Business Valuation Methods-All You Need To Excel In Your Careers
People who are unaware of finance or business-related financial processes generally believe that pricing and valuation are two names for the same phenomenon. However, this is an erroneous statement that cannot be further from the truth. Valuation and pricing are phenomena that are like water and coconut oil, they appear to be the same from a distance, but the reality is very different. For business processes, pricing is a simple amount that one pays for gaining ownership of a good or service whereas business valuation reeks of complicated mathematical calculations on financial sources or better-known business valuation methods.
To dissect the various business valuation methods employed by firms to gain vital information regarding a company’s market value, you need a comprehensive understanding of business valuation, pricing, and how it operates. Furthermore, business valuation methods are complex methodologies that require a discussion of finance and the pertinent financial indicators used to compute the results of the valuation. Moreover, the variety of business valuation methods depending on the circumstances present, and the demerits and merits of each method are also worth exploring in detail. Lastly, the definition of a few important terminologies of business valuation and the reasons for conducting such an elaborate business exercise shall be understood.
Now without further delay, let’s sink our teeth into business valuation and the concepts related to it.
Business Valuation — Concept & Requirement
What is the value of a commodity, service, or article that satisfies us? Is it connected to the price we are willing to pay for it, the real price, or some concept of cardinal utility that is utilized to give valuation an exchangeable currency? Valuation is strikingly different from pricing opted because valuation is in terms of assets and pricing or rather a cost price of the creation or purchase of these assets affects their profitability and in turn, their value. Value also deals with past periods and future predictions whereas pricing suits itself with the present and is the expression of value in the short run. Before this let us grapple with a working definition of business valuation.
Business valuation refers to the determination of the value of various areas and departments of the business, which are eventually combined with multiple indices and factors to formulate the economic value of a company at prevailing prices. This process is often tedious and is undertaken to gauge the current value of a firm to map growth predictions, the value of sale for an enterprise, the accounts and balance sheets of the institution for the benefit of mergers and business acquisitions, for divorce proceedings as can be witnessed in the case of the Bill and Melinda Gates Foundation in recent years.
To establish a widely accepted value of a business, market transactions of the firm’s equity are without a doubt the most important factor to consider. For most companies trading publicly, their business value estimates can be derived from market transaction caps of their stock prices.
Market capitalization often directly reflects equity-related market transactions. Business valuation methods mostly deal with stock-related valuation to varying degrees however the major issue of business value lies in privately-owned enterprises. These established businesses are scarcely concerned with equity transactions, or any manner of transactions. Only through dealings and financial statements that are released on an annual basis do we get a peek into the revenue, shareholdings, and other business indicators of a company.
However, these transactions are usually insufficient to maintain valuation because changes in economic policy and their varying effects can have a vast variance in terms of management for firms and the large spans of little to no financial knowledge about these firms do not lead to predictability in valuation. Usually, it has been developed through indications and research that investments in private firms result in greater rewards for investors and result in greater value as well. To understand the procedures of business valuation properly, you’ll need to accustom yourself to a few terms of the trade.
Valuation is not a casual exercise as real-world transactions depend on good transactions. The conditions are known as business valuation standards and premise of value. The standard of value depicts the economic conditions presumed while valuation occurs while the other premise of value is more concerned with assumptions regarding the business itself. It is the most probable set of circumstances most likely to exist under the valuation of a subject.
It is a pivotal component in demarcating the wrong and right approaches that can be taken for business valuation in the long run. These can vary from going concern valuation to valuation based on the sale of all parts or assets of a business after discounting for liabilities. Following are the types of standards of value and premises of valuation.
Types of Standards of Value:
- Fair Market Valuation
- Investment Valuation
- Intrinsic Valuation
Types of Premises of Value:
- Going Concern Premise
- Assemblage Premise
- Liquidation Premise
- Orderly Disposal Premise
The concept of the business valuation placed inside of business valuation methods is considered to be crucial under a variety of contexts. These contexts sparsely mentioned previously are elaborated here as:
Mergers & Business Acquisitions and All Financial Transactions Involved:
In mergers, a key component of financial transactions is a mutual agreement on equity based on the valuation of the businesses. The valuation is essential to acquire an understanding of the financial conditions of businesses. They provide the standard payouts required for the sale of a business and its appropriate acquisition as well. Valuations for financial transactions including lending propositions are only possible when the lending authority has a clear indication that the business possesses the prospect of repayment. Moreover, expansions and business development depend solely on the countenance provided by the favorability of a valuation.
Tax & Succession Planning for The Future of The Firm:
Business valuation and tax are easily understandable and go together like peanut butter and jam. Valuation often reflects future benefits like increased sales profit or customer retention rate skyrocketing and taxation so levied is based on verifiable and apparent government policies. Once, sales are understood and valuation is calculated, taxation is taken under the liability section and falls under the valuation of a business.
