Table of Content
- What is Value?
- The 3 Main Valuation Approaches
- Cost and Asset Approach
- Conclusion on How to Value a Business – Use Triangulation!
When you are asked to perform a business valuation, you might wonder how to do this? Simply putting a price tag on a product is not the same thing as valuing a business. Valuing a business can either be simple or complex but in any case, you will need to understand which business valuation methods to use.
In this article, we want to outline and review the pros and cons of common business valuation methods used by professionals in Investment Banking, Mergers and Acquisitions (M&A), Private Equity, Corporate Development, Equity Research, Controlling and Finance functions. The goal of this article is to provide a better understanding of each valuation method, how to use them, their pros and cons in order to obtain a deeper understanding of how to value a business.
Business Valuation – The Top 4 Reasons
A business valuation normally is needed whenever a change in the ownership or financing structure of a company is intended. Here are the four most common reasons when a business valuation will be needed:
- Business Sell/Purchase requires a clear understanding of the intrinsic value of a business. In any Mergers & Acquisitions (M&A) transaction, the business valuation is used as the basis for price negotiations during the sale and purchase process. Such business transactions normally may include entire or partial acquisitions or divestitures of businesses.
- Mergers are a special form of an M&A transaction, as shareholders of two different companies enter into an agreement to exchange their shares in order to merge the two companies. Shareholders will end up with owning shares of the combined company. In this case, a business valuation will have to value each company separately on a standalone basis to determine the exchange ratio for the shares based on the relative equity valuations.
- Fundraising exercises, especially for startup companies, require an agreement on how much equity stake new investors will receive. The equity stake together with the amount of money raised determine the implied pre- and post-money valuation of the business. In order to check if this valuation makes economic sense, investors such as business angels, private investors, Venture Capitalists or Private Equity will normally want to obtain clarity of such business valuation can be justified.
- Change in Equity Ownership in order to issue, transfer or buy-back shares of shareholders or employees, a business valuation will be needed. This can either be performed on request or a business valuation can also use a pre-agreed formula to value a business.
There are many more reasons why a business valuation might be needed. However, for our purposes, the point is that we need to be aware of the objective of our valuation exercise and therefore include this when choosing the appropriate valuation method to use when deciding how to value a business.
According to Merriam Webster, value is defined as the monetary worth of something. It is also defined as a fair return or equivalent in goods, services, or money for something exchanged. Essentially, value is something which is regarded as having significance, benefit, worth, lasting usefulness or utility.
Value, as an economic concept, is best explained by the father of modern economics, Adam Smith, in his diamond-water paradox. The paradox is, Water is very valuable because it is needed for human survival, yet it has a much lower price compared to a diamond. On the opposite, a diamond is mainly used as an ornament and not vital for human survival yet is priced very high. Value varies from user to user or customer to customer and value is, therefore, a subjective concept. Value largely depends on qualitative factors such as preferences, utility, expectations, and levels of satisfaction.
Most valuation methods normally result in an estimation where the value lies as valuation methods base on certain assumptions which by itself depending on the appraiser’s point of view. Therefore, if you ask two or three different business appraisers what the value of a business is, you might easily get two and three different answers. In order to understand the difference between these valuations, you will have to look at their assumptions and which valuations methods they are using.
As we deal with valuation estimates, it can be more meaningful to talk about valuation ranges where a reasonable valuation of business most likely should lie within rather than a single point result. Communicating a valuation range allows us to admit the inherent inaccuracy of each valuation method and to be transparent about it.
Opposite to value, price, on the other hand, depends on varying factors such as demand and supply of the good or service, how much was spent on buying the materials needed to make the product, how much was spent on labor, how many other companies are making the same product and how much they sell it for, among other factors.
Warren Buffet, Chairman and CEO of Berkshire Hathaway, is one of the most famous and successful value investors in history. In a CNBC interview in 2017, he revealed Benjamin “Ben” Graham is one of three (first his father, Howard Buffet, and second his wife, Susan Buffet) people he credited for his success. In a 2008 letter to Berkshire Hathaway’s stakeholders he wrote: “Long ago, Ben Graham taught me that “Price is what you pay; value is what you get” (Source: Warren Buffett).
In business, the value of a company depends on the underlying valuation scenario, as the following valuation concept demonstrates:
- Book Value: The book value of a company is the total value of the company’s assets minus outstanding liabilities reflected in its balance sheet. The Book value normally represents the value of the purchased assets at a cost but normally excludes future benefits as the value is based on accounting figures and not economic valuations (with some exceptions depending on accounting standards used).
- Liquidation Value: This represents the remaining worth of a company’s assets when the company is going out of business after all the assets are sold and all liabilities are paid off. Intangible assets such as goodwill, intellectual property and trademarks will only have value if they can be sold in liquidation scenarios, otherwise, they will end up worthless if they don’t find a buyer. Calculating the liquidation value becomes relevant in insolvency scenarios.
