If Owners decide to issue 1000,000 common shares, how much would be the value of each share?
The residual net income method takes profit into account to value any organization. It takes Net profit after taxes for the calculation. The future cashflows of the company are discounted to present value and then added together to arrive at the business market value.
The valuation process in the free cash flow method of Valuation is the same as the net residual method except that this method takes free cash flow into the calculation. Free cash flow takes Operating profit to which depreciation is added and working capital, taxes and interest expenses are subtracted. Then the future free cashflows are discounted to present value to arrive at business market value.
The appropriate discount rate used in the calculation is Weighted Average Cost of Capital (WACC) for the business whose calculation is shown in the Exhibit.
The value of a share from the free cash model is $1.35/ share and the value of the share from the residual income method is $1.26/ share. The company should try its best to get the maximum value of its shares. The value quoted must not be lower than 1.26 and it should try its best to get the value higher than 1.35 as the earnings may be more than the estimated cash flows mentioned in the calculation.
Analyze and explain which one of the above valuation methods provides a better and more realistic valuation?
The free cash model shows the intrinsic stock value for the company. It takes cash flows instead of earnings, which can be increased or decreased by creative accounting or by adopting different policies for different transactions. Even this method can be used by companies to estimate the cash flows required to estimate a given stock price.
The methodsalso have some disadvantages. The future cash flowsare only assumptions which can be proved wrong.Moreover, the inputs such as WACC and the growth rate are can be estimated in a wrong manner. This method is difficult to apply whenever a company faces difficulty in estimating sales and costs of the business. As more the cashflows are projected into the future, the uncertainty increases.
Moreover, the residual income model has its problems. It takes profits into calculation which can manipulated according to the wishes of the management. However, this problem by using figures from audited accounts.
Overall, the free cash flow model is the reliable method to ascertain the market value of a company. This method is the most popular method analysts and investors. The beauty of this method is that it takes into the real cash flows to value a business