Business Valuation, 3 Methods, Basic Concepts of Each
How do judges arrive at their results, especially in a dancing competition? What factors do they consider? This calls for the need for valuation. In the business world, understanding the outcomes of a valuation report can be a great challenge. They might be questions such as reaching the concluded value and understanding the valuation methods applied. Whether you are selling your business or looking for investors, you might need to assess the economic value of your business, which is referred to as business valuation.
As you can imagine, it is not simple to determine the worth of your business because it needs to account for different factors in your business finances. The process is very complex and most of the owners of the business choose to work together with an expert to get an objective by evaluating the worth of their business. With this being addressed, if you want to know the value of your business, it is important to understand how the process works, even if you eventually decide to employ a professional.
So, what is Business Valuation?
According to CorporateFinanceInstitute.com, business valuation entails the process of determining the financial worth of an organization. There exist various approaches used to evaluate the worth of a small business, but every method will comprise an objective and full measure of every part of your business. Therefore, calculations for business valuation mainly include the worth of your inventory, equipment, liquid assets, property, and anything of economic worth owned by your company. Other factors that may be considered include your structure of management, share price, projected earnings, revenue, among other things.
Why would you require a business valuation? The complication of the process of business valuation makes calculations, not a daily activity. Generally, there are several reasons why owners of a business need to assess the worth of their business. These include when selling your business, when looking to mergers or acquisitions, when looking for investors, when creating partner ownership percentages, adding shareholders and for divorce proceedings and tax purposes.
Different valuation methods for small businesses will be used in different cases. The best method will depend on the need for valuation, the business size, the industry, and other factors. For instance, in a sale situation, most private businesses are sold in terms of asset sales, while most middle-market transactions include equity sales. Each of the sales would need a different valuation method.
Source: CorporateFinanceInstitute.com
What are the 3 Common Business Valuation Methods?
Whether valuing a whole business, personal or real property, intangible assets like the purchase of price allocation, derivative securities, options, among others, there are three main approaches to determine value. These include income, market and asset (cost) approaches. Each method has a different method based on changing factors. The valuation analyst should determine the valuation methodologies to use, apply and rely on to arrive at a concluded value.
Source: CorporateFinanceInstitute.com
Income Approach
Income-based valuation methods change a projected future stream of benefit (such as earnings or cash flows) into a single discounting beneficial to stream to current value through a proper rate of discount. This implies that any income is founded on the determination of the current value of a future stream of benefit. The income approach consists of two methods: multi-period discounting and single-period capitalization. The summaries of the two most major forms of the income method applied in business valuation include;
Capitalizing Cash Flow Method: The approach is at times known as the “CCF Method”. It ensures business valuation based on an anticipated cash flow stream, capitalized by a risk-modified rate of return. It is suitable to use the Method when a focused company has historical or present results believed to be illustrative of future outcomes and when the company is only anticipated to grow at a modest or sustainable growth rate. The method is used for businesses that are mature and are facing a fairly constant stream of earnings and revenues (CorporateFinanceInstitute.com).
Discounted Cash Flow Method: This approach is commonly known as the “DCF Method”. It is a multi-period model of discounting that determines the business value based on the current value of its anticipated future stream of benefits. Precisely, the method is focused on the theory that the business’s value is equal to both the present value (PV) of projected future returns over a discrete period and the PV of a remaining value. The discrete period includes the period ranging through the ideology that the future cash flows are projected to calm before developing at a continuous rate into the future, whereas the residual value characterizes the PV of all cash flows outside the discrete period.
The method anticipates the distributable business cash flows are projected to make and discounts such cash flows to a PV basis as of the analysis date using an after-tax and risk-adjusted rate of return of cash flow. It uses the distributable cash flow as the reward stream in the analysis because it characterizes the incomes available to issue to investors after looking at the reinvestment needed to finance a business’s future growth. The DCF Method is used for businesses that assume changing levels of earnings and revenue growth in the future (CorporateFinanceInstitute.com).
Market Approach
Valuation practices under the market approach analyze value based on the prices paid for interests of ownership in businesses similar to the focus company. There are two main approaches applied in the market approach, which include:
Guideline Transaction Method (GTM): The GTM values an organization based on multiples of pricing resultant from the sale of businesses similar to the focus business. The stages taken within the GTM include looking for transactions that involve the acquisition of similar companies, selection of the connections that carefully mirror the business’s processes and which arose incomparable industry and economic conditions, and lastly, using the specified price multiples from the illustrative transactions (CorporateFinanceInstitute.com).
