3 APPROACHES TO BUSINESS VALUATION; BUSINESS VALUATION METHODS
Accurate valuation requires appropriate application of the available approaches to determine value, a clear understanding of the exact investment in a business that is being sold or acquired, and a precise measure of the company’s returns. Businesses vary in the nature of their operations, the markets they serve, and the assets they own. The target company can be listed or unlisted. For listed companies, market capitalisation can form the basis of valuation. Though market capitalization is a guide to acquiring a public company it doesn’t give an estimate of how much the target company is worth.
There are three primary approaches by which businesses may be appraised or valued.
(1) Income or Earning Based Models
(2) Asset-Based Valuation Models
(3) Market Approach Models
(1) Income or Earnings Based Approach
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. The income business valuation approach is based on the idea of valuing the present value of future benefits. This approach estimates business value by considering the future income accruing over a period of time. The methods most commonly used by business valuation professionals include the Capitalization of Earnings
Method and the Discounted Earnings Method (Discounted Cash Flow Method).
The income-based approach is further classified into:
(a) Capitalization of Earnings Method
The capitalization of the cash flow method arrives at a valuation by dividing the historical total cash flow stream of a business by its capitalization rate, a rate that reflects the riskiness of a business and its expected growth in the future. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two. This method is more appropriate when it appears that a company’s current operations are indicative of its future operations, assuming, of course, a normal growth rate. Under this method, a stable level of earnings is divided by a capitalization rate in order to arrive at an operating value for the entity. Where net earnings are being capitalized, the capitalization rate is the net earnings discount rate less the average sustainable growth rate.
Business Value = Net Operating Income / Capitalization Rate
Capitalization Rate = Discount Rate – Growth Rate
(b) Discounted Cash Flow Method (DCF Method)
Discounted Cash Flow (DCF) analysis is a method of valuing a pre-revenue startup using the concepts of the time value of money. All future cash flows are estimated and discounted by using the cost of capital to give their present values (PVs). The income approach recognizes that the value of an investment is premised on the receipt of future economic benefits. These benefits can include earnings, cost savings, tax deductions and the proceeds from disposition. Discounted Cash Flow Method is a form of the income approach that is commonly used to value businesses or equity interests.
In this method, the appraiser estimates the cash flows of any business after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met. Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders, after debt holders have been paid off. This method is more appropriate when future returns are expected to be substantially different from current operations. This method usually has two stages, the first stage involves a discreet forecast of future earnings or cash flow to be discounted to the present using a discount rate and the second stage involves the construction and discounting of a terminal value. The terminal value is determined when the entity’s future return stream is expected to achieve stable long term growth.
PV of future sum = FV/(1+r)n
(2) Asset-Based Valuation Approach
The asset business valuation approach is based on the principle of substitution that a prudent buyer will not pay more for a property than the cost of acquiring a substitute property of an equivalent utility. All assets and liabilities are adjusted to reflect the business as a going concern entity or the company in liquidation, depending on the premise of value appropriate for the valuation. An asset-based valuation is a form of valuation in business that focuses on the value of a company’s net assets (NAV), or the fair market value of its total assets minus its total liabilities, to determine the valuation. There is some room for interpretation in the asset approach in terms of deciding which of the company’s assets and liabilities to include in the valuation, and how to measure the worth of each.
The asset-based approach is best used when a business is non-operating or has been generating losses, and the company’s focus is holding investments or real estate. The adjusted net asset method is commonly used for estimating the value of the business. s. The difference between the fair market value of the company’s total assets and the fair market value of its total liabilities determines the fair market value of the business. This technique also includes the value of all of the business’s intangible assets and liabilities, such as goodwill and pending litigation.
The asset-based approach is further divided into the following:
(a) Net Asset Value Method or Asset Accumulation Valuation
Under Net Asset Value or Asset Accumulation method, all the assets and liabilities of a business are compiled, and a value is assigned to each one. The value of an entity is the difference between the value of its assets and liabilities. For the purpose of valuation, the usual thing to do is to divide the net assets by number of shares to get the net assets per share.
