Company valuation techniques

Company valuation techniques

Each company is not only a producer of products and services, but also a marketable commodity. Business valuation methods allow you to determine its value. Let's find out what these methods are, and which of them will be right for you.

The market is always unpredictable. Even industries that are performing well can suddenly find themselves in limbo. Therefore, it is important for an entrepreneur to know the market value of their assets.

The main problem when choosing methods of business valuation

Logically, when using different approaches, if we are talking about the same company, the result, i.e. the value of the business, should be the same. However, this is not the case: firstly, different methods use different indicators, and secondly, the figures that the market can provide are not always objective.

So one has to be on guard, realizing that different businesses cannot be valued using the same criteria. For example, it is impossible to value real estate and an intellectual product in the same way. In preparing for the financial valuation of a business, it is important to ask in advance which method the appraiser will choose, and compare this information to the characteristics of the business and your own knowledge. Although an experienced appraiser will always determine what will work for you and why. 

There are three general approaches to business valuation, each of which offers different methods. They all help to determine the value of a company relative to a certain date. Choosing the approach and method, you need to consider many factors: the size of the company, the form of business organization, the purpose of evaluation - for sale, for the processing of bankruptcy proceedings, for investment.

Often the assessment allows to make conclusions for further development: about the expediency of certain assets, the possibilities of business expansion, etc. Let us turn to basic methods of business valuation. 

The cost approach to business valuation (balance methods)

The cost approach presupposes the evaluation of a company from the point of view of expenses. As a rule, the book value of its assets may not coincide with the market value. Therefore, a balance sheet adjustment is required here. This approach is used for businesses that do not generate stable revenues: if the company is newly formed, or is in the process of liquidation.

This method helps determine the market value of the assets, from which the company's liabilities are deducted and the amount of equity is derived. The cost approach to business valuation offers the following methods.

Net Asset Method

The basic balance sheet methods of business valuation include the net worth method. With its help, you can calculate the market value of a company's assets, and then subtract the amount of its liabilities. It is not the income and expenses of the company that are adjusted, but the balance sheet items.

This method of assessing the value of a business is of a basic, initial nature. Then the figure is further adjusted depending on the market. The method is more often used by LLCs: auditing, consulting, and brokerage companies. 

Residual value method

This method helps determine the amount of money that would be raised if the decision is made to sell all assets. The calculation pays attention to the costs of dismantling the equipment, takes into account sales taxes, commissions and other possible expenses. As a result, the price of the business will be equal to the value of assets, minus the costs associated with the bankruptcy procedure. At the same time, intangible assets lose in value. 

The income approach to business valuation (income methods)

The income approach to the financial valuation of a business involves working with the company's revenues. The price of a firm or enterprise turns out to be directly dependent on revenue. That is, it calculates the price of income that can be obtained from the company in the future.

Revenue methods are popular when business valuation is organized for the sake of launching new projects and some managerial decisions concerning development in general. As for investors, they are first of all interested in income, but not in the material basis of the company, how much profit will turn out as a result of investing or buying the company.

That is why the income approach to business valuation is applicable mainly to stable firms working under long-term contracts, i.e. able to forecast profits in advance. 

Direct capitalization method

The direct capitalization method is used to determine the value of a firm using the following formula: V=D/R, where V is the market value of the business, D is the firm's net annual income, and R is the capitalization ratio. The calculation requires an idea of the amount of profits for a certain period of time ahead. This is a method for those who are confident that the company will be able to maintain profitability in the future. 

The discount rate is the rate of return on the investment, the interest income on the invested funds. Discounting is used in situations where there is reason to think that the company's income in a period of time will be different from today's income, or if the profits are seasonal. The forecast is made for the period during which the company's activity should remain effective.

This period is determined by the economic life of goods, the depreciation of equipment, the relevance of technology, lease terms, and market conditions. The described method of business evaluation is effective for big companies. Income methods are used quite often, but they can hardly be called irreplaceable.

To obtain more objective results, it is good to have an idea about all methods of business evaluation. Ideally, it is more effective when a company-appraiser decides to use several methods and approaches.

The method of discounting estimated cash flows

Using this method, expert appraisers focus on discounting future cash flow at a certain rate. What does this mean? Discounting assumes (or rather, speaks to a fact noticed in economics) that the value of money itself changes in the future.

Receipts that are expected in some time to come have less value than what they have today. The decrease in value is due to the fact that the money could have been put in the bank at interest and brought in profits. And since there are no profits yet, their value, when reduced to today, is reduced by the amount of interest not earned. 

The discount rate is the rate of return on the investment, the interest income on the funds invested. Discounting is used in situations where there is reason to think that the company's income after a period of time will be different from today, or if the income is seasonal. The forecast is made for the period during which the company's activity should remain effective.

This period is determined by the economic life of goods, the depreciation of equipment, the relevance of technology, lease terms, and market conditions. The described method of business evaluation is effective for big companies. Income methods are used quite often, but they can hardly be called irreplaceable. To obtain more objective results, it is good to have an idea about all methods of business evaluation. Ideally, it is more effective when the valuation company decides to use several methods and approaches. 

Comparative approach to business valuation (market methods)

The comparative approach involves using information about companies that are similar to the one being valued. The price of the business is determined according to the amount for which similar companies are sold in the market. Therefore, the reliability of information about competing companies is important here. There are very few twin-companies on the market, so the comparative approach to the valuation of business experts use rather rarely.

But if such decision is made, the following methods are relevant. Capital market method The capital market method is based on the work with prices, which have formed on the stock market. An analysis of small transactions on the open stock market for a notional period is carried out.

The purpose of this analysis is to evaluate the minority shareholding. The information on the freely traded stock prices, after some adjustments, helps to determine the price of the stock of the enterprise being evaluated. That is, figuring out the value of his company's shares, the appraiser takes into account the value of one share in a competing company. And in documents on valuation it is often written as follows: "The purpose of the appraisal is to determine the value of company X's stock." 

Transaction method

The transaction method is similar to the previous method of business evaluation, except that it is based not so much on the price of a single share, but rather on the value of the entire controlling stake. The transaction method and the capital market method are used for companies with insufficiently liquid shares. Their estimated value is usually inflated.

Industry coefficients method

When using the industry coefficients method, it is necessary to make a comparison with an enterprise of the same sphere, whose indicators have recently shown stable growth. In order to calculate industry coefficients, it is necessary to collect data on the conditions under which companies with certain financial and production characteristics were sold.

The specifics of the business and industry are taken into account. Therefore, for example, it makes sense to compare the cost of gas stations with the amount of income for 1.5-2 months, and the price of an advertising agency to determine based on the amount of his income for six months. The method of industry coefficients can be used to assess the value of small companies: for example, for catering, retail, hospitality businesses.