Business Valuation Overview

What is a Business Valuation Overview?

Business valuation is a foundational pillar of corporate finance. In valuing a business, professional appraisers determine the fair value of a company or business or the current economic value that serves to establish the company’s selling price. When a company is contemplating either selling its operations or seeking to acquire or merge with another company, the valuation serves as an objective estimate upon which to base a transaction.

Business valuation is a central component in many activities, such as buy and sell-side mergers & acquisitions (M&A), equity research, IPOs, and fairness opinions, among others. A valuation can also be required in other circumstances, such as when a company wishes to issue debt or equity to finance operations, or in capital budgeting, investment analysis, or tax analysis. There are four common methods used to value a business, including discounted cash flow (DCF) analysis, comparable company analysis, precedent transactions, and asset-based business valuation. For healthy companies generating a profit, the DCF method is most commonly used.

Business Valuation Methods – Four Common Methods

Discounted Cash Flow Analysis – What is DCF and DCF Analysis

The DCF is derived from a company’s financial statements and impacts its valuation. DCF analysis is an intrinsic valuation method.

The DCF method is based on an estimation of a company’s future after-tax cash flow (free cash flow) generated from the core business operations after funding capital expenditures and working capital. A company can use free cash flow as it sees fit, whether that be to pay dividends, pay down debt, or spend the money on other business activities.  Companies with high free cash flow are more attractive to investors. A company with negative free cash flow is earning less than it is spending.

How free cash flow is distributed in the company management’s responsibility, and how free cash flow is used will impact business performance, growth prospects, and valuation. In a DCF valuation, estimates of future financial performance are used to construct pro forma financial statements from which free cash flow is calculated. Typically, free cash flow is estimated for ten years, and then the terminal value is calculated. The free cash flow is added to the terminal value and discounted using the weighted average cost of capital (WACC) to determine the company’s net present value or enterprise value. This value can be divided by the number of shares outstanding to determine the fair price of the company’s stock.

Free Cash Flow – Formula

Determine company value using the following formula:

Free cash flow = Net Income + Depreciation and Amortization and other non-cash items +/- working capital – Capex – Dividends Paid

Comparable Companies Multiple Method

The comparable companies’ multiple methods is a relative valuation methodology in which ratios of similar publicly listed companies in the same industry are used to estimate the value of a target company.  The key ratios used for this purpose are EV/EBITDA, P/E, EV/Revenue, EV/Gross Profit, P/B, EPS, and P/NAV.

The advantage of this method is that it can provide an objective value predicated on benchmarks that are publicly available. However, the challenging aspect is identifying companies that are sufficiently comparable in terms of accounting policies, product portfolio, capital structure, profitability, and investment strategy.

Precedent Transactions or Transaction Comparables

Another relative valuation method uses precedent transactions. In this method, the price paid in an M&A transaction is used for the valuation rather than the stock price. Here the valuation insight is derived from assessing a peer group of transactions. The analyst compares the target company to other companies that have recently been sold or acquired in the same industry. The take-over or control premium that is included in the price at which they were acquired is included in these transaction values. The basis of all valuations is public information.  A key issue in this relative valuation methodology is understanding the size of the premium that buyers are willing to pay to take a controlling stake in a company.

This is one of the most common methodologies used in M&A to determine the value of a company. Multiples such as P/E, EV/EBITDA, EV/SDI, EV/Revenue, and P/B from comparable transaction analysis are applied to the target company in order to determine the implied valuation range.

The selection of comparable transactions determines the accuracy and quality of transaction analysis. Keeping this in mind, the selection should be made on the basis of criteria such as industry, deal size, and transaction characteristics. The more recent the data, the more relevant it will be.

Asset-Based Valuation Approach

The asset-based valuation method takes into account the value of the assets and liabilities of a company. The value of the company is equal to its net assets (assets minus liabilities). Basically, in this valuation method, the focus is on the fair market value of the company’s total assets after liabilities are deducted.  There are two asset-based valuation methods: asset accumulation valuation and excess earnings valuation.

Asset-Based Valuation Approach – Workout

Below find an example of an asset-based valuation approach in which the value of the company is estimated by deducting total liabilities from total assets – both of which are obtained from the company’s balance sheet. The share capital and reserves and surplus are on the liabilities side of the balance sheet but these two items are not taken into account. Using this valuation approach, the company is valued at US$ 575,000.

Conclusion

Business valuation, which is carried out using one of four methods, is the basis for decision-making in many types of transactions, from mergers and acquisitions to IPOs or debt and equity issues. The valuation takes into account every aspect of a business, including the management of a company, its capital structure, projected earnings, and the market value of its assets, in order to determine the current worth of the company.