Business Valuation is the process of determining the financial value of a business. Business valuation is performed because it is helpful information during litigation; it helps develop your business' exit strategy for buying and selling a business, acquiring funding, and strategic planning.
Valuation methods refer to the different approaches and methods set in place to determine the value of your business or asset for financial reporting. There are four approaches to valuation. These are-
- Cash approach
- Market Approach
- Income Approach
- Brand Valuation Approach
The cost approach to valuation is one of the three main valuation methods. The cost approach method of valuation is a common real estate valuation tool that is based on the simple assumption that a person buying a property would not pay more for a property if the cost of the property equals the cost to build the property from scratch.
In the case of business valuation, the cost approach to valuation ascertains the value of the business by estimating the values of tangible and intangible assets and liabilities which comprise the business.
Although the cost approach to valuation is not perceived as a true indicator of the business value, it is a viable approach for mature companies with sizable assets, holding companies, and asset-intensive companies.
In real estate valuation, this method is appropriate for conducting the valuation of special use properties like schools, hospitals, and places of worship. It is also the go-to valuation method for evaluating new constructions, insurance appraisals, and commercial properties.
The cash approach is categorized into two different valuation methods-
Replacement cost method and Book value method.
Replacement Cost Method
The Replacement cost method of valuation calculates an asset’s estimated value by assigning it a cost that could replace it. This approach of asset valuation calculates the estimated cost of replacing the asset with a similar asset in the same condition.
This valuation method assumes that a buyer will not pay more for an asset, and a seller will not sell an asset for a price less than the value of a similar asset. This approach to valuation is best suited for evaluating "start-ups" where projections of cash flow are insufficiently certain.
The Replacement Cost Method of valuation's biggest drawback is that it does not consider the business' goodwill. It also does a poor job of considering intangible assets during valuation.
Book Value Method
The book value method of business valuation is one of the most common valuation methods used by asset-intensive companies. This approach to business valuation is calculated by subtracting all intangible assets and liabilities from total assets. For calculating book value per share, the formula is- (Total stockholder's equity – preferred stock) divided by the number of company common shares.
The book value method of valuation is calculated by businesses to compare different companies and look for undervalued and overvalued stocks. This valuation method is prevalent amongst businesses that have particularly low profits when the company is hemorrhaging money on an operational basis and prevalent amongst small distribution companies.
The book value approach is one of the valuation methods that calculate the value of assets based on actual comparable data and not on assumptions and speculations. Due to its accurate measure of value, the book value approach helps educate people about the company and helps them find stock at fair prices. However, the book value approach’s biggest drawback is that it is ineffective at calculating the value of intangible assets.
When is the cash approach method of valuation chosen?
- The cost approach method is used to calculate the value of properties that are of special use, generate little income, and are seldom marketed. These properties include- places of worship, schools, libraries, and hospitals.
- The cost approach method of valuation is used during insurance appraisals because the homeowner's policy and claims only ensure the value of the improvements made on the land. Therefore, the value of land is subtracted from the total value of the property.
- Asset-intensive companies and holding companies use the cost approach to valuation.
- The book value method of the cost approach is used to evaluate non-operational/ surplus assets.
Pros and cons of cash approach
- The cost approach to valuation presents a clear value of tangible properties.
- The cost approach to valuation calculates the total value of a property by considering current market costs and the current economic factors.
- This approach is useful in calculating the value of special-use properties and other unique structures.
- The appraisal will not always be if there is no comparable vacant land available.
- The cost approach requires certain assumptions to be made, and that can make this a little less reliable than the income and market approach to valuation.
The market approach is one of the most commonly used business valuation methods. As the name suggests, this valuation method uses relevant financial information of identical or comparable companies to estimate the value of the subject business, its intangible assets, security, and business ownership interest.
In this valuation method, the subject business's value is ascertained by comparing the business with a similar business in size and operations. This valuation method utilizes price-related indicators like sales to determine appraisal value. This valuation method is also known as the relative valuation method.
The market approach to business valuation is categorized into four distinct methods- Market price Method, Comparable Companies Method, Comparable Transaction Method, and EV to Revenue Multiples Method.
Market Price Method
Market value or market price method of valuation is a business valuation method in which the stock market determines the value of a business. The market price method of business valuation is the preferred method to ascertain the value of frequently traded equity shares of companies that are listed in the stock exchange.
The market value of a company is calculated by multiplying the total number of outstanding shares with the current market price of each share. The prices of shares fluctuate throughout the day, and so does the market value of the company.
Comparable Companies Method
Comparable companies method or comparable analysis or guideline public company method is a technique under the market approach of business valuation. In this method of valuation, appraisers analyze the ratios of a similar company to derive the value of the subject company.