Net asset value is useful for shares valuation in sectors where the company value come from the held assets rather than the stream of profit that was generated by the company business. The examples are property companies and investment trusts. Both are convenient ways wherein the investors can buy diversified bundles of the assets they hold.
The assets’ value can be obtained at book value or market prices and used depending on the circumstances and the sector. Other considerations for net asset adjustments may include certain intangibles that are not fully valued on the balance sheet or included on the balance sheet at all.
(b) Excess Earnings Valuation
This approach is a combination of the income and the asset-based valuation method (hybrid method). Under this method where income and assets are both taken into consideration. One can also use this method to come up with the value of goodwill of the firm. To calculate the goodwill, we need to use the earnings as input and then apply the income method. Its usefulness for goodwill is why analysts prefer the Excess Earnings Valuation method when valuing a firm with strong goodwill.
In the US, IRS Revenue Ruling 68-609 describes the Excess Earnings Method as: “A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of, say, 15 to 20 percent, is the value of the intangible asset of the business determined under the `formula’ approach.”
(3) Market Approach
The market approach aims to establish the value of a company based on how similar firms are priced on the stock exchange or through company transactions. Using the market approach, price-related indicators such as price to earnings, sales and book values are utilised. The market business valuation approach is also based on the principle of substitution. The business valuation expert identifies business entities that have transacted as a way to compare the subject business. Sold businesses in comparison to the subject is a way to calculate value of an equally desirable company from an ownership or investment standpoint.
The comparison is based on certain financial ratios or multiples, such as the price to book value, price to earnings, EV/EBITDA, etc., of the equity in question to those of its peers. This type of approach, which is popular as a strategic tool in the financial industry, is mainly statistical, based on historical data, and current market sentiments. The market approach is a business valuation method that can be used to calculate the value of property or as part of the valuation process for a closely held business. Additionally, the market approach can be used to determine the value of a business ownership interest, security or intangible asset.
The market approach method has the following subdivisions.
(a) Public Company Comparable or Comparable Company Method
Comparably Company Analyses, or “Comps”, are a relative valuation technique used to value a company by comparing that company’s valuation multiples to those of its peers. Typically, the multiples are a ratio of some valuation metric (such as equity Market Capitalization or Enterprise Value) to some financial performance metric (such as Earnings/Earnings Per Share (EPS), Sales, or EBITDA). (An astute reader will note that Sales and EBITDA are enterprise-wide metrics, and thus should be used with Enterprise Value, while Earnings/EPS is an equity-related metric, and thus should be used with Market Capitalization.) The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal.
Comps are relatively easy to perform, and the data for them is usually relatively widely available (provided that the comparable companies are publicly traded). Additionally, assuming that the market is efficiently pricing the securities of other companies, Comps should provide a reasonable valuation range, while other valuation methods such as DCF are dependent upon an entire array of assumptions. These factors make Comps one of the most widely-used valuation techniques in practice. Investment bankers, sell-side research analysts, private equity investors, and other market analysts all use Comps.
(b) Precedent Transactions
Precedent Transaction Analysis, also known as “M&A Comps,” “Comparable Transactions,” or “Deal Comps,” uses previously completed mergers and acquisitions deals involving similar companies to value a business.
Precedent Transaction Analysis typically uses the same multiples as Comparable Companies’ Analysis (or “Comps”). In particular, Enterprise Value/Sales, Enterprise Value/EBITDA and Earnings/Earnings Per Share (EPS) are the most commonly used metrics. However, unlike in Comparable Company Analysis, the basis for value comparison is the price paid by the purchaser for a business, rather than the traded market values of the company’s securities. These prices can be different because there is a control premium—the value ascribed to being able to control a business rather than simply own a percentage of the equity in it. Thus, Precedent Transaction Analysis will typically result in valuations that are higher than standard Comparable Company Analysis.
Precedent Transaction Analysis tends to focus on the value of a business as of the time an acquisition of the business can be completed, rather than today. This is because deals take time to close, whereas current market values for a business can be assessed on any day. Sometimes, deals can take as long as a year (or more!) to close, so the Precedent Transaction Analysis should reflect that fact.
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