Valuation of a Business means determining its fair economic value by following a complex set of rules. This requires knowledge of various factors and valuation techniques besides professional experience and good judgement. A business valuation might include analysing a company’s management, its capital structure, expected future cash flows, or the market value of its assets. The tools used for valuation usually vary among businesses, industries and evaluators.
Following are some of the factors that should be considered while valuing a business.
Why Should a Business be Valued?
Business valuation begins with identifying the purpose behind it. The purpose for the valuation will determine the standard of value to apply and the basis of value which in turn will determine the valuation approach to be used and the assumptions made in arriving at the valuation. A business could be valued for the following purposes:
- Sale of the Business
- Business Merger or Acquisition
- Tax Purposes
- Marital Dissolution
Key Principles of Business Valuation
Business owners who want to create value and wealth must know the following principles
- The Value of a business changes every day and is defined only at a specific point of time.
- A company’s value is based on its ability to generate future cash flow.
- Market forces determine the rate of return required by prospective buyers in the market place.
- Value of a business may be influenced by underlying net intangible assets.
- The transferability of a business’ cash flows to a potential purchaser will impact the company’s value.
- The value of a business is influenced by liquidity.
- The ability to control is something that any buyer will pay a premium for
What Basis of Value to be Applied?
The Basis of Value takes into account the perspectives of the parties, i.e., the buyer and seller, to the transaction. The basis of value explains the type of value being measured and impacts the valuation approach which will be used, inputs and assumptions in the approach.
What Premise of Value to be Used?
The premise of the value is based on the purpose for the valuation and the basis of the value. The premise of value is either one of the following
- A Going Concern Premise
This approach assumes that the company will continue to operate as a business and its assets will be continually used.
- A Forced Liquidation Premise
This valuation premise assumes that the company will not continue operation and its assets will be operated or sold individually.
The premise of value for a business may be substantially higher for an M&A
How Has The Business Performed So Far?
In order to establish how a business has performed historically it is important to understand its history and evolution, its management and ownership structure. Various metrics like P/E ratio, Price to Book Ratio, Price to Free Cash Flow and Sales Price for recent transactions can be used to compare a company’s performance to other similar companies. In order to analyse a company’s historical performance, one must also consider its non-operating assets
How will the Company Perform in the Future?
While a company’s past performance is important, an investor is more concerned about its future outlook. The future outlook is in turn determined by its current performance and its current strategy. Based on this we can forecast the company’s future revenues, market share, operating expenses and cost of capital. These metrics can be compared with the metrics of other companies in the similar industry to understand a company’s future prospects.
The future outlook of the business also depends on the company management’s plan for ongoing value creation and its strategic plan for the future.
Which Valuation Approach to Use?
Once all the above parameters are established, the valuation approach to be used must be established. The following are the 3 basic business valuation approaches:
- Market Approach
Value of a company can be arrived at by using 2 market approaches.
In the first approach the value indicators (multiples) of comparable companies are averaged and the average is applied to the subject company. This is not a very precise approach.
In the second approach the value of a company can be determined on the basis of recent sales or asking price of similar businesses.
Limitations of the market approach include limited data as not much data of comparable companies may be available. Also very few companies are available for comparison when valuing large and complex companies. Another disadvantage is that it is difficult to value intangibles like intellectual property, customer relationship and contracts.
- Income Approach
The Income Approach is a classic method of valuing a company by converting its future cash flows into a single present discounted amount while reflecting the current expectations about future cash flows.
The Discounted Cash Flow (DCF) is the most followed approach under this method. The DCF approach involves the following steps
- Estimate Annual Cash Flows
- Convert the future estimated cash flows into current cash value equivalent
- Estimate the residual value at the end of forecast period
- Convert the residual value into current cash equivalent
- Add the current value of estimated cash flows to current value of residual value to arrive at the current value of the company
The major limitation of this approach is that it is subject to various assumptions and a change in the assumptions such as forecast period or cost of capital can have a big impact on the estimated value.
- Cost Approach
This approach reflects the amount that would be required currently to replace the service capacity of an asset. The logic in this approach is that investors will not pay more for an asset than they would pay for a substitute asset of equal utility.
Arriving at the Final Value
Before applying any of the valuation approaches everything from the purpose of the valuation, the basis and the premise of the value assumed, the past performance and future outlook of the company must be considered. In order to arrive at a fair and accurate value of a company the major challenge is to select the most appropriate valuation method and making the necessary adjustments. Thus valuation of a business is a complex process since not only quantitative factors but a lot of qualitative factors also have to be considered.