What is business valuation?
Business valuation is a set of processes and steps that help to assess and arrive at the worth of a business. In other words, valuing a company refers to the processes adopted to set an objective and fair price for a company in a financial market.
The Need for Company Valuation
Company valuations are undertaken under different contexts. There are many situations that may drive a business owner or management to step back and assess what the firm may be worth. For instance, if you are a business owner, you may do a valuation if:
You want to know the accurate assessment of the business’s value, which is crucial during the sale or purchase of business. In this case, you know the exact worth helps sellers set a fair price and buyers make informed decisions.
You plan to approach external investors such as debt or equity finance for support, as lenders require a clear understanding of the business’s financial health to assess the risk involved.
You plan to divorce settlements or resolving partnership disputes, where an equitable distribution of assets is required.
You want to understand the business environment is key to making the sound decisions during such valuations.
You are planning to aid in strategic planning and growth. By understanding the value drivers and financial strengths, business owners can make informed decisions to enhance profitability and sustainability.
You have to identify potential areas for improvement or expansion. In India, where a family-owned businesses are prevalent, valuations are crucial for succession planning and ensuring a smooth transition of ownership
You are looking for a well-documented business valuation can attract potential investors or partners by showing the business financial stability and growth prospects.
Valuation Methodology and Approaches of Business Valuation
The standard of value used in the Analysis is “Fair Value”, which is often defined as the price, in terms of cash or equivalent, that a buyer could reasonably be expected to pay, and a seller could reasonably be expected to accept, if the business were exposed for sale on the open market for a reasonable period of time, with both buyer and seller being in possession of the pertinent facts and neither being under any compulsion to act.
Valuation of a business is not an exact science and ultimately depends upon what it is worth to a serious investor or buyer who may be prepared to pay a substantial goodwill. This exercise may be carried out using various methodologies, the relative emphasis of each often varying with:
• whether the entity is listed on a stock exchange
• industry to which the Company belongs
• past track record of the business and the ease with which the growth rate in cash flows to perpetuity can be estimated
• Extent to which industry and comparable company information is available
Fundamentally, there are three different approaches that are used to arrive at a value for a business.
1. Asset Based Valuation Model
Being a straight forward method, the value of shares of target company is computed in terms of net assets acquired. This method of valuation is not based on income generation rather than on income generating assets. This method is least important in case of IT companies where ‘hard’ assets make little importance as these companies’ assets are intellectual property rights and human resources.
This approach further can be classified into following three methods:
i) Net Asset Value – The most simplest method also called ‘Book Value’ Method computes the value of shares of the company as follows:
Net Fixed Asset = Fixed Assets + Net Current Assets – Long Term Debt
ii) Net Realizable Value – Also called Liquidation Value or Adjusted Book Value it can be defined as realizable value of all assets after deduction of liquidation expenses and paying off liabilities. Though in some case liquidation expenses can be ignored if business of target company is acquired as a going concern.
iii) Replaceable Value – This method involves valuation as per determination of the cost of group of assets and liabilities of equivalent company in the open market. This method has an advantage over Book Value as it takes into consideration proper valuation and generally it is slightly higher than Net Realizable Value as quick asset disposal is not encouraged. And due to this reason many author believes that it is the maximum price that an acquirer would pay for the equivalent business.
2. Income Approach or Earning Value Approach
This approach looks to overcome the drawbacks of using the asset-backed valuation approach by referring to the earning potential. This method is more suitable when acquiring company is intending to continue business of target company for foreseen future without selling or liquidating assets of the same. Accordingly, if any additional earning is there due to acquisition the same should also be considered in valuation. Basically, PE Ratio also called Earning Yield is used in this approach. Though there is another version of the same called Capitalization Rate.
i) PE Ratio or earning Yield Multiplier – Price Per Share = EPS x PE Ratio
ii) Capitalisation of Earning –
Capitalisation Earning Value = Expected Annual Maintainable Profit
Capitalization Rate or Required Earning Yield
3. Cash Flow Based Approach
As opposed to the asset based and income-based approaches, the cash flow approach takes into account the quantum of free cash that is available in future periods, and discounting the same appropriately to match to the flow’s risk.
Simply speaking, if the present value arrived post application of the discount rate is more than the current cost of investment, the valuation of the enterprise is attractive to both stakeholders as well as externally interested parties (like stock analysts). It attempts to overcome the problem of over reliance on historical data as seen in both the previous methods. There are essentially five steps in performing DCF based valuation:
Arriving at the ‘Free Cash Flows’
Forecasting of future cash flows (also called projected future cash flows)
Determining the discount rate based on the cost of capital
Finding out the Terminal Value (TV) of the enterprise
Finding out the present values of both the free cash flows and the TV, and interpretation of the results.
Outsourcing your Company Valuation
You need external help to arrive at a fair valuation for your business, simply because a business owner or an in-house team of the company will not be able to take a detached, objective analysis of what his or her company is worth. A certified chartered account with specialized skill in valuation can help you with your company valuation.
If you are looking for tax consultants in Bangalore for business valuation services, get in touch with us today