Guideline Public Company Method (GPCM): The GPCM values a business based on trading multiples resultant from public-traded corporations similar to the main company. The stages used in the method include recognizing similar public corporations, changing the designated multiples for variances in risk and size relative to the focus corporation, and applying the price multiples from the representative businesses.
Preferably, the designated guideline corporations contest in one industry as the focus company. Though, when the publicly traded businesses do not exist, other firms with comparable features like markets served, risk profile, growth outlook, or other relevant factors can be measured. In both the GPCM and the GTM exact comparison is not needed, but closer equivalents are ideal (CorporateFinanceInstitute.com).
Asset Approach
The asset method is a technique of valuation that determines the worth of a subject corporation based on the market value of its assets or liabilities. The main valuation method used in the method is the Adjusted Net Asset Method (ANAM).
Adjusted Net Asset Method (ANAM): While using the ANAM, a business’s equity value is looked at as the disparity existing between the fair market value of an organization’s assets and liabilities. This approach adjusts the assets from book value into fair market value and the entire adjusted assets are then reduced by documented and undocumented liabilities. Using ANAM creates a “floor value” of a business that would be recognized when selling a business’s assets and satisfying its liabilities.
Such a method is suitable in holding businesses or capital-intensive firms, when losses are repeatedly generated, or when methodologies of valuation based on a business’s cash flow or net income levels show a lower value compared to the net asset’s value. Finally, the ANAM does not include any intangible value of asset or goodwill of a company, which are properly shown in the values realized through the use of market or income approach (CorporateFinanceInstitute.com).
Which approach is right for you?
There is no single size that fits different types of business valuation because there are different valuation methods for different companies. Out of the three approaches, there is no single perfect method. Each one has its advantages and drawbacks based on the factors from norms of industry valuation to the present interest rates and economic market. Choosing the best one for your business would be an imperative part regarding the return on investment until the time of exit. Every business is different and would have a unique way of valuation. The businesses with the best valuation apply more than a single valuation method.
Most companies use a broader valuation method drawn from the valuation methods described above. The core reason for doing so is that each company has a unique model and ideas, and all industries cannot apply one method. For example, an online firm made around the clients would value the business differently compared to brick-and-mortar stores.
Business owners open to discussing the differences existing in their streams of revenue, comparative rates of sale of other businesses within the market, and their business’s asset valuations would enjoy a fair market price for their business. Additionally, investors would understand that the businesses have wide-ranging information and know the consistent procedures occurring in the business. This will help them gain more trust in their valuation.
Out of the three methods, there is a single mistake that most owners of businesses make. They do not value the need for a professional to guide them. Professional advice is needed because the owner of the business is attached to the business and would not view things objectively. Therefore, an expert would help you unlock any hidden worth of your business.
How do you find a Business Valuation Professional?
While it is important to understand different business valuation methods, it is important to work with an expert if you do want to assess the value of your business. Even though the methods may appear simple on the surface, as shown in the DCF example, there are wide and deep calculations used to determine the worth of a business. Not only can professionals offer you a detached inspection of your business, but they will also likely join many methods of business valuation to get the most detailed sense of the worth of your business.
Therefore, if you require a professional in business valuation, you will need to know where to get one. You will need to look for a certified business valuation expert. The American Society of Appraisers (ASA) and the American Institute of CPAs (AICPA) provide such certification. You may use either of them as a resource to look for an appraiser to do your valuation. Also, you might consult with your business accountant or CPA expert to get some recommendations.
What is an Independent Appraisal?
When selling a business, if there are purposes for business financing, departure or addition of business partners, the legal separation of owners, there is the transfer of part or all of the ownership. This calls for a business appraisal.
Individuals who usually get a business appraisal are owners and the buyers, legal professionals, courts, investors, tax authorities and commercial lenders. The owner should have a company valuation performed by experts. If the owner performs it themselves, they may miscalculate and understate or overstate the value of the business. Also, the business may lack safe harbor when the IRS resolves to do further investigations.
Summing up
Business valuation is very complicated, particularly considering the diverse methods available to assess your business and understand its economic value. Generally, it is safe to say that a single approach is not needed more than the other. Instead, the best valuation of your business will be as a result of joining various methods of business valuation.
When you do need a business valuation, your best action will be hiring an expert appraiser. You might wonder what the appraisal has to do with the valuation methods or the company valuation. Well, the assumptions made when estimating the value of your business would have a huge change on the results of business appraisal. This remains the main reason for getting the correct value of your business using an independent appraiser.
Reference
CorporateFinanceInstitute.com. “Financial Analyst Courses and Training Online “