What is Business Valuation?
Business valuation is the process of measuring the present value of a business. The meaning of the value of a business depends on the method of valuation used, as you will see later on in this article.
Usually, a business needs a valuation when it considers a merger or acquisition, raises investments, takes a bank loan or carries out strategic planning.
The process of valuation begins when a company contracts the valuation service to a certified appraiser. The appraiser then collects information about the company, including a thorough due diligence of operational, financial and legal matters. The appraiser may also conduct a qualitative analysis of external factors like trends or technological innovations in the industry in which the company is operating, as well as how competitors are responding to those. This is followed by identifying the appropriate method of valuation, adjusting financial variables as required, estimating the value of the business and reporting findings.
Approaches & Methods of Valuation
Primarily, there are three approaches of business valuation- asset based, income based and market based. Under each approach, there are various methods of measuring a business’s value.
Broadly speaking, the asset based approach equates the value of a business to the value of its assets. For example, when the Book Value Method is used, the value of a business is equivalent to the value of its tangible assets. This value is calculated by subtracting the value of the business’s liabilities and intangible assets (like copyright or patents) from the value of its assets.
Likewise, when the Liquidation Method is used, the value of a business is equal to the value it would receive by selling off its assets within 6-12 months in the open market. Similarly, the Replacement Cost Method equates the value of a business to the cost of replacing its assets- by buying the same assets having similar conditions in an arms-length transaction.
In contrast to the asset based approach, under the income based approach, the value of a business is equivalent to the present value of its future income, which is called the “intrinsic value” of a business. Discounted Cash flow (DCF) Method is the most commonly used method under this approach. This method is based on the “time value of money”, which assumes that the value of money increases over time through investment. So, the future cash flow of a business is estimated for a certain time period (say, the next 5 years), then a discount rate is applied to it to arrive at its present value. The discount rate is usually the weighted average cost of capital of the company being valued.
On the other hand, the market based approach evaluates a business based on how it compares to other, similar businesses. This is why the valuations generated using market based approach are called “relative values”. The comparable businesses should be in the same industry and geographical area and should sell the same product or service. They should have similar size, assets, number of employees, revenue, profitability and growth.
There are two methods under the market based approach. The first is Public Company Comparables Method, in which the subject company is compared to a publicly listed company of similar nature. To perform the valuation, a list of comparable companies is prepared, their financial data are collected, like share price, revenue, EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization), market capitalization (total value of all outstanding shares) and enterprise value (cost of purchasing a business). Then, the ratios of these variables are calculated, like price to book value (P/B), and price to sales (P/S), to provide a relative value of the subject company.
The other method is Precedent Transactions Method, which measures the value of a company by analyzing the price paid for similar, publicly traded companies during mergers & acquisitions in the past.
Outside of the three approaches, there are other methods of business valuation like Market Capitalization Method, which measures the value of all outstanding shares of a company. Another one is the Enterprise Value Method, which measures the cost of purchasing an entire company.
Which method should be chosen for a business?
Which method of valuation should be applied to a company depends on how much data is available, how much detail is being sought, and the industry in which the business is operating.
For example, Discounted Cashflow (DCF) Method is suitable for industries in which cash flows are stable and predictable, like pharmaceutical and FMCG industries. If a company has just started operating, it may not have the required data to apply DCF Method. Similarly, a small company’s valuation does not have to be as detailed as a larger company’s valuation.
Sometimes, appraisers conduct valuations using multiple methods before providing a final value for a business based on those methods.