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The purpose of this part of Victoria‟s analysis is to evaluate the risk factors of owning this business
as compared to an investment in the average peer company. As previously discussed in this chapter,
investors have options of where to place their capital and rational investors require a higher reward—
in the form of returns—for investments with higher risks.
Valuation Methods
Victoria tells Bob that Acme‟s shares of common stock are private securities and there is no liquid
market for their sale. Furthermore, no obvious firms can easily be found that would serve as price
benchmarks to value Acme. Next, in her analysis, Victoria considers all relevant valuation approaches
and ultimately relies on two ways to estimate the value of Acme‟s common stock—the market
approach and the income approach. She rejects the asset approach because the premise of value is a
going concern and the company has no intention to liquidate its assets. In addition, the asset approach
does not clearly reflect the value of this firm arising from its earnings potential.
Debt-Free Analysis
Victoria further explains to Bob that there are two ways to value the shares of a private firm using the
income approach. The first way is the direct equity methodology. Using this approach, a firm‟s net
cash flow drives the value of its stock. This methodology either capitalizes the net cash flow for one
year or calculates the present value of a series of future cash flows.
The second way is the debt-free methodology (sometimes called the invested capital methodology).
How much or how little a firm is leveraged can have a significant impact on the value of its stock. If a
firm has too little leverage or too much leverage compared to an ideal blend of debt and equity capital,
the direct equity methodology may result in a distorted valuation of the firm; therefore, the debt-free
method should be used instead to value the firm.
A firm‟s invested capital represents all of its sources of capital to fund the business—capital from
investors (equity) and creditors (debt). When we say the value of a business or a business enterprise, it
has a different meaning from the value of the firm‟s equity. This concept is illustrated in the
accompanying diagram.