Share

5. Discounted Cash Flow /Key Value Driver

Value DCF / KVD =

g
)
ROIC
WACCg

NOPLAT (1

EBITA ( 1T )(1

g
)
ROIC

WACCg

This valuation has two parts; discounted cash flow model based on a projected
Net Operating Profit less Adjusted Taxes and Key Value Driver model. DCF assigns the
value of the explicit forecasting period whereas KVD assigns the continuing value before
that explicit period. In other words, that present value of the continuing value becomes
the future value of KVD and you need to discount the future value to get a present value.
Since the model involves a continuous Return on Invested Capital as well as
growth rates, the value you come up with could be vague. Although any firms could have
a sudden decline or hike in their NOPLAT and growth rates, this model seems more
applicable for firms with large capitalization that has been in business for a while since
they are relatively stable compared to high growth firms.
Even though this model is not used in practice as stated in the textbook, it still
gives an insight to what drives value: ROIC, growth, and cost of capital. By investing
capital to generate future cash flows that are higher than the cost of capital, firms can

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create value. When ROIC is greater than the cost of capital, there will be sound growth in
a firm while if ROIC is less than the cost of capital, growth destroys value due to the
rapid growth of the firm. Thus, if a firm has a low ROIC, the firm should focus on
improving its ROIC first so that the firm will have a solid ROIC and then the firm can
focus on improving growth, resulting in creating more value within the firm.