Understanding the Basics of Business Valuation
Introduction
Business Valuation is the process of evaluating a business to understand the true worth of the venture in terms of its potential as an operating entity and potential value as a saleable asset. The purpose of Business Valuation is to determined how much a business is worth so that a potential buyer, investor or lender can make an informed decision on whether to pursue such an opportunity.
When considering a business valuation, there are several different methods that are often used.* Some of these methods are more traditional, while others are more modern or nuanced. In this blog post, we will take a look at the different types of business valuation methods.
*Reference: https://www.hg.org/legal-articles/what-are-the-different-types-of-business-valuation-methods-44744Comparable Company Analysis
Comparable company analysis is a method of valuing a company that is based on the comparison of sales or value indicators of similar businesses. This method of business valuation relies on finding companies that are similar to the one that is being valued and then analyzing their business performance, enterprise value, and other valuation multiples to come up with a valuation of the subject company.
Explanation of Method
When performing a comparable company analysis, analysts take a look at the financial performance of similar companies in the same industry and same geographic area to establish an estimated business valuation. With this method, analysts search for publicly-traded companies with similar characteristics, such as company size, industry classifications, and product offerings, to identify their market capitalization, which is the total value of a company's outstanding shares. They then use this financial metric to estimate the value of the subject company.
Advantages
- This method is relatively quick and simple to use, compared to other methods such as discounted cash flows.
- This method is best suited for valuing public companies.
- It is also useful for valuing private companies, especially those that do not have published financials.
Disadvantages
- This method is subject to market fluctuations, resulting in inaccurate valuations.
- It is difficult to find comparable companies, especially for a small business.
- This method does not take into account potential future growth or potential risks.
Discounted Cash Flow Analysis
Discounted Cash Flow Analysis (DCF) is a method of valuing a business based on the sum of its projected cash flows within a certain timeframe and discounted back to the present. It is also known to give estimates of future cash flows to determine a company's intrinsic value. The calculation attempts to estimate an appropriate discount rate and is used to account for risks and the time value of money.
Explanation of Method
When using the DCF method, first a forecast of the cash flows from the business is created, usually over a five to ten year period, although longer or shorter periods can be used. The sum of all of these cash flows is then discounted back to present value. The discount rate used should reflect risks and the time value of money. The more detailed the assumptions in the forecasting the more accurate the end result will be.
Advantages
- DCF is an accurate measure of a business’s value. By using the future cash flows of a business, a more realistic value is gained that takes into account all of the possible risks.
- The DCF method allows all of the assumptions to be adjusted to reflect the changing market environment. This makes it an advantageous method for a business to use since the DCF model can be easily adjusted for any potential investment opportunity.
- The DCF method can be used to compare different investments and business opportunities. By taking into account the same assumptions, different investments and business opportunities can be compared to get the best options.
Disadvantages
- The complexity of the assumptions used to develop cash flow forecasts can lead to inaccuracies. If any of the assumptions are off, the end result of the valuation will be inaccurate.
- The DCF method is complex and requires a lot of time and effort to accurately estimate future cash flows. The results of the DCF analysis can be affected by small changes in the assumptions used, which can lead to inaccurate results.
- The DCF method does not take into account any qualitative aspects of a business. By failing to consider factors such as customer relations or a company’s culture, the DCF method can provide an incomplete assessment of a business’s true value.
Asset-Based Valuation
Asset-based valuation is a method of business valuation that involves looking at the overall value of existing and potentially liquidated physical and intangible assets. It involves both tangible and intangible assets, such as land, buildings, inventory, furniture, equipment, copyrights and patents, trademarks, customer relationships and noncompete agreements.
Explanation of Method
When performing an asset-based valuation, the first step is to identify all of the physical and intangible assets owned by the business. Once the items have been identified, their individual values must then be determined. Tangible assets typically must be appraised in order to calculate their value. Once the values of all of the individual assets have been determined, they must be aggregated to determine the company's total asset-based valuation.
Advantages
One of the primary advantages of asset-based valuation is that it typically does not require extensive market research or analysis, which can be costly and time consuming. Additionally, it is generally easy to understand and always considers the tangible and intangible assets of a business, which can provide a more comprehensive view of its value.
Disadvantages
The primary disadvantage of asset-based valuation is that it does not always accurately reflect the true value of a business. This is because it does not take into account future cash flow projections, profitable growth potential, returns on investments, and other factors that may affect the company's current and future value. Additionally, it can be a lengthy and expensive process to accurately identify and appraise all of a business' assets.
Market Approach
The market approach to business valuation is conducted by comparing the subject company’s financial information to that of similar, publicly traded companies. This method looks at the prevailing price/earnings ratio (P/E) of companies that operate in the same or similar industry. Information on the market conditions of the industry, the competitive landscape that the subject company operates in, and the stability of the industry all factor into the overall market approach assessment.
Advantages
The market approach is typically an efficient method to use when evaluating the value of a business. This method is based on publicly available information, allowing for savings in cost and time, as a qualified business appraiser is not needed to conduct this analysis. Furthermore, it reflects the relatively recent market conditions, as the published financial data of comparable companies is recent. Finally, subjectivity is minimized by this approach.
Disadvantages
This approach relies heavily on the availability of reliable and applicable financial data. Companies in the same industry can display vast disparities when it comes to financial information and performance. As the value derived by this method is heavily influenced by the chosen comparable companies, it may often lead to non-applicable results. Additionally, large sums of data needs to be analyzed, which can be a tedious and time consuming task.
Cost Approach
The cost approach is based on the idea that the market value of a business is roughly equal to the comparison between the cost of a replacement for an asset and its current condition. It is used to estimate the current value of a business by examining its tangible assets, such as plants and property, and intangible assets, such as licenses and patents. It is important to note that the cost approach does not consider potential future cash flow or risk.
Advantages
- It considers both tangible and intangible assets in the valuation.
- It is simple and quick to calculate.
- It is highly useful for distressed assets where future cash flow is uncertain or unavailable.
Disadvantages
- It ignores future potential cash flow which could be particularly important in establishing the value of business.
- It does not account for systematic risk associated with the business.
- It may be ineffective in the case of rapidly changing technology.
Conclusion
Business valuation is an essential part of any business transaction or investment decision. Whether you are an owner considering selling a business, or an investor evaluating an acquisition, understanding the different business valuation methods is key to determining the worth of a business and/or the best way to value it accurately.
This post has explored the different business valuation methods, from the most traditional to the most cutting edge. Each method has its own unique strengths and weaknesses, and each business must evaluate them carefully to choose the right one.
Recap of Different Business Valuation Methods
The following methods were discussed in this post:
- Asset-based Valuation
- Market Comparison Valuation
- Discounted Cash Flow Valuation
- Industry Rules-of-Thumb Valuation
- Excess Earnings Valuation
- Real Options Valuation
Importance of Utilizing Proper Valuation Method
Because each of the above methods has its own advantages and disadvantages and no one method can capture every aspect of a business’s worth, it is important for business owners and investors to use a combination of different business valuation methods to ensure that a fair and accurate valuation is obtained.
In conclusion, business owners and investors must understand the different types of business valuation methods in order to choose the right one that best suits the need and helps derive the most accurate and reliable business valuation.