An overview of business valuation methods

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.

Net asset value valuation method (the Asset Approach)

This is one among the traditional valuation methods that help to reflect the actual value of a business at a specific point in time.

Overview

  • Definition

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.

  • Object to be applied: Small and Mid-sized Enterprises (SMEs)

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.

Pros

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.

Cons 

  • This approach does not take into account the arising of tax obligations related to the value of the business’s assets. Therefore, the accurate-to-be value will generally be lower than the value stated on the balance sheet.
  • The most significant pitfall of the this method is that it doesn’t consider a business’s ability to generate profit from its products or services offered. As such, this method should only be used when the Asset and Income Approach yield a lower value than the book value or adjusted book value or a company with significant value attached to its tangible assets.

Discounted cash flow method (the Income Approach)

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.

Overview

  • Definition

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:

  • DCF (discounted cash flow) is the sum of all the future discounted cash flows that the investment is expected to produce.
  • CF (cash flow) is the overall cash flow for a given year. CF1 is for the first year and the CF2 is for the second year, and so on.
  • r (discount rate) is the discount rate in the decimal form. Basically, it is the target rate of return that you want on the investment.

 

  • Object to be applied: businesses with relatively good financial status, high debt-paying capacity, large capital and business ability to generate profits to cover all costs.

Pros and cons

Pros

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.

Cons

  • Quite difficult to access, which requires the valuator to acquire sound knowledge and experience in handling complex financial models.
  • Require many input variables and subjective assumptions of the analyst. However, with a new project or an upcoming project, it is difficult to identify variables and make reasonable assumptions. This can lead to errors or results that are dictated by the biased aspiration of the valuator.
  • The probability of error is relatively high. It can be seen that the final estimated value accounts for 70% of the model, but the calculation of the value is relatively sketchy. Moreover, future events always have many unpredictable risks.

Market value valuation method (the Market Approach)

This is an approach to determine the value of a business in terms of market realities based on the P/E ratio.

Overview

  • Definition

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

or

P/E = Market Capitalization/Total Net Earnings

  • When to apply?

When there is data on rival enterprises in the market listed on the stock exchange or UPCom for comparison.

Pros and cons

Pros

  • Simple and accessible

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.

  • Based on market price

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.

Cons 

  • Business value is accurately reflected only 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.

  • Error due to inaccurate market price reflection

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.

  • Limited to listed businesses

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.

Notes in the process of business valuation

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:

  • Choose an appropriate valuator

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.

  • Properly and sufficiently assess the growth potential of the business

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.

  • Combine qualitative and quantitative methods

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!

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