Business Valuation - Explained
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What is Business Valuation?
Business valuation refers to the general process of ascertaining the economic value of a company unit or a whole business. Business valuation can be utilized in ascertaining a business' fair value for various reasons, with the inclusion of sale value, taxation, divorce proceedings, and establishing partner ownership. Owners would often consult professional business evaluators for an objective estimate of the business' value. Important: Estimating a business' fair value is an art, as well as a science. Several formal models exist which can be utilized, but picking the right one, as well as, the appropriate inputs can be somewhat subjective.
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How Does Business Valuation Work?
The business valuation topic is often discussed in corporate finance. Business valuation is usually carried out when a company wants to sell either a portion or all of its operations, looking to merge with, or seeking to acquire another company. A business' valuation is the process of ascertaining a business's current worth, utilizing objective measures, and evaluating every aspect of the business. A business valuation may include an analysis of the company's management, its future earnings prospects, its capital structure, or its assets' market value. Ghetto tools utilized for valuation can range from businesses, evaluators, to industries. Common business valuation approaches include discounting cash flow models, financial statement review, and similar company comparisons. Valuation is pertinent for tax reporting. The Internal Revenue Service (IRS) requests that a business is valued based on its fair market value. Some tax-related events like purchase, sale, or gifting of shares of a company would be taxed depending on valuation.
What are Business Valuation Methods?
Business valuation can be a complicated subject. Numerous methods exist and there is no hard and fast way of arriving at a valuation for a business. Examples of methods employed to value a business include:
Asset-Based (or Cost-Based) Valuation Methods
The asset-based approach focuses on the valuation of the firms assets or, in some instances, the cost of replacing those assets. This approach puts emphasis on the total assets and liabilities of the firm. It therefor reflects a whole-firm valuation, rather than simply an equity valuation. To identify the equity value of the firm, one subtracts the market value of any debt held by the company. Determining the valuation may also require adjustment for the intangible assets of the firm that may be incapable of replacement. Asset-based valuation has many variables based upon the purpose or type of company being valued. Common asset-based valuations include:
- Book Value,
- Replacement Value, and
- Liquidation Value.
Market-based Valuation Approaches
Market-based approaches value the business based upon the productive characteristics of the business in a given market. These methods focus on comparisons of like businesses, transactions, or industries (known as comparables or comps). Most of these methods focus on identifying a value-based, characteristic of the comparable and comparing it to the total price or value of the firm (i.e., Value-based Characteristic / Total Value of Outstanding Share). The ratio of this value-based characteristic to price is used to value businesses with similar productive output, involved in similar transactions (the reason for valuation), or operating within the same industry. In summary, these methods attribute a value to a business by using ratios (value characteristic to price) to compare the firm being value with other firms whose value is readily determined.
What are Income-Based Valuation Approaches?
Income based approaches value a business based upon the past, current, or expected future cash flows of the business and the risk that the business will not produce the desired return. Estimating and valuing flows of income is done through a process called capitalization. Capitalizing the income streams will produce a so-called present value. Risk is incorporated into this valuation through a discounting process. An applicable valuation formula will discount the present value of cash flows based upon the probability that the firm will not achieve the desired cash flows in the future. The discount rate uses many factors relevant to the individual firm that make the firms projections more or less likely. Below are multiple income-based valuation approaches:
- Earnings Capitalization
- Build-Up Method
- Discounted Cash Flow Method
- Excess Earnings Method
- Economic Value Added Methods
Hybrid Methods of Valuation
Numerous hybrid methods exist for valuing a business given the situation or scenario. For example:
- Venture Capital Methods - This method combines market-based multiples and discounts on projected cash flows for the the business.
- First Chicago Method - This method uses the venture capital method and employs an averaging function among multiple VC method valuations.
- Options-Based Methods - These methods employ complicated mathematical models to value a business based upon the options that exists for the use of money.