When you go out shopping, you come across many vendors. Yet, you somehow figure out which vendor you may want to shop from, by calculating a lot of different things. However, the product value is the final deciding factor. Majority of the people compare the quality and value of any goods or service before purchasing it. This way of making decisions also tags along in the world of business and finances. When varied businesses are looking at investors, with hopeful eyes, the business valuation is what helps the investors in figuring out which business is worth investing in.
Valuation is the process where you put numbers on a business. Simply, it allows you to get the monetary value on your entire business. On the basis of this valuation, different stakeholders can know the true financial picture of a business. So, from these things, it is very evident that the process of valuation is more like an art. Moreover, since art does not have just one format, nor does valuation. So, in this blog, let’s dive into the deep waters of different methods of valuation of a business.
Why is Business Valuation Important?
As stated previously, business valuation allows various stakeholders to see the true financial picture of a business. Hence, a correct valuation report will disperse whether your business is profitable in the present and near future or not. Moreover, it also helps you in determining the growth potential of your brand. With that said, here are a few reasons that make valuation for a business integral to its growth:
- It attracts investors;
- It helps in making better plans for employee incentives (ESOPs and SWEAT Equity, etc);
- A correct report will help you figure out the drawbacks, limitations, etc.;
- You can work on the different areas of improvement in the business; and
- With valuation at regular intervals, you can trace your businesses’ success, and make informed decisions.
Also Read: Why is Valuation Important?
What are the various approaches to Asset Valuation?
In business, you have a varied range of approaches to asset valuation to choose from. Hence, the first thing you need to do is choose the appropriate method of assessing your assets and finances. The table below shows the most common approaches to asset valuation with the reasons behind its popularity.
|Approach of Asset Valuation
|Area of Focus
|Market Value Approach
|It focuses on the current situation of the market. Hence, it consists of a market comparables method.
|The approach of asset valuation focuses on comparing the current cost and the cost of obtaining an asset. Hence, it covers replacement and depreciation of assets.
|It centres around the income that an asset is generating, or capable of generating in the future.
|Intrinsic Value Approach
|In this approach, the fundamental value of the company stock is considered on the basis of the current expected value of the future dividends. It is quite complex, and most favourable for stocks.
|Options Pricing Model
|Here, certain assets are considered as options, and then evaluated.
|Relief from Royalty
|Specifically tailored for intangible assets, this approach allows owners to earn more profit by avoiding giving up ownership.
All these different approaches to valuation are created to cater to the varied needs of each type of business and asset. Hence, the ideal way of choosing the most appropriate approach to valuation is by focusing on the specific reasons why and how you are going to use the valuation report.
What are the common methods used in Financial Valuation?
Now that we are aware of the different aspects and approaches to asset valuation in business, let’s also dive deeper into understanding the common methods used in financial valuation.
Discounted Cash Flow Analysis
The DCF method is the most fundamental mode of assessing finances in a business. Which means, it is quite commonly used for financial valuation. Here, you can know the value of an investment on the basis of cash flows expected in the future. Hence, the time value of money is an integral aspect when you are trying to value a financial instrument like securities. Simply put, this method of analysis happens on the concept that the value of money is more now than it will be in the future.
Let’s try to understand it with an example:
Person A decides to buy a chai stall. However, he thinks knowing the valuation of the business would be better before he actually purchases it. So, he asks the current owner of the chai stall for his expected profits in the near future. Here are the expected profits:
1st Year: Rs. 10,000/-
2nd Year: Rs. 15,000/-; and
3rd Year: Rs. 20,000/-
Now, since the value of money gets lesser with time, you have to set a discount rate. Suppose you set a rate of 10%. This 10% represents your rate of return on the chai stall.
Let’s determine the current value from these projections.
Step 1: Calculate Present Value from Expectations
|₹10,000 / (1 + 0.07)^1
|₹12,000 / (1 + 0.07)^2
|₹15,000 / (1 + 0.07)^3
Step 2: Add the Present Values for all three years
Once you have the present value, you need a sum of all three years’ present value. In this case, the total will surmise to ₹31,949.34 approximately/
Step 3: Decipher your Potential Investment
Now you know that the current valuation on the DCF method for the chai stall is Rs. 31,000 approximately. So, on this basis, the final choice is also yours. Moreover, in this method, when you apply a different discount rate, it will have an impact on the result of valuation. So, consider the complexities and make decisions accordingly.
