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2. Residual Value Business Valuation Methods
The three main business valuation methods to measure the residual value, which is calculated as part of the Free Cash Flow method, are as follows:
2.a The Perpetuity Business Valuation Method
The perpetuity business valuation method assumes that the company’s future cash flow will continue forever. The residual value of the business is calculated according to the following formula:
Where:
r = Discount Rate
n = The last year of the analysis period
Notes
1.Some analysts suggest using the operating profit instead of the free cash
flow in the formula.
2.Some analysts use a different (higher) perpetuity discount rate as opposed
to the free cash flow discount rate, assuming that the uncertainty grows in
future period that is far from the plan period.
3.Some analysts include growth rate in the formula assuming that the
business will continue to grow. They do it by multiplying the free cash flow
of the last year by the growth factor, and reducing the growth rate from the
discount rate.
4.The software does not support the above methods and they are described
for your information.
2.b The Liquidation Business Valuation Method
This business valuation method assumes that the most conservative way to calculate residual value is to assume that the firm will be liquidated at the end of the forecasting period. Therefore the residual value should be calculated as the net liquidation value – the assets value (including cash, account receivable, inventory, plant and equipment) less liabilities value (including accounts payable, short and long term liabilities). This value that is calculated for the end of the forecasting period is discounted for the beginning of the period before adding it to the discounted cash flow, in order to calculate the company value.
2.c The Price Earnings Business Valuation Method
This business valuation method assumes that the best way to determine a company’s residual value is to calculate its market price using the relevant Price Earning factor.
The Formula
Where:
Comparative P/E = P/E of any similar public company or industry average
r = The discount rate
n = The selected year
The residual value calculated by this formula is discounted to the beginning of the plan period and is added to the discounted cash flow.
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