Valuation: Cash Flow Discounting-Based Methods: 1. Balance Sheet-Based Methods

Strategic Finance

Today’s article is going to be a section of Business Valuation training’s that I have performend in different companies and universities such as selected Anadolu Group companies and Istanbul Technical University’s all year classes. I will concentrate on balance sheet based methods.

Valuaiton: Cash Flow Discounting-Based Methods

Before jumping into the topic, it is important to be familiar with the critical aspects of a valuation. Valuation is:

Dynamic: The valuation is a process. The process for estimating expected risks and calibrating the risk of the different businesses and business units is crucial

Involvement of the Company: The company’s managers must be involved in the analysis of the company, of the industry, and in the cash flow projections

Multifunctional: The valuation is not a task to be performed solely by financial management

Strategic: The cash flow restatement technique is similar in all valuations, but estimating the cash flow and calibrating the risk must take into account each business unit’s strategy

Compensation: The valuation’s quality is increased when it included goals (sales, growth, market share .etc) on which the managers’ future compensation will depend

Real Options: If the company has real options, these must be valued appropriately.

Historic Analysis: Although the value depends on the future expectations, a thorough historic analysis of the financial, strategic and competitive evolution of the different business units helps assess the forecasts’ consistency

Technically Correct: Technical correction basically refers to calculation of the cash flow, adequate treatment of the risk, which translates into the discount rates, consistency of the cash flow, treatment of residual value (salvage or terminal value)  and the treatment of the inflation

Financial statement and analysis could be divided into three major areas illustrated below:

Financial Statement and Analysis





Basic Financial Statement Analysis:

As there are dozens of the analysis methods in the sector used to find the best outcome of analysing the company’s financial statements, I would like to summarize some of them with the chart below:

Methods of case study evaluation





 1.      Balance Sheet-Based Methods

In this article, I will only discuss the balance sheet-based methods very briefly.

Balance sheet-based methods seek to determine the company’s value by estimating the value of its assets. These are traditionally used methods that consider that a company’s value lies basically in its balance sheet. They determine the value from a static viewpoint, which, therefore, does not take into account the company’s possible future evolution or money’s temporary value. Neither do they take into account other factors that also affect the value such as: the industry’s current situation, human resources or organizational problems, contracts, etc. that do not appear in the accounting statements.

Some of these methods are the following: book value, adjusted book value, liquidation value, and substantial value.

Book Value:

A company’s book value, or net worth, is the value of the shareholders’ equity stated in the balance sheet (capital and reserves). This quantity is also the difference between total assets and liabilities, that is, the surplus of the company’s total goods and rights over its total debts with third parties

Let us take the case of a hypothetical company whose balance sheet is that shown in Table 1. The shares’ book value (capital plus reserves) is 80 million dollars. It can also be calculated as the difference between total assets (160) and liabilities (40 + 10 + 30), that is, 80 million dollars

Assets Liabilities

This value suffers from the shortcoming of its own definition criterion: accounting criteria are subject to a certain degree of subjectivity and differ from “market” criteria, with the result that the book value almost never matches the “market” value.

Adjusted Book Value:

This method seeks to overcome the shortcomings that appear when purely accounting criteria are applied in the valuation.

When the values of assets and liabilities match their market value, the adjusted net worth is obtained. Continuing with the example of Table 1, we will analyze a number of balance sheet items individually in order to adjust them to their approximate market value. For example, if we consider that:


– Accounts receivable includes 2 million dollars of bad debt, this item should have a value

of 8 million dollars.

Stock, after discounting obsolete, worthless items and revaluing the remaining items at

their market value, has a value of 52 million dollars.

– Fixed assets (land, buildings, and machinery) have a value of 150 million dollars,

according to an expert.

– The book value of accounts payable, bank debt and long-term debt is equal to their

market value.


The adjusted balance sheet would be that shown in Table 2.

Assets Liabilities 2

The adjusted book value is 135 million dollars: total assets (215) less liabilities (80). In this case, the adjusted book value exceeds the book value by 55 million dollars.




Liquidation Value

This is the company’s value if it is liquidated, that is, its assets are sold and its debts are paid off. This value is calculated by deducting the business’s liquidation expenses (redundancy payments to employees, tax expenses and other typical liquidation expenses) from the adjusted net worth.

Taking the example given in Table 2, if the redundancy payments and other expenses associated with the liquidation of the company Alfa Inc. were to amount to 60 million dollars, the shares’ liquidation value would be 75 million dollars (135-60).

Obviously, this method’s usefulness is limited to a highly specific situation, namely, when the company is bought with the purpose of liquidating it at a later date. However, it always represents the company’s minimum value as a company’s value, assuming it continues to operate, is greater than its liquidation value.

Substantial Value

The substantial value represents the investment that must be made to form a company having identical conditions as those of the company being valued. It can also be defined as the assets’ replacement value, assuming the company continues to operate, as opposed to their liquidation value. Normally, the substantial value does not include those assets that are not used for the company’s operations (unused land, holdings in other companies, etc.).

Three types of substantial value are usually defined:

  • Gross substantial value: this is the assets’ value at market price
  • Net substantial value or corrected net assets: this is the gross substantial value less

liabilities. It is also known as adjusted net worth, which we have already seen in the previous section

  • Reduced gross substantial value: this is the gross substantial value reduced only by the value of the cost-free debt (in the example of Table 2: 175 = 215 – 40). The remaining 40 million dollars correspond to accounts payable

Book Value vs. Market Value

In general, the equity’s book value has little bearing to its market value. This can be seen in Table 3, which shows the price/book value (P/BV) ratio of several international stock markets in September 1992, August 2000 and February 2007.

Sept August Sept





Relative Valuation Ratios

The chart would give a feeling of what we are looking for in a simple valuation.


On the other hand, there are a set of financial analysis dashboard for different purposes about liquidity, activity, performance, profitability, leverage and dividends of targeted company.










Balance Sheets – Function in Valuation

I find this list of actions useful for many of you who is working in business development, m&a, p&e, m&e and dd deals.


To Do’s

–          Allows for analyzing and tracking all working  capital accounts (including cash) (Historically and Projected basis)

–          Validates capital exp. and depreciation ratios  going forward (Explicit forecast of PP&E)

–          Tracks other non-current assets/liabilities levels  that the company needs to operate

–          Tracks debt assumptions if appropriate

–          Review History

–          Establish Assumptions and Ratios

–          Focus on:

  • Net Property/Plant/Equip (PPE)/Net Sales
  • Days or turns for major working capital categories
  • Debt and equity financings that may be imbedded in projections (need to account for properly or remove)
  • Intangible Asset Treatment
  • Other ratios as appropriate
  • Minor misalignments in depreciation and capital expenditures potentially cause major issues
  • Issue occurs with most projections
  • Consider building own capital expenditure tax based depreciation “water fall” to test or as part of own projections
  • Debt and working capital analysis: short term and long term debt forecasting



– Standard& Poors, Valuation Consultants, LLC

– Fernandez, Pablo, `Company Valuation Methods, The Most Common Errors in Valuations`, Johanning, Lutz, `Risk Management ` class notes, Kellogg, Northwestern U.

– Istanbul Technical University, “business valuation” Seminar Series, Cem Sari, 2011

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