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INTRODUCTION

At present, valuation of firms is a very relevant topicnot only in the Czech Republic, where it has become anecessary precondition of ownership transformation, butalso in developed market economies, where it is associ-ated above all with needs of an efficient allocation of free

financial means. However, there are also many other rea-sons why it is important to estimate the current value ofa firm. Among them, besides purchasing, selling and/or

partitioning of enterprises to smaller, independent sub-jects, it is necessary to mention above all the transforma-tion of firms into other legal entities and, last but notleast, also the implementation of the main objective of anyform of entrepreneurship, which under conditions of freemarket economies means the growth of the market valueof the firm. The value of a firm is influenced by all short-term and long-term decisions of its managers. It is influ-enced by financial policy of the firm, its businessstrategy etc. Firms managers must be able to evaluatethe impact of their decisions on the firms value. Thismeans that for a good management, it is necessary toknow also the methods and ways of firm valuation.

Although it is necessary, especially when valuatingagricultural enterprises, to know some differences, whichresult from the character of their operation, one can gen-erally say that the basic methodological approach to thefirm valuation remains to be the same in all branches ofthe national industry, regardless to their practical appli-cation.

The aim of this paper is to present a survey of funda-mental methodology of a firms valuation, especially withregard to methods based on the estimation of future rev-enues and to describe one of possibilities how to deter-mine its value.

OBJECTIVES AND METHODOLOGY

The objective of determination of firms value is to ex-press its price by means of a monetary equivalent. As arule, the final result then arises from the application ofseveral methods of valuation. The most popular methodsof firm valuation can be classified from different pointsof view. For practical purposes, however, it seems to beadvantageous to use three basic categories, viz.: methods based on an analysis of expected revenues of

a firm

methods based on the estimation of the market value of

a firm and

methods based on the determination of the value of

firms assets.

Each of these methods has been elaborated on differ-ent principles and for that reason, their informative valueis also different.

Methods based on the analysis of expected revenues

integrate valuation of a firm with capital investments. Thevalorisation of invested capital is reflected in future rev-enues. This future valorisation is put down as the deci-sive parameter of firms value, regardless to the currentvalue of its assets, which, however, represent a source

Possible approaches to the valuation of a firm

Pstupy k oceovn podnik

I. IVLOV

Mendel University of Agriculture and Forestry, Brno, Czech Republic

Abstract: Measurement of business performance by using the value of a firm represents a modern tool of financial management.

The paper deals with this problem and discusses basic methodological approaches to the determination of farms value, especially

by means of methods based on the estimation of future revenues.

Key words: farms value; methods of determination; future revenues

Abstrakt: Modernm nstrojem zen podniku se stv men jeho vkonnosti pomoc hodnoty podniku. Pspvek jezamen na zkladn metodick pstupy k oceovn podniku, zejmna na metody zaloen na odhadu budoucch vnos,

s clem stanovit hodnotu podniku.

Klov slova: oceovn podnik, metody oceovn podnik, stanoven hodnoty podniku

This study was written within the framework of the Research Plan of the Faculty of Economics, Mendel University of Agriculture

and Forestry Brno, No. MSM 431100007 Formation of structure of agriculture and food industry and trends and tendencies in thebehaviour of enterprises within the framework of integration of the Czech Republic into the European Union.

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of these future revenues. From the viewpoint of eco-nomic theories, this approach can be considered as oneof the most suitable methods of firm valuation.

Methods based on the estimation of the market value

of a firm are based on the appreciation of the expectedmarket evaluation of firms profitability. This market va-lue is represented by the estimated sum of money, which

would be paid by an investor in case that the companywould be sold on a capital market. This means that theapplication of these methods necessitates a functioningcapital market because this market projects into thefarms market value not only its current and future reve-nues, but also rates of growth and some other relevantfactors. The application of these methods is dependenton the fact if the firm is sold in the capital market or not.

