BUSINESS VALUATION

How to value a company or business?

While there are numerous valuation models and metrics around, there are only three valuation approaches:

Intrinsic valuation

It 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 valuation

It 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 valuation

It 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 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 marketplace 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 methods
• Comparable transactions multiple methods
• 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.