Why does one need a valuation? The purpose could vary from buying or selling a business to , raising capital, and planning for succession, to resolving disputes, or complying with tax and accounting regulations.
What Is Business Valuation Used For?
Business valuation is used for different reasons and by different stakeholders, such as:
- Business owners: Business owners may need to know the value of their business for strategic planning, exit planning, or personal wealth management. They may also need to value their business interest in case of a divorce, a partnership or a shareholder dispute.
- Buyers and sellers: Buyers and sellers may need to value a business for merger and acquisition (M&A) transactions, to negotiate a fair price, conducting due diligence, or structuring a deal. They may also need to value a business for financing purposes, such as securing a loan, attracting investors, or issuing shares.
- Tax authorities and regulators: Tax authorities and regulators may need to value a business for tax compliance, such as determining the taxable income, capital gains, or estate and gift taxes. They may also need to value a business for regulatory compliance, such as enforcing antitrust laws, protecting consumer rights, or ensuring fair market practices.
- Courts and arbitrators: Courts and arbitrators may need to value a business for legal purposes, such as resolving disputes, awarding damages, or enforcing contracts. They may also need to value a business for forensic purposes, such as detecting fraud, tracing assets, or assessing solvency.
Methods of Business Valuation
There are three main methods of business valuation, which are:
1. Income approach: The income approach values a business based on its ability to generate income or cash flow in the future. It involves projecting the future income or cash flow of the business and discounting it to its present value using an appropriate discount rate. The discount rate reflects the risk and the time value of money associated with the business. The income approach can be further divided into two sub-methods, which are:
- Discounted cash flow (DCF) method: The DCF method values a business by estimating its free cash flow, or the cash flow available to the owners after paying all operating expenses, taxes, meeting working capital needs and incurring capital expenditures. The free cash flow is then discounted to its present value using the weighted average cost of capital (WACC), which is the average cost of financing the business using both debt and equity. The DCF method is suitable for a variety of businesses including those that have stable and predictable cash flows, as well as high-growth companies, and businesses that do not generate revenue at the moment (eg., pharmaceutical or life-sciences companies).
- Capitalization of earnings method: The capitalization of earnings method values a business by dividing its normalized earnings, which are the earnings adjusted for non-recurring or extraordinary items, by a capitalization rate, which is the rate of return required by the investors. The capitalization rate is usually derived from the market multiples of comparable businesses or the industry average. The capitalization of earnings method is suitable for businesses that have steady and consistent earnings.
2. Market approach: The market approach values a business based on the market prices of similar or comparable businesses. It involves identifying and analyzing the transactions or the trading multiples of comparable businesses and applying them to the subject business. The market approach can be further divided into two sub-methods, which are:
- Market transaction method: The market transaction method values a business by comparing it to the prices paid for similar businesses in recent M&A transactions. It involves selecting and adjusting the transaction multiples, such as price to earnings, price to sales, price to book value, or price to cash flow, based on the size, growth, profitability, and risk of the subject and the comparable businesses. The market transaction method is suitable for businesses that operate in active and competitive markets, such as technology and consumer businesses.
- Guideline public company method: The guideline public company method values a business by comparing it to the market prices of similar publicly traded businesses. It involves selecting and adjusting the trading multiples, such as price to earnings, price to sales, price to book value, or price to cash flow, based on the liquidity, growth, profitability, and risk of the subject and the comparable businesses. The guideline public company method is suitable for businesses that have similar characteristics and performance to the public businesses.
3. Asset approach: The asset approach values a business based on the net value of its assets and liabilities. It involves adding the fair market value of the assets and subtracting the fair market value of the liabilities of the business. The asset approach can be further divided into two sub-methods, which are:
- Net asset value method: The net asset value method values a business by using the book value of its assets and liabilities, as recorded on the balance sheet. The book value may need to be adjusted for depreciation, amortization, impairment, or obsolescence of the assets and liabilities. The net asset value method is suitable for businesses that have low or negative earnings, such as distressed or bankrupt businesses or very early-stage companies.
- Liquidation value method: The liquidation value method values a business by using the net proceeds that would be realized from selling its assets and paying off its liabilities in a forced or orderly liquidation. The liquidation value may need to be adjusted for the costs and taxes associated with the liquidation process. The liquidation value method is suitable for businesses that have no going concern value, such as discontinued or non-operating businesses.
Factors Considered in Business Valuation
There are many factors that can affect the value of a business, such as:
- Financial factors: Financial factors include the historical and projected financial performance, position, and condition of the business, such as its revenue, expenses, profits, assets, liabilities, cash flow, growth rate, margins, ratios, and trends. These factors indicate the profitability, efficiency, solvency, and sustainability of the business.
- Non-financial factors: Non-financial factors include the qualitative and intangible aspects of the business, such as its industry, market, customers, competitors, suppliers, products, services, brand, reputation, technology, innovation, management, employees, culture, and risks. These factors indicate the competitive advantage, differentiation, customer loyalty, market share, and potential of the business.
- External factors: External factors include the economic, social, political, legal, and environmental factors that affect the business environment, such as the demand and supply, inflation and interest rates, consumer preferences and behavior, regulations and policies, and opportunities and threats. These factors indicate the opportunities, challenges, and uncertainties that the business faces.
Business Valuation Process
The business valuation process involves the following steps:
- Define the purpose and scope of the valuation: The first step is to define the purpose and scope of the valuation, such as the reason, perspective, standard of value, the date and level of value, and the premise of value (going concern or liquidation).
- Gather and analyze the relevant information: Next step is to gather and analyze information, such as the financial statements, tax returns, business plans, market data, industry reports, and legal documents of the business. This step also involves adjusting the financial statements for non-recurring or extraordinary items, normalizing the earnings for owner compensation or discretionary expenses, and calculating the financial ratios and indicators.
- Select and apply the appropriate valuation method: The third step is to select and apply the appropriate valuation method, such as the income, market, or asset approach, based on the nature, characteristics, and performance of the business. This step also involves selecting and applying the appropriate valuation multiples, discount rates, or capitalization rates, based on the risk, growth, and profitability of the business.
- Reconcile and report the valuation results: The fourth step is to reconcile and report the valuation results, such as the range, average, or median of the value estimates, based on the reliability, relevance, and consistency of the valuation methods. This step also involves preparing and presenting the valuation report, which summarizes the purpose, scope, method, assumptions, and conclusions of the valuation.
FAQs
- What is business valuation?
Business valuation is the process of determining the economic value of a business or company. It involves analyzing various aspects of the business, including financial performance, assets, market competition, and future earning potential. - Why is business valuation important?
Business valuation is crucial for various reasons, such as investment analysis, business sales, mergers and acquisitions, tax compliance, and financial reporting. It helps business owners and potential investors understand the true worth of a business. - What are the main approaches of business valuation?
The main methods include the income, market and cost approaches. - How does market condition affect business valuation?
Market conditions can significantly impact business valuation. Factors such as economic stability, industry trends, and consumer demand can influence a company’s projected earnings and, consequently, its valuation. - Can the purpose of valuation affect the valuation outcome?
Yes, the purpose of the valuation can affect the outcome. For instance, a valuation for a business sale might focus on maximizing the company’s marketable assets, while one for a merger might emphasize synergies with the acquiring company.
