Business value is such a familiar terminology in the investment field. However, determining the exact value of a company is not an easy feat. This article will give a brief overview of business valuation methods.
This is one among the traditional valuation methods that help to reflect the actual value of a business at a specific point in time.
As the name suggests, this type of approach considers the business’s total net asset value, minus the value of its total liabilities, according to your balance sheet.
Pros and cons
The net asset value valuation approach is typically used when valuators are faced with a company that has produced negative earnings or with companies with significant value in their fixed assets. Often, this approach is used to determine the lowest possible value that a company would be worth without considering the business’s ability to generate profits.
The noticeable pro of this method is that it’s very straightforward. The conclusion to value is merely Assets minus Liabilities. The assets and liabilities are available on the financial statements, so performing the calculation will be relatively quick and does not require complex skills and resources.
The discounted cash flow method is a fairly effective and widely used method. However, this method has a rather complicated approach, requiring a lot of specialized knowledge as well as input data.
This is a business valuation method by making predictions about the future cash flows that the company can generate then discounting it to the present time. Given that the value of the business is equivalent to the total present value of the cash flows that the business can generate in the future. Here is the equation for finding the DCF:
DCF = CF1/(1+r)^1+ CF2/(1+r)^2+ …+ CFn/(1+r)^n
Let us break this down:
This approach can assess both the present value and the expected future value of the company, especially for businesses with potential for future growth, startups or businesses that do not have many fixed assets such as technology companies.
This is an approach to determine the value of a business in terms of market realities based on the P/E ratio.
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share. The essence of this method is to compare the company’s P/E ratio with its competitors in the market to find the most suitable correlation value for the business.
P/E = Stock Price Per Share/Earnings Per Share
P/E = Market Capitalization/Total Net Earnings
When there is data on rival enterprises in the market listed on the stock exchange or UPCom for comparison.
Financial indicators of enterprises listed on the stock exchange or traded on UPCom are standardized. Therefore, it is relatively easy to get data and calculate.
This is the valuation approach from a market perspective on the basis of comparison with direct competitors in their field, so the value of the business can reflect the actual market situation at the calculation timing.
Since the comparison is based on actual market prices, valuators tend to overlook the growth potential as well as the potential risks of the business. As a result, this method may not fully reflect the true value of a business, especially those with potentially large future profits.
Market prices are determined by supply and demand. In some cases, due to psychological impact from investors, the market value may fluctuate very high or low compared to the actual value of the business. If prices are used at these times for valuation, the result may not be accurate.
As described above, this approach uses data of rival businesses that have been listed as a basis for comparison and pricing. It will be difficult for startups or unlisted companies to apply.
Determining business value is the activity that requires a lot of knowledge, experience as well as vision. Here are some important notes when conducting a valuation:
Accurate valuation requires an expert in numbers and possessing a sound understanding of the industry and the market in which the company operates. Therefore, there should be careful consideration and specific criteria to choose the right valuator.
Traditional valuation methods often refer to current numbers like sales, profits, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). However, a thorough valuation also needs the prediction of the picture of the business for at least the incoming 5 years to see the full potential of development as well as possible risks. Market is always moving, so the assessment should not just stop at a static state.
The terminology “valuation” makes most people think of quantitative methods with a lot of metrics to deal with. This is true but not enough.
Qualitative factors such as human and company culture may not be quantified by data, but significantly contribute to the development of the business. That is also the reason why investment funds, especially venture capital funds, consider humans as one among the key factors to consider investing.
The foregoing is a brief overview of common business valuation methods. In fact, determining the value of a company is rather complicated and requires time to learn and evaluate. Valuation is not simply calculating the numbers, it is an art that requires an investment of knowledge and effort!