Business Valuation: Most business people know the value of their home, automobile… but have no idea on the value of their business.
Most business management rely on simple formulas or multipliers that do not take into consideration many business variables, such as– industry trends, technology, revenues, profitability, receivables, equipment and much more… But, quite simply, business valuation is a process and a set of procedures used to determine what a business is ‘worth’– it’s a measure of the worth of the business…
The premise of business valuation is that– we can make reasonable estimates of value and determine the worth of all types of assets, even intangibles… Some assets are easier to value than others and the details of the valuation varies from asset to asset; similarly the uncertainty associated with each value estimate is different for different assets, but the core principle remains the same…
There are those who are disingenuous enough to argue that value is in the eyes of the beholder, and that any price can be justified if there are other people willing to pay the price. That is patently absurd: Perceptions may be all that matter when the asset is a painting, sculpture… but we do not and should not buy most assets for aesthetic or emotional reasons; we buy business-financial assets for the cash flows we expect to receive from them.
Consequently, perceptions of value must be backed up by reality, which implies that the price paid for any asset should reflect the cash flow it’s expected to generate– various valuation models attempt to relate value and levels of uncertainty about the expected growth in cash flow. There are two extreme views of the valuation process: At one end are those who believe that valuation, done right, is a hard science, where there is little room for analyst views or human error.
At the other end are those who feel that valuation is more of an art, where savvy analysts can manipulate numbers to generate whatever result they want; but in reality, the truth lies somewhere in the middle…
Business Valuation Methods: Business Valuation has become an intrinsic part of the corporate landscape. The corporate landscape has witnessed dynamic changes in recent years as– mergers and acquisitions, corporate restructurings, and share repurchases are happening in record numbers, both in the U. S. and abroad. At the core of the dynamics of all these activities stands some notion of business valuation.
The valuation methods are not only necessary for accounting purposes, but they also serve as roadmaps for– capital investors, venture capitalists, corporate acquirers… in order to know an estimated value of a company’s assets… Four standard business valuation approaches are:
- Asset accumulation: This approach is based on the premise that it’s generally possible to liquidate the property, plant and equipment (PP&E)… assets of a company and after paying off the company’s liabilities the net proceeds would accrue to the equity of the company. Valuation of assets based on liquidity does not yield better results, if the fair market value of assets is in excess of the value of its assets on a liquidated basis.
- Discounted cash flow method: This valuation method based on cash flow is considered a strong tool because it concentrates on cash generation potential of a business. This valuation method uses the future cash flow of the company discounted by the firm’s weighted average cost-of-capital, plus a risk factor measured by Beta (measure of volatility or systematic risk); since risks are not always easy to determine precisely…
- Market Value: This valuation method is applicable for public companies only. The market value is determined by multiplying the share price of the company by the number of issued shares. This valuation reflects the price that the market, at a point in time, is prepared to pay for all shares, and that determines the value of the company…
- Price Earnings Multiple Valuation: The price-earnings ratio (P/E) is simply the price of a company’s share of common stock in the public market divided by its earnings-per-share. By multiplying this P/E multiple by the net income, the value for the business could be determined…
In the article Myths in Valuation by Aswath Damodaran writes: Myth–Valuation is a science that yields precise answers…
Reality 1: Valuations are always biased…
- Truth 1.1: All valuations are biased. The only questions are how much and in which direction.
- Truth 1.2: The direction and magnitude of the bias in valuation is directly proportional to who pays you and how much you are paid.
Reality 2: Equity valuations are always imprecise, but they are most valuable when they are most imprecise.
- Truth 2.1: There are no precise valuations.
- Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Reality 3: Complex valuations do not yield better estimates of value.
- Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model.
- Truth 3.2: Simpler valuation models do much better than complex ones.
In the article Business Valuation: Three Approaches by ValuAdder writes: Quite simply, business valuation is a process, and a set of procedures used to determine what a business is worth. While this sounds easy enough, getting your business valuation done right takes preparation and thought.
Business valuation results depend on assumptions: For one thing, there is no one way to establish what a business is worth. That’s because business value means different things to different people… For example; business management may believe that the business connection to the community it serves is worth a lot, and an investor may think that the business value is entirely defined by its historic income… Traditionally, there are three fundamental ways to measure what a business is worth:
- Asset approach: The asset approach views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question: What will it cost to create another business like this one that will produce the same economic benefits for its owners?
- Market approach: The market approach, as the name implies, relies on signs from the actual market place to determine what a business is worth. Here, the so-called economic principle of competition applies: What are other businesses worth that is similar to your business?
- Income approach: The income approach takes a look at the core reason for running a business– making money. Here the so-called economic principle of expectation applies: If I invest time, money and effort into the business; what are the economic benefits and when will they be available?
In the article Valuation Myths by Lewis Schiff writes: Since valuation is part science and part art, it’s very easy to fall into misconceptions of the business valuation process… Two valuation experts recently identified common myths that could lead to poor management of intangible assets, and could also cause confusion:
- Myth 1: Valuation is a well-defined and well-understood term.
- Myth 2: Valuation of intangible asset is equal to price someone is willing to pay.
- Myth 3: Valuation is equal to the cost of creating an item.
- Myth 4: Each intangible should have only one official value.
- Myth 5: Balance sheet provides good information about the value of intangibles.
- Myth 6: Fair market value is a good construct for use with intangibles valuation.
- Myth 7: There should be only one accepted method for valuing intangibles.
- Myth 8: Current estimate of the future price must equal the eventual transaction price, in order to be considered accurate.
- Myth 9: Patents cannot be valued credibly because each one is unique.
- Myth 10: Value of company’s intangibles is the difference between its market value and the value of its tangible assets.
Determining the value of a business is a complicated and intricate process. Even valuation experts have referred to it as more of an art than a science. Valuing a business requires the determination of its future earnings potential, the risks inherent in those future earnings, an analysis of its mix of physical and intangible assets, and the general economic and industry conditions…
A business valuation is not just for a businesses preparing for a sale: In fact, there are numerous business and legal situations that require a detailed valuation. First, a detailed valuation is needed when a seller is considering merger, sale, acquisition, or shareholder wishes to buy-out other shareholders… Second, government or judicial authorities often require a business valuation for legal matters such as; shareholder disputes, divorce proceedings, eminent domain takings; employee stock ownership plans (ESOPs), S-corporation election, or breach of contract disputes… Third, taxable events, such as; estate and gift planning or charitable giving also necessitate a valuation…
Finally, a detailed valuation can help identify what’s needed– to increase the value of the business, attract new capital, project potential proceeds from an initial public offering (IPO)… With this many potential situations requiring a business valuation, it’s important to have an up-to-date estimate of the value of business. However, unlike fine wine, valuations do not age well. Sales can go up-or-down, demand for products and services can go up-or-down, the economy can go up-or-down: The state of a business can change pretty quickly… and a valuation becomes out of date, quickly– perhaps even by the time it’s done…
But, a valuation can be very useful when there is a specific reason for it, and a time frame within which to use it… Learn to understand the principles of valuation and what a valuation is trying to achieve, and then harness what the valuation provides to– identify strengths, weaknesses, opportunities, and threats in the business…