- Going Concern Value: The term “going concern” is a fundamental concept in accounting as here we assume that a business will keep operating for the foreseeable future. This avoids having to value the assets at their liquidation values and allows to attribute more value to each asset as they can be put to work in the future. In simple terms, the company can keep using the assets to generate future income. Going Concern Value is the opposite of Liquidation Value and normally leads to higher valuations.
- Intrinsic Value: This represents the actual value of the company including intangible assets such as goodwill, intellectual property, patents, brand trademarks. The intrinsic value normally is determined through income-based valuation methods as fundamental analysis and argumentation are required to understand their valuations.
- Fair Value: Oftentimes, this is interchanged with market value but the two are not the same. Fair value represents the estimated worth of an asset and liability and is derived fundamentally (does not fluctuate and not influenced by market forces).
- Market Value: This refers to the current or recently-quoted price of an asset that is traded in an open market place such as a stock exchange. This commonly refers to publicly listed companies and generally represents the sentiment of the market and not entirely the present and the actual state of a company. For property valuations, also well-functioning property markets can be considered to lead to market values.
Business valuation is a process used to determine the intrinsic value, fair value or market value of a business (enterprise value). By subtracting net financial debt from the enterprise value, we arrive at the equity value. The art of valuation now is to select the appropriate valuation methods in light of the circumstances and data availability. Once the valuation results are available, their data points can be used to triangulate where a reasonable valuation of a business should lie within. As any valuation is a subjective estimate, it is therefore imperative that before conducting such valuation, you must know the purpose of the valuation exercise. More often than not, the purpose will greatly influence the standard of value, the methods used, the level of research performed, and possibly the date of the valuation.
Each valuation method can be attributed to one of the three main valuation approaches which allow to better understand the conclusions which can be drawn of the corresponding business valuation methods.
- Income Approach – determines the value by estimating the business’ value based on the expected income or cash flows which can be generated from a business. It’s normally based on fundamental analysis.
- Market Approach – determines the value based on observable multiples of similar companies or transactions.
- Cost Approach – determines a company’s value by calculating the costs it takes to build a similar business or asset or looks at a company’s asset value.
In the above chart, we also include Economic Value Add (EVA) analysis and Leveraged Buyout (LBO) Analysis as part of the income approach. Each of the valuation methods of the income approach is using a different definition of the underlying income or cash flow streams, therefore looking at a valuation case from a different angle. Valuation methods based on the income approach normally use fundamental analysis to build up their case and lead to a more detailed understanding of how a company can create value than when using market or cost-based valuation approaches.
The market approach mainly bases on observable market multiples from either the stock market or private transaction data and reflects market conditions. However, market prices paid might be distorted by the current market conditions. Therefore, for any solid business valuation, these methods normally only serve as a complement to fundamental analysis.
Where it is not possible to estimate the income (or revenues) or where estimates lie too far apart, one needs to switch to a cost-based valuation approach. Costs estimates are easier to obtain, however, as they do not include any form of revenue, their explanatory power lies significantly lower than income-based valuation approaches. Therefore, an income-based valuation approach in most cases appears superior to a cost base valuation approach.
Now that we understand a bit more to which approach each valuation method belongs, let us review the available methods to choose when having to decide how to value a business.
Valuation Methods of the Income Approach
The income approach relies upon the main assumption that the value of a business should be equal to value one can reasonably expect to derive from the business in the future in the form of income or cash flows. As the income or cash flow streams lie in the future, income-based valuation methods take into account the risk via the discount rate (or capitalization rate) which is used to convert future cash flows into their present values.
The two most frequently used valuation methods under this approach are the Discounted Cash Flow (DCF) valuation method and the Capitalized Earnings valuation. Both methods are very common for business valuations but also for property valuations. Let’s discuss each method in the following:
The DCF valuation method forecasts a company future Free Cash Flows to Firm (FCFF) and uses the discount rate to calculate the net present value of those. DCF valuation is one of the most widely used valuation methods and today is not only used for business but also for property valuations.
To conduct a DCF valuation analysis you will need three main things:
- 5 Year financial plan of a business
- Discount Rate
- Terminal value assumptions
The forecast horizon should be a minimum of 5 years, so that means the company will need to develop a business and financial plan for this period. The financial plan should go beyond a pure profit and loss forecast as the DCF methods require to determine the Free Cash Flows to firm. This can easily lead that the analysis becomes a bit more complex as a forecast of the Balance Sheet and Cash Flow Statement will be needed.