If there are changes in taxation policy that boost tax collections at expense of business profits, valuation is adjusted accordingly and can be sustained at high rates through diversification of products in different markets. Succession planning entails the change in leadership positions in an establishment and fostering of potential candidates to fill these vacancies. Succession planning involves choosing the most appropriate candidate– a vital person who has established themselves as an important figure in the company by acting with purpose to fulfilling objectives and meeting deadlines.
The department that’s drawing the biggest pool of revenue is an important consideration as well while considering head executives for succession purposes. Business valuation through different business valuation methods is paramount for deciding the value of a business for the successor. It assists in maintaining the stability of a business while successors learn the workings of a business and the aspects that require greater attention. Finally, business valuation is often based on intrinsic valuations that require the balance sheets of a business and a complete compilation of financial statements. This process provides indispensable information regarding the sources of business value and armed with the knowledge of the sectors that provide the most value to your business, you can strategically plan for succession.
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Valuation for Litigation:
Divorce is a phenomenon that can be extremely depressing for many couples who suffer from the misfortune of encountering it in their life. It is a psychologically damaging and ostracizing process that incurs privately held public shame for the participants. Divorce litigation in most countries split the economic holdings of the breadwinner for the equitable distribution of economic wellness of the family as well as providing for the person who does not have a stable job.
If the breadwinner is a business owner/founder, the monumental impacts of divorce on business valuation are often lightly termed catastrophic. Most assets are divided into equal shares whereas in certain cases, entire companies might be given away to separated loved ones. On the other hand, the cases of legal damages due to minor infringements of patents and intellectual properties or class-action lawsuits in the infrequent case of major crimes on the premises of the company also stipulate business valuations be presented before the court.
The judicial procedure so activated will investigate and hear appeals on the same. However, if the entity is convicted, business valuation methods that fit the bill need to be utilized expeditiously. Business valuation derived from the appropriate business valuation methods is kept in mind while fines or compensation is charged to the convicted firm.
Strategic planning is essential for business growth and the sustainability of this growth for an extended period. As competition has grown over time even in the small to medium sector there is a rising call to engrave a direction for the brand image and the market towards which a company today should be focused. Furthermore, strategic planning ingrains focus on the priorities of a business through business valuation acting as a telltale measure of segments providing the highest business opportunities.
The aforementioned formulate the common contexts wherein business valuation methods are rigorously applied to gain valuation for direct benefit to the business at hand. We have clearly defined the contexts of use for business valuation and the context itself, let’s begin to unravel the different types of business valuation methods…
Types of Business Valuation Methods:
Business valuation is a comprehensive concept that is as wide as it is deep. So, it is obvious that business valuation methods to begin this process are multi-faceted and categorized under three different categories. They are:
These approaches are focused on the assets and liabilities of your company based on the balance sheet value.
These approaches are focused on the future profitability or earnings of the business and valuing them in present terms.
Market Value Approaches:
These approaches centre on the precedent of other businesses sold in the same industry and the valuations that led to their sale.
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These are three major types of business valuation methods. Let’s discuss them in detail with a few prominent methods as well:
Market Value Valuation:
This method involves collecting financial data from competitors and striking a balance with your valuation by using competitor valuations as a strong foundation. Methods under this valuation are:
PCC (Public Company Comparable values):
In this method, a subject is established (usually the company being valued), and public transactions of equity of other businesses in the same industry are utilized as metrics. In this method, precautions regarding comparability thresholds and the worthiness of comparing with guideline companies. Direct comparability refers to the comparability of business features due to their similarity with the subject’s features. Even with similarity being a strong part of the valuation, there is still significant for errors to emerge so there is always a need to be careful while adjusting competitor metrics to estimate your business value.
Precedent Business Valuation Method:
It is a method that utilizes pricing factors of business transactions of competitors as a basis for business valuation. It does utilize the limited data available as in a realistic situation, entire company data is not fully available. The presence of valuation databases and historical data can be useful for creating data principles for business valuation. Guideline transactions i.e., transactions from a very comparable company in the same sector are extremely useful. The majority or minority may be represented by such transactions and tackling the downsides of each situation is up to the professional conducting the business valuation, usually a business broker. However, this method suffers from a clear weakness that shifts it backwards in the choices for business valuation. The transactions utilized are not verified by this method and ones that reflect very different methods can be deleterious to the entire process of valuation.
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Some Merits and Demerits of These Methods:
- A straightforward method involving simple calculations that require little to no special expertise.
- Real and public data lend to transparency and applicability.
