photo credit: businesstown
Business valuation can be assumed differently by different people for different businesses. From business owners’ point of view, the valuation of business might be defined by the value it is offering to the market, whereas from investor’s point of view, the valuation would depend on the historical income of the business and how well it has fared.
A business valuation can make or break the business, and therefore, the method of valuation should be chosen carefully. There have been some common methods devised to find out the business valuation. These methods are inclusive of all the factors that investor and the business owner thinks should be included for fair valuation of the business.
Valuation of businesses is most commonly undertaken during a potential sale of the company but could also be used when applying for SME loan in Singapore or undergoing auditing with external accountants.
Asset Based Approach
This approach works on going concern approach, and therefore, net asset value of the business is deducted from the liabilities in the books, the difference is the business value. This approach answers the question – how much will it cost to develop a similar business like the current one?
The calculation seems to be quite simple, but the devil lies in the details, wherein it is complex to decide what assets or liabilities, such as SME loans, should be included for reaching the valuation. Also, it is difficult to determine a standard of measuring their value, and also the actual assets and liabilities value to reach the valuation.
Another challenge is that balance sheet of various businesses may or may not include the indigenous product, which are important in deciding the valuation of the business. On paper, the valuation might be less than the actual because the product that has been left out would be adding much value to the business.
Asset Based valuation can be done in three ways – Economic Book Value Calculation, Liquidation Value Calculation, and Valuation at Replacement Cost. Under Economic Book Value, the accounting book values of assets are adjusted to their current market value, while in Liquidation Value method an estimated value of assets at liquidation less the cost of liquidation is used. In the Valuation at Replacement Cost method, the cost to get the same assets from scratch is used for valuing assets.
Comparable Transaction Valuation
This method is usually used when the valuation is carried out for sale. Under this method, peer group is compared on same standards. For valuation purpose, similar companies are decided by their industry, as well as, the market capitalization.
Thereafter, the companies are assessed on common multiples such as EV/EBITDA, PE ratio, PEG ratio and so on. For fair valuation, the company should be assessed on more than one standard to identify the current and the potential value of the company.
Things look easy when there are set standards on which the companies have to be compared. However, this approach has its own set of drawbacks wherein collecting all the past data of the company is difficult, especially the transactions conducted between the private companies.
Therefore, this approach is not used solely, but in combination with other approaches. Comparable Transaction Valuation is often used along with Discounted Cash Flow to present fair value of business.
Discounted Cash Flow Method
It is the most popular method to arrive at nearly accurate valuation. The term discounting is used because the value of the future of the cash flows is reduced to present. Discounted Cash Flow method is regarded superior to the other methods mainly because it takes inflation into account while calculating the valuation of the business.
One of the first things to calculate under this method is the present value of the future cash flows of a company. For instance, someone is offering you $1,000 now, or $100 per year for 12 years then which offers should you accept. At first glance, it might appear that $100 for 12 years is a better option because it makes $1200 at the end of 12 years. However, the inflation rate is not considered.
Assuming an inflation rate is 5%, the $100 amount, which you might have got next year, is worth $95 now. After 12 years the value of $100 would be less than around $56. Discount rate is used to arrive at a present value.
Though all the methods are commonly used for valuing a small business, the Discounted Cash Flow gives the best picture of the business. This method gives a better picture of company’s value at present, and is more relatable for the investors, as well as, the business owners. Most of the companies, however, go for a combination of two or more methods for calculating the valuation of the business to reach at unbiased decision.