The discount rate often is estimated by the company’s Weighted Average Cost of Capital (WACC), the average costs of the financing sources of the business. One advantage of the WACC concept is that the WACC can easily be compared to the Internal Rate of Return (IRR) of an investment project. Where the IRR is higher than the WACC, such investment will generate positive net present value and therefore will enhance the company’s DCF value.
You will also need a framework to estimate the company’s terminal value to account and credit value for the period beyond the 5-year forecast. Simple ways to estimate a terminal value are by using the Gordon growth model with the formula FCFF(WACC-g) or simply by using an exit EV/EBITDA multiple.
Below example shows a simple DCF valuation:
Pros/Cons of the DCF valuation method:
Capitalized Earnings Method
The capitalized earnings method values a business by simply capitalizing the company’s income or cash flows. Capitalized Earnings valuations are normally based on historic financials as there is no financial plan available (if there would be a financial plan available one would use the DCF method). Also, as income for businesses fluctuates over the years, many valuation experts use a normalized figure of income as they are afraid of relying on a single year in order to avoid that the valuation becomes biased to an outlier. Below example shows a capitalized earnings valuation for a business based on a three-year average of the NOPAT (Net Operating Income adjusted for taxes):
As you can see the valuation result lies lower than the DCF valuation as this valuation bases on historic financials which in this case does not include the upside visible in the company’s financial plan.
This valuation method is also commonly used for property valuation purposes in real estate as rental income in most cases provides a very stable income stream and income does not fluctuate very much (for businesses cash flows and profits normally fluctuate more over the years). For property valuation purposes, the capitalized earnings valuation can either be applied on income (Gross Cap Rate) or on Net Operating Income (Net Cap Rate).
Pros/Cons of the Capitalized Earnings valuation method:
The EVA valuation method seeks to value a company be focusing on the economic value add created by the company compared to its cost of capital. Initially, this method was designed to help with performance measurement and developed by Stern Value Management. The method is useful to analyze historic results as below simplified example shows.
In practice, the method is difficult to use as there are many adjustments required to account for all the effects NOPAT. The main question that this method answer is if the company has created more value than it has to generate to service its cost of capital.
Now the EVA method can also be applied to forward-looking results and in this way be used to value a company. The starting point of any EVA valuation is the Invested Capital today to which the present values of all future Economic Value Adds are added. Future Economic Value Adds can be forecasted for a couple of years but will have to be capitalized at some point to account for the time beyond the initial forecast period.
The EVA method sometimes is also used as an alternative and more precise way to the terminal value as part of a DCF Valuation (ROIC value driver formula).
Pros/Cons of the EVA valuation method:
Leveraged Buyout (LBO) Analysis
LBO analysis determines a business value from an investor’s point of view, normally based on a holding period scenario of 5 years and the required hurdle rate LBO analysis is widely used by Private Equity funds who need to achieve a certain return for their investors.
The underlying rationale is that an investor would be willing to pay a purchase price only up to a certain amount which just allows him to achieve his minimum hurdle rate on his investment during a certain time period. This approach offers a special way of how to value a business. The focus of the analysis lies in the Internal Rate of Return (IRR) and assumes an entry and exit scenario.
See below-simplified example. In this case, the calculated IRR is 25%. If the Hurdle rate is 25%, it means the investor can afford to pay a purchase price of up to $220,000 while obtaining $50,000 debt financing. For him, it would only be possible to pay a higher price (and value the business higher) if he lowers his hurdle rate.
Pros/Cons of the LBO Analysis
Market-Based Business Valuation Methods
Market-based valuation methods focus on observable market multiples of similar companies or transactions to perform a business valuation. It can be applied wherever you can collect sufficient and reliable data points to determine the value of a business based on the implied valuation multiples of similar businesses or transactions.
This valuation method uses the implied valuation multiples from publicly traded companies at the stock market to value our target business. We analyze the valuation multiples of a suitable peer group to determine the appropriate valuation multiple (or range) which should be applied to the company we seek to value. If the stock market values peer companies in the range of 4.5x – 5.5x EV/EBITDA, a company with $1m in EBITDA would be valued between $4.5 – $5.5m.
The following illustration shows the valuation process.
Most frequently used multiples are P/E ratio, EV/Sales, EV/EBITDA, EV/EBIT and Price to Book ratio as well as industry-specific valuation metrics such as EV/subscriber, EV/user, etc. In many cases preference to the EV/EBITDA multiple will be given as the EV/EBITDA multiple includes the cost structure (opposite to the EV/Sales multiple) but is not affected by the company’s depreciation policy (such as the EV/EBIT multiple) or financing structure (P/E ratio, Price to Book Ratio).
Important to note is that the quality of a stock market multiples analysis stands and falls with the selection of suitable comparable companies within the peer group. Each company needs to be comparable in terms of activities, geography, industries, customer segments, size, etc. Only the best comparable peer companies will make this analysis powerful. In reality, many times peer companies are not truly comparable which limits the explanatory power of this analysis.