One of the biggest drawbacks of this valuation method is that the appraiser has to find the right comparable companies. Companies are chosen based on similar characteristics like industry classification, size of the company, revenue, growth rate, profitability, geography, assets, and the number of employees.
Although it is hard to find an identical company match, financial metrics like valuation ratios can be derived from similar enterprises. However, adjustments in the metrics must be made on account of dissimilarities with the subject company for more accurate results.
In this valuation method, the following financial information is analyzed- EBDITA (earnings before interest, taxes, depreciation, and amortization), EPS (earnings per share), gross profit, net debt, and revenue.
Comparable Transaction Method
Comparable transaction method or precedent transaction analysis or mergers and acquisition comps is the business valuation technique where the value of a business is determined based on past mergers and acquisitions of similar companies.
In this valuation method, financial information used in comparable companies methods is analyzed- EBDITA (earnings before interest, taxes, depreciation, and amortization), EPS (earnings per share), gross profit, net debt, and revenue.
Comparable transaction method of business valuation analyses for how much a similar publicly-traded company is sold for, the type of investors that purchased those similar companies, and the market conditions in which the acquisition was made.
The advantage of using precedent transactions is that it uses publicly available data and can provide important mergers and acquisition information like potential buyers and sellers. However, this method's drawback is that publicly available information can be misleading sometimes.
EV to Revenue Multiples Method
Enterprise value-to-revenue multiples method or enterprise value-to-sales method is a valuation method that calculates the value of a business by comparing the business’ equity value to its annual revenue.
The EV-to-revenue multiples method is used in the instances where the business has no positive Earnings Before Taxes Depreciation & Amortization or positive net income to calculate the value of a business via EV/EBITDA method and Price Earnings ratio method.
This valuation method is also used to determine whether a stock is fairly priced and is used to estimate a company's value during potential acquisition. The formula for the EV-to-Revenue multiples method is EV/R. Where EV stands for an Enterprise value (Enterprise value= Preferred Shares+ Equity Value+ All Debit- Cash and cash equivalents) and R stands for Revenue.
For example- There is a company with ₹500,000 cash. There are ₹100,000 outstanding shares, each valued at ₹25. The annual revenue generated is ₹10,000,000, and there is a debt of ₹250,000.
When is it appropriate to use the market approach of valuation?
The market approach of valuation is suitable for valuation-
- In case there is a legal dispute or a business needs to defend itself in front of the tax authorities, the market approach of business valuation is suitable.
- In the case of a buyout or partner disagreements, when a business has to justify its value, then the market approach to valuation is suitable.
- It is also suitable when a business has to set an asking price or offer price for business purchase.
Pros and Cons of market approach
- The biggest advantage of the market approach is that there is data publicly available to compare transactions. For example- data regarding publicly traded shares are readily available.
- The results are reasonably accurate since no assumptions are made.
- The market approach of business valuation involves simple calculations and is straightforward.
- It is practically impossible to calculate the business’ value when there is no readily available data on comparable transactions.
- It is also difficult to ascertain and identify which transactions or companies are comparable.
- It is not a very flexible method of business valuation compared to other valuation methods.
The income approach to business valuation is one of the three main valuation methods. The income approach to valuation calculates the present value of future income that a business will generate by analyzing variables like revenue, taxes, and expenses.
The income approach to valuation is based on the assumption that an investor would like to know the economic benefits an investment will provide them in the future. The income approach to business valuation assesses the risks associated with investing in a business and the money it is likely to earn.
The income approach to business valuation is a valuation method that calculates future earnings, operating profits, costs, net profit, and how much cash the business will be generating in the future that can be disposed of.
The income approach to business valuation is categorized into three distinct valuation methods: the Discounted cash flow method, Price Earning Capacity Method, and the Option Pricing Method.
Discounted cash flow method
The discounted cash flow method is the go-to valuation method for most appraisers. The discounted cash flow method of business valuation calculates the value of a business by discounting all future cash flows from the present value using a discount rate.
In other words, the discounted cash flow method of valuation determines the value of a business by estimating future cash flows and then discounting the cash flows back to the present date of valuation.
Although it shows the investors how much earnings their investments will make in the future, its biggest drawback is that it is hard to predict the future. Another drawback of the discounted cash flow is that it relies solely on projections and assumptions, resulting in mistakes in projecting.
The discounted cash flow method of business valuation analyses the following inputs-
- Business earnings- The business earnings forecast estimates the amount left after all expenses are paid for.
- Discount rate- The discounted cash flow method of business valuation analyses the discount rate, which expresses the risk of investment in a business.
- Business Terminal Value- The business terminal value refers to the value of a business at the end of a forecast period.
The process of estimating business value under the DCF method includes the following steps-
- Forecasting Revenue
- Forecasting expenses
- Calculating the terminal value
- Reviewing the industry and prevalent trends
- Identifying the business model and the business cycle.
