There are three key approaches to valuing a business. Each approach includes different valuation methods. The appropriate approach and method will depend on the circumstances. The valuation method selection will depend on factors such as: the basis of value and the purpose of the valuation, the relative strengths & weaknesses of each method, the appropriateness of the method and the availability of reliable and relevant information.
The market approach looks at identical or comparable companies or transactions. Providing that price information is reliable, verifiable and relevant. The use of the market approach might be appropriate where shares in the company (or shares in a comparable company) have been recently sold in a relevant and appropriate transaction under the same basis of value or where relevant shares are publicly traded in an active market.
Key issues include how recent the transitions are to the valuation date, how active the market is, how comparable the transactions or publicly listed companies are and whether the relevant transactions took place on the same basis of value, eg. arms length, unrelated parties, not a distressed sale, full and reliable information available to parties.
Where difference exist between the company and comparable transaction and companies then adjustments need to be made. Adjustments might be made for physical differences (such as relative size), location and the related economic and regulatory environment, growth and profitability.
Valuing a business under this approach involves converting future cash flows to a value today. The fundamental basis underpinning the income approach is that investors expect a return and the return reflects the perceived risk of the business. At the foundations of all income approach methods is the Discounted Cash Flow (DFC) method.
Under the DCF method cash flows are forecast into the future and then discounted back to a present value today. Key steps in the DCF method include: choosing the appropriate measure of cash flow (e.g. should it be before or after tax and/or interest), the appropriate period to project cash flows and the relevant discount rate.
When valuing a business with an indefinite life (as opposed to a business with a finite life, such as a mine) it is usual to project cashflows for a limited period say five tor ten years. In the final year of the period, the cash flow is then assumed to continue at that level in perpetuity. This creates what’s know as terminal value.
The terminal value concept is the basis for the Capitalisation of Future Maintainable Earnings method (FME). Under FME, the business is assumed to have stable earnings, with minimal growth and finite life. FME is the valuation method often seen in the valuation of small private businesses. Note though that if earnings aren’t stable or the business is in strong growth stage or has a limited life, then the FME is not appropriate and the DCF method should be used.
The cost approach captures all the costs that would be incurred by a typical competitor, including materials and labour, but also all overheads and depreciation. The cost approach is not usually applicable to valuing businesses, but maybe applicable to start-ups or. in situations where for example earnings are low or none existent or the business has a high level of operating assets relative to earnings.
Which approach is used?
The preferable approach is to use the market approach. However, this only works if there is relevant, reliable and appropriate information. In particular, the market information must tie in with the basis of valuation.
If a market approach is appropriate then the value would move to an earnings base approach. A cost approach would tend only to be used, when the earnings approach produces a value below the asset value of the business.
Earnings drive value. Value is a function of earnings. But what level of earnings should be used in the valuation? The key is the sustainability of earnings. How sustainable are earnings? What are the core underlying earnings
Value is driven by future earnings and the discount rate. The discount rate is the rate of return required by investors. The rate also reflects the expected future growth in earnings and the rate of inflation.
Valuing equity versus enterprise value. Enterprise value is the value of the business. Equity value is the value of the shares. How do you get from enterprise value to equity value?
Simon is a CA Accredited Business Valuation expert, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to giant Bernie Madoff Ponzi scheme. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
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