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Valuation
Valuation of a business
An important skill for investors, entrepreneurs and consultants is the ability to value an opportunity, or business. This is important for buying, selling, investing in, or starting a new business. While valuation of a business can be considered more of an art than a science, there are three commonly used valuation techniques: balance sheet analysis, multiple of earnings, and discounted cash flow analysis. Using the different techniques based on various assumptions, is likely to produce a range of values, which will assist in any negotiations over the value or price of the business.
In balance sheet valuations, three types of values are commonly used: book value, adjusted book value and liquidation value. Book value is the simplest of all valuation techniques, and is simply the assets minus the liabilities on company's balance sheet, also known as net worth. This value is however rarely equal to the true market value, so this technique is of little use. The adjusted book value tries to compensate for the market value by estimating replacement values for assets and liabilities assuming the company continues to operate. Liquidation value is the approximation of the value of the assets and liabilities assuming the company were to cease operations and immediately liquidate assets. This method for the valuation of a business can be helpful in setting a floor price for the company prior to negotiations.
The multiple of earnings technique uses the earnings stream for the valuation of a business. There are a number of ways to calculate the earnings stream, and finance professionals select one that's appropriate to the industry and market environment. Earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortisation (EBITDA) are two of the most common earnings metrics. Applying a multiple to these is the standard way to estimate the sale price of a company, as they are thought to most closely reflect the true cash generating potential of a business. If EBIT shows no earnings, a multiple is sometimes applied to cash flow and even to gross margin. Multipliers are determined by looking at companies of known value and earnings in the same industry, known as comparables. The ratio or multiple of earnings for this known entity is applied to the last 12 months earnings of the target company to arrive at a valuation estimate. Historical multiples may also be used if comparison companies are difficult to find. Multipliers are market driven based on market conditions, comparables, and value in the eye of the beholder, and are thus subject to intense negotiation.
Discounted cash flow (DCF) is another commonly used method for the valuation of a business. The rationale for this technique is that the value today reflects the future cash flows of the company, discounted at a rate that reflects the riskiness of the cash flow stream. Opponents of this technique argue that they do not want to pay for future earnings, particularly as projections are speculative. Thus, it is more appropriate for determining shareholder value than for valuing acquisitions. The steps involved in this method are: projecting the cash flow stream, choosing an appropriate discount rate, determining a terminal value for the business, and then applying the discount rate. The cash flows are typically projected to 5 - 10 years, making realistic assumptions on growth and margins. For a discount rate, the weighted average cost of capital (WACC) is often used, as this accounts for industry risk, the company-specific risk, and the financial risk of the target company. The terminal value is the worth of the company at the end of the projected cash flow stream. There are a number of ways to determine this value, one of which is to treat the final cash flow as a perpetuity, then divide by the chosen discount rate. The net present value (NPV) of the company is then calculated by discounting the stream of future cash flows to the present. (LINK TO NPV CALCULATION ARTICLE)
The three methods for valuation of a business outlined above each have strengths and weaknesses, and each offers a unique insight. The balance sheet techniques provide quick reference points and are useful for asset-heavy companies. The multiple of earnings method is used the most frequently as it is easy to use and communicate, and is relevant for moderate growth service industries. DCF is most often used by investment banks and consulting firms and is widely accepted for valuing large companies. The price paid for a business and its value may not be identical. Price is also very dependant on the negotiation skills of the parties involved. A skilled consultant can help provide further insights into these methods and choose the appropriate value for a particular business.
