How to Value a Business?

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What is Company Valuation?

Company valuation is the process of determining how to value a business? A typical business valuation is performed on the basis of company’s nature of business, using standardized procedures, incorporating justified assumptions and considering various economic factors. Company valuation is important to business stake holders like owners, investors, capital providers, regulatory and tax authorities etc. Different stakeholders perceive a same value differently implied in any public company valuation and or any small business valuation.

What is the standardized measure of a Company Value?

The standardized measure to estimate value a company or value a business is based on fair market value.  The fair market value measure is based on the fact that what value is concluded by an agreement between an independent buyer and seller to buy or sell the company. The buyer and seller are deemed to possess all the necessary knowledge and facts of the business, are not under any undue influence to deal and are free to access all of the information to make an informed decision to buy or sell the company.

Why valuation of a company is required?

Business valuation is required for number of reasons like evaluating an investment, credit analysis, tax reporting, financial reporting and litigation purposes. Details of various reasons to perform a valuation are mentioned below:

1. Investment/ financial valuations are performed to assess value for:

  • Business combinations like merger, acquisitions, equity structuring, debt structuring etc.
  • Investment in a business or sale of a business.
  • Giving fairness opinion and determining quality of earnings in due diligence.
  • Raising capital through bank finance, private equity and venture capital or through an IPO.
  • Valuation of components like capital assets, intangible assets, ESOPs, goodwill etc.

2. Tax valuations are performed to assess value:

  • To comply with IRC 409A or GAAP requirement of ASC 718.
  • To comply with federal, state and national tax requirements pertaining to capital gains, estate and gift tax.
  • To account for embedded differences arising by changing the form of corporation like conversion from C-corporation to S-corporation in US etc.

3. Financial reporting valuations are performed for:

  • Fair value measurement to account for investments in business entities as per ASC820.
  • Purchase price allocation requirements of ASC 805.
  • Intangible assets and goodwill impairment requirements of ASC 350.
  • Accounting for stock-based compensation as per ASC 718.
  • Accounting for derivative instruments and hedging activities as per ASC 815.

4. Litigation valuations

Legal valuations are performed for issues arising from partnership or shareholder disputes, filing for bankruptcy, business damages or claim for lost profits, marital dissolution, succession planning etc.

business valuation approaches

What are the various business valuation approaches?

There are several valuation approaches to conclude an estimate in any public company valuation or small business valuation depending on the nature of business operating stage of company, industry categorization, financial performance etc., which are mentioned below:

  • Intrinsic valuation

Intrinsic valuation involves valuing an asset or the company based on its inherent characteristics i.e. capacity to generate cash flows and risks underlying cash flows. Discounted cash flow valuation, or DCF valuation, is the most common form of intrinsic valuation method and value is determined by calculating the present value of the business’s future cash flow at appropriate discount rate. This approach is purely based on time value of money as future projected cash flows are discounted at appropriate required rate of return.

Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) are two types of DCF valuation techniques and are based the attributable cash flows to providers of capital. FCFF is used to value the firm i.e. value attributable to equity holders and debt holders and FCFE is used to value the equity part of the firm. Future projected FCFF are discounted at the weighted average cost of capital (WACC) to arrive at firm value and future projected FCFE are discounted at the cost of equity to determine value of equity.

  • Relative valuation:

Relative valuation is used for asset valuation, small company valuation or any public company valuation based on actual sale of similar assets or company in the market. Value is determined by applying the transaction multiple of pricing or company value relative to common variable like earnings, cash-flows, book value or sales to the subject company or asset. Comparable company analysis and precedent transaction analysis are the two relative valuation methodologies used in public company valuation and private or small business valuation.

Comparable company analysis involves determining industry specific multiple like Price to Earnings (P/S), Price to Earnings (P/E), Price to Book value (P/B) etc. based on public companies having similar business to that of subject company and applying the concluded multiple for public company valuation and private or small business valuation.

Precedent transactions analysis uses multiple based on historical transactions involving actual sale of assets and companies. Precedent transactions analysis is similar to comparable company analysis the only difference is that multiples derived through precedent transaction analysis include control premium as enterprise value multiples are used and transactions for majority stake are analyzed.

  • Asset-Based Approach:

An asset-based technique of business valuation based on company’s net asset value (NAV). In a typical asset-based valuation economic value of a company is equal to value of tangible and intangible assets, recorded and unrecorded assets in excess of its outstanding liabilities. This approach can is generally used to value a pre-revenue company or company with a poor financial performance.

  • Contingent claim valuation:

Other traditional methods of valuation are not able to address the dynamic nature of company’s business environment. Therefore the contingent claim valuation involves the application of dynamic option-pricing theory to the valuation of company, in turn the future value depends on changes in business environment.

public company valuation and private company valuation

Difference between public company valuation and private company valuation?

There is difference between valuation of private company and valuation of public company majorly due to difference in size of private company and public company. Generally a greater amount of risk is attributable to small business valuation or private company valuation due to many factors. Valuators discount value of private companies to account for lack of market liquidity, limitations of access to capital, very less public information, key person issues etc.

Concluding the valuation traits in any public company or small business valuation:

Business valuation is essential to be performed for a company as it is required for number of conclusive, statutory and legitimate purposes. Therefore, to estimate the fair market value of public company or small business it is required that we use an appropriate and justified valuation approach. Selecting an appropriate valuation approach is marked by factors like company’s nature of business, stage of development and purpose of valuation. Importance of valuation is also marked by the fact that it is used for evaluating companies, financial and tax reporting purposes, and also for regulatory purposes. Therefore any valuation specialist is required to invoke trust and confidence in valuation reports by employing holistic and proactive approach with significant experience and accredited professional affiliations.

Author: Ankur V. – Analyst


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