Importance of business valuation
Valuation is the process of determining how much an asset is worth. The same methods used to value assets are used to value companies. Business valuation is necessary for several reasons. These include the following:
- Understanding how much a company costs if you need to sell it in whole or parts of it
- Increasing the efficiency of the company
- Determining how much a company’s stocks/shares are worth on the market
- Knowing the worth of a business in case of liquidation of the company, its takeover, or division into a separate structure
- Creation of a plan for the development of the company as it allows to understand what future income may be and how stable the company will be in the future
- Determination of the company’s opportunities for loans
- Business insurance in case of unexpected events
- Making informed management decisions
- Working with an investment project for the development of the company.
When inflation occurs, the company’s reporting is distorted. In this case, it is necessary to re-evaluate the company with the participation of independent appraisers. Note that if one and the same object is evaluated at the same time from different positions, then its value may differ to a certain extent because it will be determined by different methods and using different instruments.
Business valuation methods
There is no single business valuation formula that you can use to calculate its value. To evaluate their company, business owners usually hire a specialist, but it is worthwhile to learn the basic methods of determining it yourself.
The market value of an enterprise is a combination of tangible and intangible property, taking into account future income. Assessing this value requires careful cash flow analysis. The market value is the price for which the business is most likely to be sold on the exchange on the day of valuation. The market value of an enterprise is not always the same as the investment value. The market approach is needed in the following cases:
- when a company or its property is seized by the state;
- to clarify the value of shares;
- to determine the value of the company as collateral;
- in case of bankruptcy of the owner of the enterprise;
- appraisal of property received free of charge;
- transactions of sale and purchase of the whole business or part of it.
The market price of the enterprise is highly objective. It does not depend on the wishes of the parties. The market approach can also be referred to as a comparative approach to business valuation because the real selling price of a similar company, which is known because it is publicly traded or recently sold and the sale terms were disclosed, is considered to be the most probable value of the appraised business.
The main advantage of this approach is that the appraiser is guided by the actual purchase and sale prices of similar enterprises. The method reflects the supply and demand for the given company. To calculate the business value using the market approach, reliable market information on purchase and sale transactions of other businesses and reliable financial information on comparable businesses is required.
This approach has its limitations. It does not take into account the development potential of the assessed business, so it is advisable to assess enterprises that have reached a stable profit and it can be assumed that in the realistically forecasted future their activities will not be terminated.
Capitalization of earnings
This method of assessing the value of a business is used if the appraiser has conducted an analysis of financial and economic activities and there is reason to believe that the efficiency of the enterprise will be maintained in the future.
There are situations where the use of capitalization of the earnings method is limited or completely impossible. One of them is when the business was created recently and is still at the stage of formation, so it is not yet possible to generate data on income stability. It might also be not possible to draw conclusions about market transactions because the business owner provided insufficient accounting data. Finally, if the restructuring of the business is planned, its profitability is unclear since it is not known what the financial indicators will look like after the change in the structure of the company.
Limited use is the only drawback of the method. The advantages include simplicity of calculation and the ability to assess the current market conditions. Estimators use the following business valuation formula in their calculations:
Business value = Expected cash flow for a single period / Capitalization rate
As you see, there are two important numbers. For example, if the business had a cash flow of $100,000 a year and you want a 25% return on your money (capitalization rate), then you would be willing to pay $400,000 for this particular business.
Discounted cash flow
This method also falls under the income approach and is used to assess enterprises that are in the stage of intensive business development, to evaluate companies for which there is no reason to assume an unlimited life span. The life of a business can be limited by lease agreements, falling demand for manufactured products, etc. Under the discounted cash flow method, the enterprise value is based on future projected income streams.
The further you look into the future, the more risk there is to the investment as there is no guarantee you will receive as much as you expect or receive it at all. Thus, investors use the discounted cash flow method to find the sum of the present value of the asset’s future cash flows because they are concerned with the price of the asset today. After all, the further the cash flow is the less valuable it is to the receiver. So, you look at all of the future value of the cash flows the business is generating and convert them into today’s price using the following business valuation formula:
An asset-based method is used when valuing a charity or non-profit organization or for-profit businesses that are at a loss or a break-even point or when the capitalization of earnings (income) approach cannot be used. The business valuation formula in this case is very simple. It is just total assets less total liabilities, without taking goodwill into account.
The assets portion includes:
- Long-term assets are reflected in the first section of the Balance sheet (intangible assets, fixed assets, construction in progress, profitable investments in tangible assets, long-term financial investments, other non-current assets, except for the actual costs of buying out own shares from shareholders).
- Current assets are reflected in the next section of the Balance sheet (stocks, accounts receivable, short-term financial investments, cash, other current assets).
The buyer can evaluate whether the assets were valued fairly. As you might know, there are several methods of valuing assets. The going concern value method will provide you with the highest value because it also includes the intangible value of the business. The business can also use a replacement value or the cost to go and buy the assets it currently has. There are also depreciation value and net realizable value among others.
The structure of liabilities taken into account comprises long-term liabilities, which include loans and other long-term liabilities, and short-term liabilities, including interest payments on loans, accounts payable, and other short-term liabilities.
Business valuation is necessary not only when selling it. The effective development of a company is impossible without knowing the value of company. As you saw, there are multiple ways to arrive at the final number. Each of the methods for calculating the value of a business has its own advantages and disadvantages.
Business valuation performed by an independent professional appraiser removes subjective factors and questions about the possible manipulation of information. Correctly carried out calculations using the business valuation formula help to develop business plans based on real indicators, improve the methods of enterprise management, make the right investments, assess the creditworthiness of a business, and carry out effective reorganization.