The recent surge in stock trading to prevent private equity funds from realizing profits arising out of their bets against struggling companies has raised significant questions as to how a company should be valued. While there are several different ways to value a company, no single method is perfect. For example, if someone has a really nice house, she may still struggle financially if she has no cash to pay for anything, and even if someone has a large income, they may not be able to make ends meet because they are overwhelmed by debt. These situations have created a flexible approach to determining the valuation of businesses, and the need to use different metrics to determine value has been codified in the revisions to Florida’s corporations statute, which uses the Balance Sheet and Income Tests to determine whether a corporation is insolvent, and has indirectly incorporated the market test to this determination by giving shareholders appraisal rights.
In the context of recent events,
The stock of GameStop and other similar entities has sky rocketed, but it does not actually establish the realistic value of the company. While the “market test” as defined below is one way to value a company there are other common methods to figure out what a company’s value is. Those are:
The Balance Sheet Test
One of the easiest ways to determine the value of a company is to take the value of a company’s assets and subtract it from the value of a company’s liabilities. This is often referred to as the balance sheet test, because it takes a balance sheet as the point of reference. The problem with this method is that it does not fully account for contingent assets, such as receivables, and may not show an accurate reflection of a company’s financial condition at a given time. Even if a company has more assets than liabilities, it may not have the ability to meet its obligations, rendering it insolvent.
The Cash Flow Test
Also known as the Gordon Growth Model for determining terminal value, cash flow is a measure of just how much money the business will bring in, i.e. revenue. Total revenue is then multiplied by a figure representative of the business’s discounted cash flow ( 1/discount rate – growth rate).
The Market Test
This method for evaluating value simply looks at what a willing buyer and seller would pay for it. One way to determine the market value of a company is by multiplying a company’s share value(what a buyer and seller of the stock is currently willing to pay per share) by its number of shares outstanding, but the value of shares is different than the value of a company itself and what a willing buyer and seller would pay. However, recent events, such as the purchase of stocks such as NOK, AMC, and GME, without any increase in the company’s balance sheet or cash flow valuation, establishes deficiencies in this method.
While these methodologies are commonly used to value a company, the value of stocks as traded in the open market is based on what investors believe a company will be worth some day and not an accurate reflection of the company. Compare the value of a company divided by # of shares to the value of stock. It’s measured differently. In the context of people purchasing stock, without any basis underlying the purchase, it only inflates the trading price of the stock and not the actual value of the company. What this means is that while the Reddit users have temporarily harmed the interests of those shorting GameStop, their conduct did not help the company at all, and, once the actual value of the company, as opposed to its stock is disclosed, there likely will be a significant correction. Given the proliferation of litigation concerning these circumstances, there will be substantial disputes over which valuation methodology best reflects what a company is worth.
At Millennial Law, we are very mindful and understanding of the dynamic way that businesses operate and are here to help you with any of your needs.
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