Wealth Channels » Different Methods Of Business Valuation

Wealth Channels » Different Methods Of Business Valuation

Posted In: Investing Tips

Being a businessman, you are always interested in knowing the exact market value of your company. Knowing the value of business helps businessman in taking some critical decisions such as mergers and acquisitions. It also helps company benchmark itself with its competitors and come up with new strategies and tactics to do better in the market.

There are several methods that can be used to value a business. Which method a company follows depends on the nature of the business. In this article, we will elaborate on certain methods – some of these are Asset Based, Market Based, Earnings Based and Cash-Flow Based. A valuation course outlines all these methods and helps you get in-depth knowledge on the same.

1) Asset Based Method: This method is used to calculate the bottom end price for an operating business. A company must be an ‘ongoing concern’ to use this method. The method is preferred by only those companies whose assets reflect a true value of their businesses such as real estate companies. In this method two values are determined - the liquidation value and replacement value. For liquidation value one has to first establish the current liquidation market prices for the assets excluding those assets that can not be sold. For the replacement value, you need to first find out the current market prices for the business assets. The main drawback of this method is, you can not determine the value of intangible assets using this method.

2) Market Based: This method is one of the most popular methods of business valuation. It is used to analyze the value of other similar businesses to arrive at an approximate value for your business. The method analyzes the public markets to determine price to earning ratio for similar companies in the market. Then the average of a median P/E ratio of those companies is taken and multiplied it by the net ordinary pre-tax earnings of your business.

However, this method too has some shortcomings. First, the public companies are quite different than the private companies. They differ from closely held companies in terms of access to capital, layers of management, liquidity for owners etc. Hence, even if the PE ratio of other similar public firms is determined, the ratio is subject to several modifications. The two companies also differ in the nature of sale of stake in the companies so the PE ratio is derived at is always subjective.

3) Earnings Based Method: This method is closely associated with the market based approach. The value is calculated by using formula - Valuation = Weighted Average of Normalized Earnings Before Taxes / Capitalization Rate. The end value depends on the stage of life of the company and the company’s growth over the time period. Weighting will probably be consistent for a mature company; whereas for a start-up venture, earlier years will probably be discounted more heavily.

4) Cash-Flow Based Method: It is similar in some aspects to the earnings based approach. Cash flow based method bases business value on the future cash coming from the business. That cash flow is discounted to a net present value at a specific discount rate to determine the value of the business.

Each of these methods involves a detailed analysis and calculation of the factors affecting the finances of the business. Since, a business valuation provides a range estimated based on an educated guess, it is necessary to review the methods used to arrive at the value and the information upon which it is based.

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