Under the option-pricing method, each class of stock is modeled as a call option with a distinct claim on the enterprise value of the company. The option’s exercise price is based on a comparison with the enterprise value (versus “regular” call options that typically involve a comparison with a per-share stock price). Both the common stock and preferred stock have, at the time of a liquidity event, “payoff diagrams” that are similar to the payoff diagrams of regular call options. The characteristics of each class of stock, including the conversion ratio and any liquidation preference of the preferred stock, determine the class of stock’s claim on the enterprise value.
The most commonly used methodology under the income approach is a discounted cash flow analysis. A discounted cash flow analysis involves forecasting the appropriate cash flow stream over an appropriate period and then discounting it back to a present value at an appropriate discount rate. This discount rate should consider the time value of money, inflation, and the risk inherent in ownership of the asset or security interest being valued.
A company may require to perform a stock valuation for a variety of reasons, including: 409(a) of the IRC, fair value of ESO expense, merger & acquisition, tax and financial reporting, business combination, minority shares and fractional interest valuations, stock option valuations, employee stock ownership plans (ESOPs), litigation/audit support and expert testimony, etc. A stock valuation is performed in two stages. First, the fair value of the enterprise is determined by applying one of the generally accepted approaches to valuation. Then, the stock is valued by applying an appropriate allocation method. Allocation of the determined fair value of an enterprise to the different classes of stock requires an understanding of preferred stockholder rights. Such rights are meaningful, substantive rights and often are intensely negotiated and bargained for by the investors.
The asset based approach is most useful when it is applied to tangible assets and to enterprises whose assets consist primarily of tangible assets. The reliability of value determined under the asset-based approach tends to be greater for tangible assets recently purchased in arms-length transactions. Asset based approaches can also be valid in the context of a company which has very poor financial performance.
The discrete valuation of an asset using an asset-based approach is based upon the concept of replacement as an indicator of value. A prudent investor would pay no more for an asset than the amount for which he or she could replace the asset. The asset-based approach establishes value based on the cost of reproducing or replacing the property, less depreciation from physical deterioration and functional obsolescence, if present and measurable. This approach generally provides the most reliable indication of the value of land improvements, special-purpose buildings, special structures, systems, and special machinery and equipment. Of the three approaches to valuation, the asset-based approach, is generally considered to be the weakest from a conceptual standpoint.