FAQ: When is the DCF method of valuation most suitable?
The DCF method focuses on the future cash flow. Hence, it is ideal for valuing investments, businesses and different projects.
Comparable Company Analysis
Also popularly known as the comps method of valuation, this analysis does include a comparative study of your company, to similar publicly owned companies. So, if you are a shoe manufacturer, you can do your valuation by comparing your finances to other accessible public shoe manufacturing companies’ data. Hence, the market value of another company will help you determine your company’s value.
If you want to buy a shoe company, you will do a market study of another shoe company that is open to public trading. You need to take a look at its financial metrics.
You can easily carry on valuation with this method, by following these steps:
- Search for Comparable Companies;
- Collect relevant data (revenues, profits, price-to-earning ratio, etc);
- Calculate the valuation ratio for that company; and
- Lastly, apply that ratio to your target company.
Applicability of Comparable Companies Analysis
This method of valuation is the most suitable for conducting valuation for a publicly owned company. The reason being, the fact that here the comparison of a target company is also done with public companies. So, if the target company is also a public company, the accuracy of valuation is improved.
Precedent Transaction Analysis
This is somewhat majorly similar to the comparable analysis method of valuation. However, the major point of difference is the fact that this method is open for private and other types of companies as well. Moreover, here, the comparison between the two companies happens based on their previous transactions. So, it is more applicable in mergers and acquisitions between two or more companies.
Market cap is not a mode of valuation. It is a measure that will allow you to see the total value of a company. Specifically, the outstanding shares of that company in the stock market. So, it is apparent that this measure checks the current value of a public company. Moreover, it also helps in figuring out how other companies and the market as a whole, values your company.
Book Value Analysis
Out of the different models employed in asset valuation, this one is quite simple. Here, the valuation of all net assets of the company is done based on its balance sheet. The simple calculation is removing the liabilities from the assets and deriving the current value for the investors. The current book value of a company represents the amounts that all shareholders will receive in case the company liquidates and closes.
XYZ Furniture Ltd has total assets worth Rs. 50 Lakhs. Moreover, its total liabilities are about Rs. 20 Lakhs. Now, use this formula to calculate the book value of the furniture business.
Book Value = Total Assets – Total Liabilities
BV of XYZ Furniture Ltd = 50,0000 – 20,0000
BV = 30,00000/-
Applicability of Book Value Analysis
This method of valuation from all different modes of assessing assets, is only suitable for businesses and companies where the value of its tangible assets is a huge and vital part of the company’s total worth. Moreover, this analysis is less suitable for valuing intangible assets and other securities of a company. Yet, it stays as one of the most basic techniques for determining the value of assets.
Liquidation Value Analysis
This is somewhat similar to the book value analysis, especially in terms of simplicity. It is one of the most simple appraisal methods for assessing asset worth. In this method, you need to calculate the worth of all company assets, similar to a forced liquidating scenario. This will help in deciphering the exact current value if the company closes today.
What is the applicability of the Liquidation Value method of assessing assets?
This mode of valuation is an extreme measure. Hence, it is specifically used in situations of distress or at the time of liquidation of a company.
Option Pricing Model
This method of valuation is common for asset assessment in European pricing stocks. However, the concept is such that it uses mathematical formulas to derive the theoretical value of options. Besides, assets are treated as options to get the value of a company. Out of all the different pricing models, the Black-Scholes model is the most preferred. Besides, this model is most useful when you are looking for the value of various financial models rather than any assets.
In conclusion, it is quite evident that there are different income and market-based approaches for valuation in different scenarios. Moreover, combining two or more methods and using them to get accurate results for business valuation is also a popular method you can use. Business valuation is a very complex and important aspect of your growth, so choose wisely, after considering all pros and cons.
Also Read: What is Valuation?
Is there more than one way for valuation?
Yes, there are many modes of valuation, depending on the specific circumstances, assets and business requirements. You need to choose the mode suitable to you very carefully.
Can I combine two different methods of valuation?
Yes, this is the ideal way to get valuation for an entire business. You can choose two or more methods on the basis of your company size, your needs, and your assets, cash flow, and market size.
Is the income approach better than the market approach for valuation?
This is purely circumstantial. You need to consider the nature of your assets and all the data you have before figuring out the better suited approach. You can use the income approach usually for assets which can and commonly do generate income. Whereas, the market approach focuses on the actual market standing and the real-world scenario of the market transactions.