Question

Briefly explain business valuation and its purpose (also referred to as company valuation). Select a valuation method from the introduction in the Learning Guide and describe why you might use that method to value a business.

Answer 1

What is business valuation?

Business valuation refers to ascertaining the future value of a Company or an asset. Business valuation is very important in in financial decision making of a company. There are several techniques used in business valuation. While thinking of acquiring new business analysts root value of the company to forecast the future earnings, capital structure of the company, market value of the company's assets. Business valuation is also used in determining value of a security we traded into securities exchange. Business valuation can be used in determining the value of an asset as well as liabilities of a company. Liabilities includes bonds issued by company. Business valuation is required for financial reporting, merger and acquisition transactions, capital budgeting investment analysis etc.

Purpose of business valuation

Business valuation is required for several purposes out of which some important purposes are listed below with brief explanation.

1] Buying a Business

Buyers and sellers have their individual opinion on the valuation of a company's assets and its net worth. But the seller will pay the actual value determined to business valuation. This activity of valuation can be done by hiring an expert. A good Business valuation will give details about market conditions, earning potential and future income from the investment.

2] Selling a Business

Why is selling a business or a company to a third party it is important to ascertain the actually worth of the business. When the actual worth is determined it is easy to determine the expected price from selling the business. This helps to fix an attractive expected price for the transaction.

3) Funding
Business valuation is of immense importance when a company required to raise funds for its initial operation or additional capital for its ongoing business. This helps in negotiating with the potential investors or banks from whom the funds are raised. Professional documentation of company's worth enhances the credibility of the company.

4) Strategic Planning
Why dealing with business transactions it is important to know the actual worth of the company. This exercise helps in mitigating the risk as well as making business decisions. Current business valuation explains adjustments made in the financial results of the company anaira close look while analysing the balance sheet of the company.

5) Exit Strategy Planning
In the instances where planning to sale a business or a company is going on it is a wise decision to determine current value of the business. This is an early activity which starts much before the actual exit from the company or business. Business valuation helps in forming a strategy for exit. Enhancing a company's profitability to increase the value of of the company before the actual exit is a key strategy in exit plans.

There are several methods of business valuation. All these methods are briefed in the following paragraphs.

1) Comparable Analysis
In this method the current value of a company is compared with the current value of another company in same business. That's why it's called the cost approach of business valuation.

2) Precedent Transactions Method
In this method the current value of a company in question is compared which other businesses which have been recently sold or acquired. In this method the premium included in the price at which a company is sold or acquired is compared. That's why it is called as market approach of valuation.

3) Discounted Cash Flow Method
In this method future cash flows of a business are forecasted and later on discounted to arrive at the present value of the future cash flows. This simply means that in this method future earnings are taken into consideration present value of the business aur cash flows is determined. That's why this approach of valuation is called as intrinsic value approach.

Going forward based on the above discussion I may use the discounted cash flow method to value a business. Why I will use this method will be cleared by referring the following reasons.

1) Estimation of Future Earnings -
As mentioned in the definition of this method future earnings all future cash flows are considered as the base for valuation. since the cash flows are discounted to arrive at the present value of the earnings give clear picture about making the investment decision.

2) Viability of the Project -
Future earnings and return on the investment decides the gain from an investment. If a project is profitable for investment the future earnings are estimated today helps in deciding whether the project is going to be viable or not from earnings point of view. If the project is viable by discounting the cash flows a we can arrive at the present value of income going to be received in future.

3)Accuracy of Results -
As discussed in the earlier approaches there is a comparison between values of Companies either into same business or industry. Comparative result includes several assumptions and produce highest values. However discounted cash flow method requires lot of efforts in preparing the model of future earnings. The model prepared in discounted cash flow method is based on the current financial results and position of the company. Hence the chances of wrong forecasts about the future cash flows are very rare. Discounting of future cash flows helps in deciding the present value of income gives realistic comparison between two companies. This leads to accurate business decisions from future prospects view of the company.