Approaches to Valuation
In our previous blogs we have looked at some detail information that we would need to develop an indication of the value of a business, such as EBITDA and then adjustments to that number to arrive at the earning power of a business. I want to step back now and look at some basic concepts on how to value a business. There are many more details as to how each of these approaches is used and we will get in to that in future blogs.
When a valuation is done each of these approaches should be considered; however, not all are appropriate to use, especially for smaller privately held businesses. Hopefully, this summary will give you an idea of what you should expect to see in a valuation report.
This narrative is focused on the privately held business that is to be sold to another entity and not to be “taken public” by the issuance of publicly traded stock.
There are three basic approaches to valuing a company and multiple methods for each.
Market Approach – this assumes that the value of a company tends to be determined by the cost of acquiring an equally desirable substitute.
Guideline Company Method – this method assumes that the prices of publically traded stocks for similar companies are an objective indicator of price. This method has very limited use in privately held company transaction. Any public company providing similar services tends to be much larger and diversified and therefore is not reasonable to make a comparison to a much smaller company. As we noted the focus here is on smaller private companies so this method is rarely used.
Transaction Method – this method analyses data from proprietary databases of private company sales. Although there may be no direct comparison in each NAICS code, there generally is enough data from similar companies to develop a reasonable comparative data set. The key metric that is determined by looking at similar private transactions is the “multiple”. That metric can take several forms such as a multiple of EBITDA or Sales. Each industry will have its preferred method of valuation. Some service business with limited assets will use a multiple of annual sales, but most businesses can be fairly evaluated by a multiple of earnings. The transaction method will be the sole subject of another blog.
Income Approach – this approach assumes that the economic value reflects anticipated future benefits, namely future cash flows discounted by the investors expected rate of return.
Discounted Cash Flow Method – this method is used to discount cash flows to a present value when those future cash flows are inconsistent. Future cash flows are analyzed on a period-by-period basis and each period’s amounts are discounted back to the date of the valuation based on the expected rate of return or discount rate.
Capitalization of Earnings Cash Flow – this is a simpler discounting method used when future cash flows are expected to be consistent with historical cash flows.
Both of these calculations rely on accurate and reality based projections of future earnings.
Often, both the Market and Income approach are used in some combination.
Asset Based Approach – this approach determines the value of a company based on the value of the underlying assets and liabilities owned and owed. This is used where a company has a large base of tangible assets. The underlying value of the assets is the key metric in this approach. The purchaser must have a clear understanding of the earning power of those assets if the plan is to have the business continue as a going concern.
In our next blog we will begin to explore the values and calculations that are involved developing and indication of value of a business.