Methods based on the determination of the value of

firms assets are based on assumption that the farms va-lue is determined by the worth of its assets, which repre-sent the source of future farms revenues. This evalu-ation results from the description of assets as recordedin accountancy books of a firm. This means that this val-uation comes out from the current situation and modifiesis with regard to the expected future conditions. Whenusing this method, it is necessary to choose a suitable

price of assets, i. e. to use both the price derived from thebook value and the liquidation price, which representsthe sum of purchasing prices of individual componentsof farms assets in case of their sale. One can also takeinto account the so-called reproduction cost price but itshould be said that their determination is associated witha number of problems.

RESULTS AND DISCUSSION

When considering these three basic groups of meth-ods of firm valuation, it is possible to say that the analy-

sis of expected revenues seems to be the most objectivemethod of estimation of farms value. These methods can

be used in various modifications, i. e. with regard to themethod of estimation of future revenues of the firm, whichcan be derived either from the estimate of future revenuesor from and analysis of the past results.

There are many models elaborated on the base of esti-mates of future revenues resulting from results of future

cash flow. These models may differ either from the view-point of expected growth of the firm or from that of esti-mation of future cash flow.

The cash flow resulting from future operation of thefirm can be classified as follows: cash flow for owners and creditors

cash flow for owners

dividends as a special case of cash flow for sharehold-

ers

economic value added.

It seems that under conditions of the Czech Republic,the model considering all cash flows (i. e. both for own-ers and for creditors) is the most suitable method of farms

valuation. However, when considering possibilities ofapplication of these methods for the purposes of evalu-

ation of impacts of managerial decision-making on thefarms value, it is possible to recommend also the met-hod economic value added because it enables to identifythe most important factors of value formation and to eva-luate economic results with regard to risks associatedwith its formation.

Determination of cash flow as a sum of profit after tax-

ation and depreciation can be taken into account as thesimplest method, which can be used in practice. For theneeds of firm valuation, however, this method of calcula-tion is not sufficient because it assumes also the estima-tion of future revenues. If the firm wants to reach futurerevenues in the required extent, it must continuously in-vest with the objective to assure at least the reproduc-tion of depreciated long-term assets. This means thatfuture cash flows used for the firm valuation must involvecash flows resulting from the firm after the deduction ofexpected investment costs expended both into the oper-ational long-term assets and into the necessary workingcapital. Only this modification of cash flow expresseshow much money may owners and creditors drain fromthe firm without any disturbances of the expected farmsdevelopment.

Referring the current system of financial reporting, it ispossible to calculate the cash flow modified with regardto expected investments using the following simplifiedscheme:

Operational results

Income tax

+ Depreciation of long-term assets

+ Formation of long-term reserves

= Gross cash flow

Investments into the long-term assets

Increase of working capital

= Free cash flow

The method of firm valuation by the means of cash flowuses expected future data. This means that it is linked upwith financial planning, especially with long-term finan-cial plans. The long-term financial planning must be

based on a long-term concept of farms development andon its future strategy. It represents a system of well-ba-lanced plans considering various aspects of farms futuredevelopment.

Regarding the fact that the expected cash flows will beattained in future, it is necessary to convert (discount)them to the current financial value. This means that it isnecessary to decide with discount rate should be usedand how to define the calculated interest rate.

The basic function of calculated interest rate is to ex-press the expected profitability of an investment. Thecalculated interest rate also enables to express the levelof expected risk. Regarding the fact that the future reve-

nues will be attained not only by means of owned capital but also by foreign funds, the calculated interest rate

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must be determined on the base of average weighed cap-ital costs as follows:

K

VKi

K

CKdiPVNK

VKCK+= )1(

where:PVNK = average weighed capital costs

iCK = costs of foreign fundsd = income taxCK = value of foreign fundsVK = value of owned capitalK = total value of invested capitaliVK

= expected profitability of owned capital.