- Subjective forecasts often affect valuations since value can often be hard to
quantify. However, this method is not dependent on subjectivity of this sort.
- Lacks flexibility in comparison to other methods of valuation.
- The reliability of data is very important in this method. It is a method that does not rectify errors or sifts data for inconsistencies. Thus, it is solely reliant on the good nature of the data.
- Lack of comparable companies or transactions is common under this method.
Asset-Based Valuation Methods:
It is a method that focuses on all assets which can be compiled to form the structure of the business at hand. They also refer to the assets added to the business. It is an approach that focuses on the net value assets of a company, i.e., the total asset value after liabilities is deducted. It is the value that would be required to reconstruct the company in layman’s terms. It usually concerns itself with two methods of valuation:
Businesses that aim to continue their enterprise need not sell portions of company equity to meet the daily requirements of a company. This valuation method takes into account the available equity of the company and valuation is done accordingly. It is a basic method that works based on assets and liabilities on the balance sheet of a company.
Liquidation Valuation Method
This method of valuation is the counterpart of the going concern method as it deals with the liquidation of a business’s assets and adjusting them to represent prices at current rates. This procedure, however, does not quite maintain fair market levels of pricing so most valuations derived through this method do not take into account the future recoveries of assets being sold. It generates the sale of assets in the moment of urgency and thus, it is a valuable method of valuation to account for emergencies.
The following methods of business valuation are useful in determining value as per the books and dealing with finance on the surface. The following are some of the merits and demerits of asset-based methods:
- This method is indispensable as a valuation tool under emergencies like the liquidation of assets and mergers & acquisitions of businesses.
- Utilizes simple mathematical formulas and calculations that do not require rigorous mathematical formulas.
- This method also takes into account off-balance values, even though it may seem like it is a method entirely driven by balance sheets. Therefore, it is a comprehensive method.
- Assets are termed as immediately profitable under this method. This presumption may not be true in all cases and all periods.
- Calculating the intangible assets of a company is a tricky endeavour and can confuse the figures used for calculation if the definition of intangible asset classification is not standardized.
- Since it is extremely useful in short-term emergencies, it needs to be recalculated to derive a fair market valuation.
Earning Value Method:
This method underlines the valuation of the business in terms of its future earnings through sales profits, increased revenue, etc. It is a method that assumes that a company is stable and profitable throughout a relatively long period. It contains many methods; the major ones are as follows:
Capitalization of Earnings:
It is a method that assumes the current ROIs will continue as well as the expected cash flows and the expected value gained. It is a method that utilizes discounting rates of future returns to current values to estimate a business’s value at present.
DCF (Discounted Cash Flow) Valuation Method:
This method works based on projected cash flows and aims to recalculate them in the present values of the firm. It is an approach that focuses on the intrinsic value of a business and turns future returns into the weighted average cost of capital (WACC). It is an exhaustive procedure that requires extensive data and projections to formulate the most accurate predictions of results based on the incredible amount of inputs. It also offers high usability for further analysis and modeling. For example- It leads to discounted cash flow analysis that is useful for understanding the limitations of a company’s ability to generate liquid assets.
The Followings Are Some Merits and Demerits of This Method:
- The flexibility allowed by this method is phenomenal due to the many important factors like terminal value used to generate valuation.
- This valuation method combines multiple important factors and thus, the resulting calculations tend to be if the data utilized is accurate.
- It utilizes free cash flow as a base which is the most representative valuation option for shareholders.
- DCF is a sensitive procedural method that is susceptible to overestimation if the variables are not completely accurate. Thus, it requires other historical valuations to verify its results.
- Choosing the right discount rate is salient to the process. This is a mistake that can easily take place.
- It accounts for changes, but it is not quick to calculate as it requires a lot of variables.
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FAQs: (Business Valuation Methods)
Q1. What is the pricing of a business valuation consultation?
This question is not easily answerable due to variability in the costs of valuation services. You’ll need to check with the service-providing agency and your business manager.
Q2. Is there any difference between business valuation and business appraisal?
There is no difference between the two terms, and they can be used interchangeably in business circles as the jargon is understood by most professionals.
Q3.What is the step-by-step process of business valuation followed by professionals?
Business valuation in reality is conducted via a rigorous process. The steps of the process are as follows:
- The standard of valuation is set, and the purpose is understood.
- The basis of value is determined.
- The premise of value is established.
- Relevant data is collected.
- The historic performance of the subject business is reviewed.
- Prospects of the business are deliberately noted.
- A valuation approach is selected.
- Application of discounts wherever necessary
- Arrive at a proper valuation of a business.
This is the standard procedure for business valuation followed today.
We hope you learned something of value through this article. Thank you for reading.