Pros/Cons of the Stock Market Multiples Valuation Method
Also known as the precedent transaction method which involves looking up historical transaction data mostly from non-public transaction to find out at which valuation multiples similar companies have been bought or sold. This method relies heavily on private transaction data being publicly available in order to have the required data points for our analysis. Private transactions normally are biased towards Small and Medium-Sized companies (if a company gets bigger, it is more likely that it will become publicly listed).
This valuation method works very similarly to the stock market valuation method. The main difference is the recent transaction analysis bases on private transaction data rather than the latest trading multiples.
Pros/Cons of the Recent Transactions Valuation Method
The cost approach determines the value of a business by the cost it takes to reproduce or replace it. A close relative of the cost approach is the asset-based approach which determines the value of a business by summing up all of the business’ assets.
Replacement cost analysis simply adds up all costs which are needed to reproduce or replace a business (or an asset). The analysis can especially be useful when having to make a buy or build decisions. Especially when looking to acquire a company in a foreign market to achieve a market entry, it can be worthwhile to evaluate how much it would take to build a company from scratch. The result of this analysis will impact the value a buyer is willing to pay for a target company.
The analysis is simple to perform as below illustration shows:
Pros/Cons of the Replacement Cost Analysis
The Net Asset Valuation Method determines the value of a company based on the value of the net assets (equal to the equity value) on its balance sheet. The analysis with the book values of each asset (normally booked at cost). Each asset book value then is adjusted to reflect the fair market value of the asset. The important concept to recognize is that the asset values can be significantly different from the asset’s original acquisition cost contained in the balance sheet. Take for example a piece of land purchased three years ago for $1 million, the same land might be worth twice or even three times more based on current fair market value. If the value adjustments result in a capital gain, a deferred tax liability may also be created which needs to be deducted as a liability.
This approach is mostly used for valuing holding companies, operating companies that are considering liquidation (sale or merger) and asset-heavy companies such as real estate investments, financial institutions, and natural resources companies. The main disadvantage is that the valuation does not consider the future earning potential of the company. Also, valuing a company’s intangible assets like intellectual property, trademarks and goodwill can be complex and may be over-or understated.
Net asset value analysis depends heavily on the underlying valuation scenario, especially:
- Liquidation scenario: Assets are valued as if they will be liquidated which in most cases results in heavy liquidation discounts to be applied.
- Going concern scenario: Assets are valued at their normal market values assuming the business keeps operating which normally leads to a higher valuation result than the liquidation scenario.
Let us look at the following example of a net asset value analysis for a restaurant which is made in order to hand-over the business from the current owner to his successor.
How does this work? Here we look at a situation where we expect the restaurant to keep operating. First, all assets are reviewed and adjusted to reflect their fair market values. We will leave cash unchanged as it already reflects its current value. Accounts Receivable is adjusted to reflect the amount determined to be uncollectible, in our example the amount is $100,000. Inventory is also adjusted to remove the obsolete inventory amounting to $100,000. For Fixed Assets, accumulated depreciation becomes irrelevant and is removed as we focus on the asset’s market value. The building is undervalued in the company’s balance sheet compared to the netted value by $1,000,000 while the kitchen equipment is overvalued by $487,500 net of accumulated depreciation. Capital gains of $1,562,500 trigger a deferred tax liability of $312,500 (at a 20% tax rate).
The next step is to add up the fair market values of the assets and deduct total liabilities. The restaurant has total assets at a fair market value of $7,812,500 and total liabilities of $4,812,500. The value of the company using the net asset value approach is $3,000,000.
Pros/Cons of the Net Asset Valuation Method
Above we have presented the most common valuation methods used for business and asset valuation purposes. As you can you see there is a wide range of suitable valuation methods available to choose from. The choice of the appropriate valuation methods not only depends on the company’s situation but also on the availability and accuracy of required data. As each valuation method will value the company from a different angle and therefore leads to different results, it is important to combine select valuation methods. By using the valuation results as data points it’s possibly better to triangulate the range where a reasonable business valuation should lie within.
In general, preference should be given to business valuation methods using fundamental analysis such as e.g. the DCF Method as this can best reflect the value to be derived from the expected cash flows of a business and can also explain exactly from where the value should come from. However, the valuation will not have much meaning unless it is cross-checked with other valuation methods. Cost-based valuation methods are another option to choose from. However, they lack the income aspect and therefore neglect an important aspect when trying to truly understand the sources of value.
No single valuation approach is best for every company for each scenario. Some business valuation methods are fairly easy and simple to apply while others are more complex to use. So try to figure out which valuation methods are most suitable to use for your own specific business valuation the next time you need to decide how to value a business.
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