Effortlessly put, business valuation entails a process and a set of steps to determine what business values up to. While this may seem simple, getting your enterprise valued the right way turns out to be difficult than expected.
Business valuation results depend on your assumptions.
For what’s worth, there isn’t a particular prescribed manner how to value your firm. Since valuation of a business means something different to different people, you cannot expect to do justice to your firm if you value it yourself.
Additionally, economic conditions have a significant impact on the financial worth. For example, when the economy struggles with unemployment, more buyers invade the market and tough competition leads to higher selling prices.
Business value fluctuates as per scenario of sale too. There lies a big difference between a business which is a gimmick under a systematic marketing effort and a quick winding up of assets at an auction.
Hence, worth of a business is essentially an anticipated price the firm would account for during the sale and/or wind up. The actual price may differ owing to peripheral factors like who ascertains the business value. The selling price shall also depend on how the sale gets executed. An auction and planned deal aren’t the same, are they?
Business Valuation Methods
Analysts basically adopt 3 common methods to value business firms:
- Asset Approach
- Market Approach
- Income Approach
This views the firm as a combination of assets and liabilities that comprise the total business value. This approach derives its foundation from the economic principle of substitution which caters to the question:
What will be the cost of creating another business like this, that will produce the same economic gains for you?
We do not know of a business that operates without a demarcation of assets and liabilities in the firm. This kind of unanimous way of operation facilitates us to derive the business value as the difference between the market value of assets and liabilities. This sounds simple, but the details pose the challenges: labelling assets and liabilities in the process of valuation, standardized value measurement, and final ascertainment of asset/liability’s worth.
The name of the approach implies that this approach relies majorly on the innate forces of the market to determine firm value. The economic principle of competition applies:
What is the worth of businesses similar to yours?
No business can operate in a vacuum. If you are doing something lucrative as an economic model, there is an extreme likelihood that there are other players in the market doing a similar thing. So if you are planning to buy a player or sell your enterprise, you decide the type of business you are inclined towards and look around to see what is the expected worth for such an enterprise.
It is intuitive to assume that the market shall settle at some price equilibrium – something that shall be acceptable to both buyers and sellers, which boils down to the following assumption:
The price that a willing buyer shall pay for a firm, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all relevant facts and are not under compulsion to execute the sale.
This approach takes into account the core reason for running a business – money. The economic principle of expectation rules the approach with the following doctrine:
If you invest time, money and effort into your business, what economic benefits do you expect and when will they materialize?
Ascertain the future expectation of economic benefits from your business. Since the return is yet not in your bank, some measure of risk stays positive in the scenario. Also, in addition to figuring out what kind of gains the business is likely to fetch, the income valuation also factors in the risk.
Since the firm value must be established in the present, the expected income and risk must be discounted up to today. The income approach uses two ways to do this:
Business Valuation By Direct Capitalization
In its simplest form, capitalization basically divides the business’s expected returns by the rate of capitalization. The idea is that the firm value is essentially the earnings of the business and the capitalization rate relates the two.
Valuation Of A Business By Discounting Its Cash Flows
Discounting works a little differently: step 1, you project the firm’s income stream over some future period, usually years. Next, you determine the rate at which the streams shall be discounted, reflecting the risk of getting this income on time and taking into account the time value of money at the same time.
Last, you chalk out what the business will be worth at the end of the projection period. This is called terminal value for the firm.
The discounting calculation gives you the present value of the business.
Business Valuation And Risk
Since both the methods for income valuation follow a similar algorithm, you can expect similar results. As a matter of fact, the capitalization and discount rates are numerically related:
CR = DR – K
Here: CR is the rate of capitalization and DR is the discounting rate. K is the expected growth rate in the projected income stream.
Hitherto, what starkly differentiates capitalization from discounting is the income input used. Capitalization uses a single gain measure such as the average of earnings over a period of time. The discounting, on the other hand, is done on a set of income values, one for each year in the projection period using discounting factors depending upon annuity conditions or otherwise.
If your business tracks steady profits every year, the capitalization method is a suitable alternative. For a growing business with rapidly fluctuating and less predictable returns, discounting gives accurate results.
Can business valuation fetch varied results?
Yes indeed! Consider two prospective buyers doing income projections and assessing the risk of acquiring a business.
Each buyer is likely to have a different perception of the risk present, therefore their capitalization and discount rates shall also differ. The two buyers may have different anticipations for the business, which shall affect how they project the income stream over the future period they consider, which shall vary as per their business ambitions.
Hence, even if they use the same valuation technique to value the firm in question, the result may be quite contrasting. This flexibility of measuring the business worth to match one’s objectives is one of the greatest strengths of the business valuation as a branch of finance, making it a service that should always be executed by a third party and not the owner itself.
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