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.

Learning guide(Introduction):

For business deals that involve merging, selling, or acquiring companies, the participants should have an estimate of the value of the entity they are selling or buying. This week’s topic explores some methods on how to estimate the value of a business entity.

Financial managers use market capitalization (also known as market cap), book value, (valuation of expected) future earnings, and many more methods and measurements to determine company valuation. Book value(s) represent the accounting and historical values, while market value(s) represent the current values. The valuation principle states that the value of an asset is equal to the present value of its expected earnings. This means that the current values are determined by future expectations.

Common methods utilized in business valuation can be assembled into several generalized approaches. Although not 100% inclusive, a valuation analyst can and will utilize these methods in each approach. Some consist as follows:

• The Asset-Based Approach consists of the book value method and the adjusted net-asset method. In addition, the adjusted net-asset method is based on three principles: replacement cost, liquidation, and going concern.
• The Income Approach consists of the capitalization of the earnings/cash flows method and the discounted earnings/cash-flows method.
• The Market Approach consists of the guideline public company method, comparable private transaction method, dividend-paying capacity method, and the prior sales of interest in the subject business.

Additional Approaches can include Income/Asset and sanity/rationality checks. The income/asset approach primarily uses the excess earnings/treasury method and the excess earnings/reasonable rate method. The sanity/rationality checks include a Justification of the purchase and the rules of thumb. The excess earnings/treasury method can also be categorized as a hybrid method because they include in consideration both the net assets and the earnings capacity of the firm.

Answer 1

For any Business Combinations like Mergers, Joint Ventures, Amalgamations, etc or even finding the Sale value etc, a Business Valuation is an important requirement.

Valuation is a process used to estimate the economic value of the business. This valuation is considered as a base for the investors/companies to determine the price to effect a purchase or sale of a business.

While there are many methods in place for assessing the valuations, each of these methods have their limitedness and exhaustiveness interms of application for the respective requirements; Hence, the financial managers should choose the best suitable / required method to apply for their requirement – asset purchase/sale, business valuations, comparative choices of investments etc;

However, in many cases of valuations, more than one method is applied as this helps the finance managers to assess the valuation to the best possible accuracy; Also, this approach of application of multiple methods shall cover the factors of valuation in more holistic way.

Among the various methods, Future Earnings or the Present Value of Future cashflows method is widely used;

In this method, based on the past trend and current strength and capacity of the company, the future cash flows are projected. The cash flows shall cover in more comprehensive way interms of Operations, any salvage value of assets, Working Capital changes, major CAPEX etc; These projected cash flows are further discounted to the Present Value using a Discounting factor; This factor is generally the Weighted Average Cost of Capital (WACC) based on the current capital structure. Finally, using these present value of the cashflows, the Enterprise Value is computed. Post adjustments of any Debt items/Cash and Cash equivalents to this Enterprise value, the resultant shall be considered as Equity Value.

This approach generally covers all the factors of operations, Debt structure, cost of capital and future expectations based on the current strength. A vision can be envisaged in a holistic way and thus helpful for the finance managers;

Once the Enterprise Value is assessed, it can used for comparing with the Market Approach, Peer comparison, EBITDA multiple approach to determine the final price between the buyer and seller of the business, in valuation.

In a typical Business valuations, once the Enterprise Value is determined using the above method, Book value method is used to determine the strength based on the actual value as at date and is used as a comparsion or base for any working capital or debt adjustments in the Share Purchase Agreements / Business Transfer Agreements. Similarly, the EBITDA multiples are assessed and Peer (market) comparison is done to have better understanding and command on the valuation and thus helps the finance managers in better negotiation of final Enterprise Value.