The average weighed capital costs represent averageexpenses, which must be paid after the acquisition of allkinds of capital. They are, therefore, dependent onshares of its individual components and on the height ofcosts associated with the acquisition of individual kinds

of capital. In this context it is debatable, which value offoreign funds and owned capital should be taken intoaccount. Should we consider its market or its book va-lue? Considering the fact that under conditions of theCzech Republic the capital market is not too much devel-oped, we can recommend the use of book value.

In practical situations, it is usually expected that thefirm will exist for an indefinite period. However, this ex-

pectation does not enable to plan cash flows for individ-ual years. This means that the cash flow resulting fromthe farms operation is usually divided into two time pe-riods, viz. into the time interval, which is explicitly prog-nosticated, and into the period that follows after this

explicitly prognosticated time interval. The expected dis-counted cash flow is then formed as follows:

Discounted cash flow = Discounted cash flow in the explicitly

prognosticated time interval + Discounted cash flow after the

explicitly prognosticated time interval.

This method is usually referred to as a standard two-stage method. The first one involves the period when itis possible to elaborate a prognosis of cash flows in indi-vidual years on the base of the available data while thesecond one represents a more distant time horizon whereall values can be estimated only with a low accuracy. In

the second stage, the value of a firm is usually denomi-nated as a constant or continuing value. The total farmsvalue is then calculated as a sum of both stages:

where:HP = total farms valueVPT

t= free cash flow in the year t

ik

= calculated interest rate

n = number of years in the first stageHPP = constant (continuing) value.

In the second stage, the calculation of farms value israther difficult but it is necessary to emphasise that it canconsiderably change this value. When calculating theconstant value of a firm, it is possible to use two assump-

tions, viz. the stable rate of growth of discounted financialrevenues or the expected profitability of new investmentsplanned for the period to come. The choice depends onthe decision of the person performing the valuation andon the economic condition of the valuated firm.

There is another problem associated with the discount-ing of future cash flows of the firm, viz. the fact that thereis usually used only one calculated interest rate for thewhole future period; this, however, could be acceptedonly in case that the capital structure of the firm wouldnot change. This assumption is not realistic because thecapital structure changes and for that reason, it is neces-sary to take into account that the calculation is not exact.

CONCLUSIONS

The estimation of a farms value is rather problematic anddifficult. However, under conditions of a developed mar-ket economy, which uses modern methods of management,this activity represents that part of operational manage-ment is oriented to the most important interests of owners.The owners are interested above all in the growth of their

property and for that reason, the increase of farms valuebecomes the main objective of business activities of thecompany top management. The farms value is affected by

various factors and a good knowledge of their quantita-tive effects and on changes in the farms value is very im- portant for a qualified decision-making of managers.Factors, which influence the value of the company, can beenumerated as follows: operational results of the firm,structure of stock capital and costs associated with capi-tal acquisition. These costs show an effect on the totalvalue of the company and the decisions of top manage-ment may significantly influence the costs of capital ac-quisition and thus also the final farms value.

REFERENCES

Kislingerov E. (1999): Oceovn podniku. C.H. Beck, Pra-ha, 304 s.; ISBN 80-7179-227-6.

Mak M. (1998): Urovn hodnoty firem. Ekopress, Praha,206 s.; ISBN 80-86119-09-02.

Neumaierov I., Neumaier I. (2002): Vkonnost a trn hod-nota firmy. Grada Publishing, Praha, 215 s.; ISBN 80-247-0125-1.

ivlov I. (1999): Finann zen podniku II. ES MZLUBrno, 88 s.; ISBN 80-7157-369-8.

Arrived on 23rd February 2004

Contact address:

Prof. Ing. Iva ivlov, CSc., Mendelova zemdlsk a lesnick v Brn, Zemdlsk 1, 613 00 Brno, esk republikatel.: +420 545 131 111, e-mail: zivelova@mendelu.cz

1

11 )1()1(

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k

n

t

tk iHPPiVPTHP

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