1962 Economic and Valution Symposium, Dallas, March 15–16, 1962

Abstract

Debate over techniques of valuation of the going concern has been intensified in the recent wave of merger activity. It is the objective of this paper to analyse various methods of valuation within the con ceptual framework of present value theory. Initially, however, it is necessary to establish an unambiguous concept of investment value before turning to the challenging problems of determining suitable bases upon which bids and offers can be formulated.

THE CONCEPT OF INVESTMENT VALUE

Valuation of an integrated oil company is perhaps best approached by considering the process by which an individual capital expenditure proposal is appraised. Investment in a project is essentially made for the purpose of maximizing profit; i. e., obtaining the highest available rate of return on outstanding equity investment over the economic life of the venture. The process by which investors can most realistically estimate earning power and evaluate alternatives is through discounting future outlays and income receipts in such a manner as to permit comparison of cash outgo and income on a present value basis. Two widely utilized techniques are the trial and error solution for the "discounted rate of return" and the present value" method in which discounting is performed via an assumed minimum acceptable rate of return. In the following discussion, the "present value" method will be employed in view of the ease of its application and the implicit assumption of reinvestment at the project rate.

The present value concept of the measurement of economic worth was propounded in a highly developed form around the turn of the century by Friedrich Von Wieser, Eugen V. Bohm-Bawerk and H. J. Davenport. Davenport, for example, suggested that the process by which the present price of capital goods is fixed is one of capitalization and that "the present money worth of any future income or of any series of income constitutes "capital". More recently, economic innovators such as Irving Fisher, Lord Keynes, Kenneth Boulding, Eugene Grant, Friedrich and Vera Lutz, and Joel Dean have elaborated on the concepts of present value and the discounted rate of return.

Application of present value theory to project proposals and to going concerns fundamentally assumes that the purchase price or capital outlay is determined by the present value of future earnings available for dividend distribution, and further that these cash earnings can be estimated into the future with some reasonable degree of accuracy. The strength of the present value method is the required quantification of all known factors having a bearing on the relation between cash outlay and income in the stream of dime. The inescapable weakness of a discounting procedure, as in all measures of prospective profitability, is the requirement of predicting events which necessarily must remain in the nature of estimates, particularly as the forecasts extend into the more remote future.

The most critical element in appraising the present worth of an asset is a realistic projection of earnings prospects. Business ventures are, however, by their very nature surrounded by uncertainty. Entrepreneurial profit is in large measure derived from out. guessing competitors as to the outcome of events which are essentially unique. The drilling of a wildcat well, the introduction of a new product or process, the establishment of a new distribution outlet, the purchase of a share of stock or the decision to become liquid all require that the investor make an estimate of the outcome of these actions. Though varying in degree, each one of these decisions must be based ultimately on judgment and understanding since no precisely accurate numerical calculation applies to such singular and uncertain events.

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