There are many reasons why a business owner or company need to know the value of a business – to sell or buy a business, settlement on litigation, capital restructuring, expansion of business etc.
Business valuation demands high level financial analysis that should be undertaken by a qualified valuation professional with the appropriate credentials. Business owners who seek a low-cost business valuation are seriously missing out on the important benefits received from a comprehensive valuation analysis and valuation report performed by a valuation expert. These benefits help business owners negotiate a strategic sale of their business to get a fair price, minimize the financial risk of the management in a litigation etc.
How to price a company?
Business valuation refers to the process of determining the current worth of a company and there are many techniques used to determine value. The typical standard of value utilized is fair market value. The fair market value is the price at which a business would change hands between an independent buyer and seller having the requisite knowledge and facts, not under any undue influence and having access to all of the information to make an informed decision. An analyst placing a value on a company looks at the company’s management, the composition of its capital structure, the prospect of future earnings and market value of assets etc.
It’s a common misperception to say that the company is worth these many times EBITDA (earnings before interest, taxes, depreciation and amortization) simply, as that doesn’t take into consideration the industry, business risks, cash flow expectation, debt and more. So, it is always advisable to do the business valuation by a valuation expert. Not knowing the actual fair market value of the business could cause the business owner to sell the business for a lesser price or buy a business at a high price than it actually worth. For these reasons, the cost to do the business valuation can be an excellent investment. Sometimes it may be a savings in millions by paying a right price or by taking a right decision not to invest in an unworthy business.
How to value a company or business?
While there are numerous valuation models and metrics around, there are only three valuation approaches:
- Intrinsic valuationIt relates the value of an asset to its intrinsic characteristics: its capacity to generate cash flows and the risk in the cash flows. In its most common form, intrinsic value is computed with a discounted cash flow valuation, with the value of an asset being the present value of expected future cashflows on that asset – in cases where cash flows are more predictive in the business.
- Relative valuationIt estimates the value of an asset by looking at the pricing of ‘comparable’ assets relative to a common variable like earnings, cashflows, book value or sales.
- Contingent claim valuationIt uses option pricing models to measure the value of assets that share option characteristics.
There are three fundamental ways and other methods to measure the value of a business practice based on the above three approaches:- Asset methods
- Market methods
- Income methods
- Other methods
Under each approach, a number of methods are available which can be used to determine the value of a business enterprise. Each business valuation method uses a specific procedure to calculate the business value.
1. Asset Method
The asset approach to business valuation considers the underlying business assets in order to estimate the value of the overall business enterprise. This approach relies upon the economic principle of substitution and seeks to estimate the costs of re-creating a business of equal economic utility, i.e. a business that can produce the same returns for its owners as the subject business.
The business valuation methods under the Asset Approach include:
- Book value method
- Liquidation value method
- Replacement value method
2. Market Method
Under the Market Approach to business valuation, one consults the market place for indications of business value. Most commonly, sales of similar businesses are studied to collect comparative evidence that can be used to estimate the value of the subject business. This approach uses the economic principle of competition which seeks to estimate the value of a business in comparison to similar businesses whose value has been recently established by the market.
The business valuation methods under the Market Approach are:
- Comparative company market multiple method
- Comparable transactions multiple method
- Market value methods (Quoted securities)
3. Income Method
The Income Approach to business valuation uses the economic principle of expectation to determine the value of a business. To do so, one estimates the future returns the business owners can expect to receive from the subject business. These returns are then matched against the risk associated with receiving them fully and on time.
The returns are estimated as either a single value or a stream of income expected to be received by the business owners in the future. The risk is then quantified by means of the so-called capitalization or discount rates.
The methods which rely upon a single measure of business earnings are referred to as direct capitalization methods. Those methods that utilize a stream of income are known as the discounting methods. The discounting methods account for the time value of money directly and determine the value of the business enterprise as the present value of the projected income stream.
The methods under the Income Approach include:
- Price to Earnings or Earnings Multiple/Capitalization of Earnings Method
- Discounted Cash Flow Method
4. Other Methods
There are some other methods of business valuation which are as follows:
- Contingent claim valuation
- Price of recent investment method
- Rule of thumb
All the above approaches can yield different estimates of value for the same asset at the same point in time. To truly grasp valuation, we have to be able to understand and use all the approaches. There is a time and a place for each approach and knowing when to use each one is a key part of mastering valuation. There is no single business valuation approach or method which is definitive. Hence, it is common practice to use a number of business valuation methods under each approach. The business value then is determined by reconciling the results obtained from the selected methods. Typically, a weight is assigned to the result of each business valuation method. Finally, the sum of the weighted results is used to determine the value of the subject business.
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