- Separating the business from other cash-generating assets.
- Identifying all surplus assets and making business projections using balance sheets and other financial statements.
- Calculating the discount rate.
Price-earning capacity method
Unlike the discounted cash flow method of valuation, the price-earning capacity valuation method uses historical earnings to estimate the value of future cash flows. The price-earning capacity method of business valuation cannot estimate future projections of cash flow if it is a new business or hasn't been operating for a long time.
Option pricing method
Option refers to a financial instrument or a type of contract that provides one of the parties involved the right to buy or sell an underlying asset before or at the expiration date at a predetermined price.
The option pricing method is a valuation method that estimates the value of an option. The option pricing method estimates the value of an option after considering all known inputs. The option pricing method is divided into three further categories, namely-
- Binomial Option Pricing Model- As the name suggests, this model calculates the payoff of an option by assuming that there are two possible outcomes. The two outcomes are that the pricing will either move up or down.
- Black-Scholes Model- This model determines the value of an option by analyzing six distinct variables: the type of option, volatility, time, risk-free rate, strike price, and underlying stock price.
- Monte-Carlo Simulation- In the Monte-Carlo Simulation model, the appraiser will simulate all possible future stock prices and use them to find the expected discounted option payoffs.
Who can use the income approach to business valuation?
The income approach to business valuation is best suited for businesses that are expected to operate in the foreseeable future, and mature businesses that have a consistent growth rate are expected.
Pros and Cons of the income approach
- The income approach to business valuation is well-suited for companies that are in a state of rapid growth.
- The income approach to valuation is very detailed.
- The income approach to valuation can calculate the value of a business based on the best-case scenario and the worst-case scenarios.
- The income approach to valuation is well-suited for businesses that have stable earnings.
- The income approach to valuation helps determine the present value of the business.
- Since some income approach methods use historical data to calculate the business value, the income approach to business valuation isn't suitable for newer businesses or start-ups because they have no historical data.
- The income approach to business valuation relies on a lot of projections and assumptions. You are likelier to cause more mistakes the further you project into the future.
- Not only is this approach to valuation very complex, but it is also not suitable for companies experiencing rapid and unstable growth.
Brand valuation refers to the process of calculating the value of a brand or how much someone is willing to pay for it. Brand valuation is a valuation method through which a brand can ascertain the value of its tangible and intangible assets. Customer perception, financial performance, brand equity, and similar metrics are used to determine the estimated value of a brand from this valuation method.
Brand valuation is important in the case of mergers and acquisitions for better financing, to ascertain their return on brand investment, and for budgeting allocations. Brand valuation is categorized into three methods- Relief from Royalty Method, Multi-period Excess Earning Method, and With or Without Method.
Relief from Royalty method
The relief from royalty method of brand valuation determines the value of an intangible asset by calculating how much a company would save on royalty payment if it owned the asset rather than license it from a third party.
The relief from royalty method uses the market approach of valuation to determine the royalty rate. And the income approach of valuation determines the value of the intangible asset based on estimated revenue, tax rates, discount rates, and growth rates.
The relief from royalty method is predominantly used to valuate domain names, computer software, and trademarks. This valuation method is used to determine how much a company would save if it were to buy the rights to an intangible asset rather than licensing it.
Multi-period excess earning method
The multi-period excess earning method or MPEEM is a brand valuation method that variations discounted cash-flow analysis. In this valuation method, the cash flow associated with an intangible asset is isolated and then discounted to present value.
The multi-period excess earning method is applied in businesses where one intangible asset is the primary contributor to that business's value. Since the intangible asset is the primary contributor to that firm's value, the cash flow related to it can be isolated from the business's overall cash flow amongst assets whose fair value can be measured using MPEEM are computer software, customer relationships, and other related assets.
To perform the multi-period excess earnings method, an appraiser would consider the following things-
- Identify the asset to be valued and the stream of revenue that is associated with that asset.
- Estimated attrition rates.
- Estimated expenses and cash flow associated with the asset.
- The estimated rate of return.
- The value of the asset after discounting the cash flow from the present value.
With or without method
With or without a brand valuation method estimates an intangible asset's value by comparing the value of the business with the asset to the value of the business without the asset. With or without a method of valuation is used to value non-competition agreements, processes and technologies, and franchises.
Why do businesses need brand valuations?
- Brand valuation determines the market value of your business. Therefore, businesses require brand valuations in the case of mergers and acquisitions.
- Brand valuation determines the company’s return on brand investment. This information is vital to developing future strategies.
- Brand valuation aids decision-making during budget allocation.
Pros and Cons of brand valuation
- Brand valuation provides intangible assets like brand recognition as other tangible investments.
- This valuation method is still in its nascent stage, and there is still a lack of an acknowledged model.