Brief Overview of Valuation Techniques

Brief Overview of Valuation Techniques

Valuation Techniques Chart from CFI showing 3 ways to value a business with Asset Approach, Market Approach and Income Approach. Under Asset apporach is Cost to Build and Replacement Cost.  Under Market Approach (relative value) is Public Company Comparables and Precedent Transactions. Under INcome Approach (Discounted cash flow) is Forecast future cash flows.

There are three main ways to value a business.

1) Valuing of your tangible assets,

2) Comparing you to similar companies (public or sold)

3) Valuing all your projected future positive cash flows as of today.

Valuation Techniques: Asset Approach

Only valuing your real tangible assets

This approach values a company based on the tangible value of its assets.

This can be important for capital intensive industries or in cases where valuable non-operating assets can be sold to help fund the acquisition.

Additionally, the Asset Approach is often used for under-performing companies or if they’re in distress.

In these cases, the company has often not performed well enough to generate positive net cash flow, and therefore has little or no intangible value. Therefore, it must be valued exclusively on its tangible assets

Opportunistic Buyers and “Bottom Feeders“

Opportunistic buyers often used the Asset Approach to find companies in trouble that they can pick up “cheap” for just the value of their assets (often when close to liquidation so it is even cheaper). This situation often occurs to small business owners whose business is dependent on them and who have not prepared the company adequately for an exit (either to sell or transfer to someone else).

The owner has waited too long to groom a successor or to properly plan a transition. In some cases he could be facing a divorce, disease or even has died (leaving his heirs to pick up the pieces and pay the consequences). On other occasions, he might have just burned out, with the company’s operations gradually declining and destroying any intangible value. Nevertheless, in all these cases, where the owner is unprepared and the company is not optimised for an exit, the company is either forced to sell at a high discount or to liquidate at a full loss.

Valuation Techniques: Market Approach (Relative Value)

Comparing you to similar companies (public or sold)

The Market Approach is based on the principle of Substitution. In particular, one will not pay more for an item than the cost of acquiring an equally desirable substitute. This implies that your company’s value is the same as other similar companies in your industry and area.

This value can be determined by using different types of market multiples to make a quick estimate of market value. For example, if you own a shoe store, its value on a certain market multiple will be close to the market multiple implied by what shoe stores have recently been valued or sold in the general area.

The market approach tends to ask whether your company is similar to any public company (Public Company Comparables) or to any recent business sales transactions in the market (Precedent Transactions).

If your company is large enough, it can be compared to “similar” public companies to estimate its value. Public comparables are popular, as pricing comes from daily equity markets, and different metrics can be used (such as Price to Earnings) to calculate your company’s value.

For example, if your company is similar to Public Company X and its share price is 12x Net Income, your company will be valued at 12x Net Income.

That’s the theory. In reality, this approach is difficult – namely, finding comparable companies that are in the same business and have the same circumstances as you. That’s why many would question whether it’s even valid to compare your private company with any public ones.

This approach compares your company with similar ones sold in the private market. The sales metrics (accessed via proprietary transaction databases) are then applied to your company.

So if, for example, the average transaction prices of similar companies X to Z were 10x EBITDA, your company would be valued at 10x EBITDA.

The main problem here is that these transactions may not actually apply. The companies may not actually be comparable.

Furthermore, the transactions measured may have been strategic and specific only to certain situations. For example, a company may have purchased a competitor at 12x EBITDA to get him out of a particular market, but that does not mean your company’s value can also be justified at 12x EBITDA.

Control versus Non-Control of Private Companies and Market Approach

just big graphic of work controlling

An important difference between public and private companies is the lack of control you have as a non-controlling (or sometimes referred to as “minority”) shareholder in holding or selling your shares.

For example, if you buy 10 shares from Microsoft (MSFT), you do not take control of the company. You are in effect a non-controlling shareholder. You have the right to sell these shares at any time, as there is an active public liquid market and you do not need the permission of the Microsoft Board of Directors to do so.

Private non-control shareholders, on the other hand, have much less flexibility. If you’re a non-controlling shareholder of a private company, you may not be able to find someone willing to buy your shares, or you may need the permission of the Controlling shareholder to sell them. As a result, the acquisition of controlling shares of a company has a premium and a discount if the shares are not controlled.

When looking at Precedent Transactions, you are analysing deals that have changed control. There is a premium applied in those multiples that might not necessarily apply to your situation if you are looking to sell a non-controlling stake in your company.

Basically, you need to use discretion when applying either public comparable or precedent transaction multiples to your business.

Valuation Techniques: Income Approach (Discounted Cash Flow)

Valuing all your projected future positive cash flows as of today.

business Value Survey showing Business Value Formula

This is a forward-looking approach, in which the value of a company is based on the expected present value of its future free cash flows, which is discounted by a required return to today.

In simple terms, a company’s value is based on all the profit it can make in the future – priced as of today, taking into account how risky it is that the company will actually make that profit.

So if I were to buy your company today, I’d estimate the total sum of all your company’s future projected profits and discount it by how risky your company seems and so how likely these projected earnings would miss and not occur.

The lower the risk the higher the value of your business. The greater the projected growth and profitability, the higher the value of your business.

The income approach is the most comprehensive, as it calculates the company’s intrinsic value by using macroeconomic, industry, competitive and other analyses in addition to the financial data to provide a rich, detailed valuation of the company.

Within the Income Approach, there are two methods used to calculate company value. Single-Period Capitalisation (SPCM) and Mutli-Period Discounting Methods (MPDM).

This is a fast and simple method that calculates the value based on the return of only one year. This approach is only applied if this one year is representative of the company’s expected long-term future performance. A crucial variable here is the expected growth rate to infinity. The chosen rate must be what the analyst believes the company will grow per year.

The formula takes the representative financial return and multiplies it by the growth rate, and then divides that number by the Capitilisation Rate (which is the result of the discount rate minus the growth rate).

The premise of MPDM is at the heart of valuation. The company’s value is determined by forecasting its surplus profits or cash flow and then discounting that amount by the risks associated with the company’s operations.

MPDM is more robust than SPCM, because the expected returns are not limited by having to be representative of earnings to eternity. Instead, one can forecast 3, 5 or even 10 years ahead and incorporate choppy revenues, erratic changes, etc. Since the projections become less reliable the further you predict in the future, a “terminal value” figure is also calculated. The terminal value is the current value of your last year of forecast earnings projected as a constant growth rate to eternity. The terminal value is then integrated into the valuation calculation.

MPDM is usually broken up into two (or three) stages. The first stage is forecasting cash flows or earnings year by year, and the second stage is the terminal value. Similar to the SPCM, the terminal value will grow at a representative rate to eternity and have a capitalisation rate (discount – representative growth rate).

Income versus Market Approach

The Income Approach is more commonly used for Mergers and Acquisitions than either the Asset or Market approaches. The buyer is investing now to get future net cash flows that are risky and not certain. These risks are best quantified through the Income Approach.

The market approach is more frequently used in small business acquisitions, but it uses multiples based on the latest historical period rather than an estimate of future profits. Therefore, Market Approach results are generally less precise then the Income Approach.

Nevertheless, investors generally prefer market approach multiples in small business acquisitions, so they are valuable as a reference and comparison point with the more robust income approach.

The Sophiall Solution utilises both the Market and Income Approaches to provide valuation ranges. The Value Builder score we provide uses both a Market and DCF Approach to estimate a high level company value. The Sophiall Solution offers an optional DCF valuation to incorporate more comprehensively the unique profitability and risk elements of the specific business.

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