Dec 20, 2018 Philip Burgess
Business valuation is an important process for small and large companies alike, offering owners and prospective buyers an objective method by which to appraise the worth of a business entity. Financial experts use a range of tools and techniques to determine the value of a company, which help them formulate selling prices, set the terms of mergers and acquisitions, and anticipate future earnings.
"Business valuation helps formulate selling prices, set the terms of mergers and acquisitions, and anticipate future earnings."
While revenues are a major factor in the process, they do not always provide a complete picture of a business's overall value. For example, investors must consider the potential that a publicly traded company has in addition to its present economic standing, otherwise their investment decisions would be limited to present market conditions. By looking at all aspects of a business, investors can balance the risks against the possibility of high returns down the line, which can be achieved through the calculation of objective measures such as capital structure analysis and earnings prospects.
Of course, valuation measures are equally important for business owners who want to understand the ins and outs of their finances. Typically, potential buyers and investors will turn to a company's financial statements to assess its value, meaning disclosures such as:
- Income statements
- Balance sheets
- Statements of cash flows
- Statements of retained earnings
- Statements of changes in equity
These records provide critical insight into a company's monetary worth and are used to ensure that financial decisions are backed by quantitative research. Depending on the specific situation, different business valuation techniques may be applied to the gathered information, though only a minor subset of these is used frequently and with wide applicability.
3 common methods of business valuation
In the world of finance, business valuations are always conducted on a case by case basis, as different industries have their own niche methods of determining value. Despite the disparate approaches, the valuation process has similar goals and a few overlapping techniques. According to the Corporate Finance Institute, most industry practitioners rely on three main valuation methods for appraising companies, including:
1. Comparable company analysis: This relative valuation method compares the current value of a company to similar businesses in the general market. By looking at a company's trading multiples - like price/earnings ratios and earnings before interest, taxes, depreciation and amortizations (EBITDA) - financial experts can develop a normalized ratio that will be applied to locate differences in capital structure, fixed assets and operational disparities. The logic behind this process holds that businesses with similar models tend to have somewhat parallel costs, earnings and share prices.
2. Precedent transactions analysis: As another form of relative valuation, this method relies on the comparison of a company's monetary standing to that of another business within the same industry, particularly one that was recently sold or acquired. While this technique is extremely useful for calculating values for mergers and acquisitions, it becomes outdated over time due to the ever-shifting nature of most markets. This is considered a common method for determining the value of an entire business and is often utilized by investment banks and private equity firms.
3. Discounted cash flow analysis: This business valuation technique takes an intrinsic value approach, whereby analysts attempt to forecast a company's future cash flow and walk it back to current market levels based on a weighted average cost of capital (WACC). Unlike the comparative methods, this technique seeks to build an accurate financial model and requires a lot of detail. Depending on the thoroughness of the model, a DCF analysis will likely produce the most accurate valuation.
These valuation methods have their own unique benefits and limitations, but when used in conjunction with one another they create a reliable picture of a business's current and potential value. There are countless techniques and tools beyond these three methods of analysis, each with its own particular uses and financial contexts. But which is considered the best method?
What is the best valuation method?
In truth, there is no single ultimate method of business valuation. For most businesses, using several techniques in tandem is the best way to set an accurate selling price or honest acquisition terms. Even these core techniques are used to suit different needs depending on the circumstances, so a fair estimate will rely on a triangulation of value. Understanding where a company fits within its broad industry landscape is essential, but comparative methods of analysis are not fully representative.
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