Business Valuation – Importance and Methodologies

Business Valuation – Importance and Methodologies Business Valuation is the process of determining what your business is worth. Determining your Business Valuation is an important prerequisite for intelligent decision making.

Therefore, Business Valuation is the ‘Economic Worth’ of a Company which is arrived at using certain assumptions and limiting conditions and subject to the data available on the valuation date.

Business Valuation is critical for strategic business decisions like: 

Fund Raising

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Mergers & Acquisitions

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Sale of Businesses

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Family/Shareholders Disputes

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Voluntary Value Assessment

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Regulatory/Accounting Compliance under RBI Act, Income Tax Act, Companies Act

Approaches and Methodologies In business valuation, valuation is typically performed by one of three core Valuation approaches:

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Asset Approach

The asset based method views the business as a set of assets and liabilities that are used as building blocks of a business. The difference in the value of these assets and liabilities on a book value basis, or realizable value basis or replacement cost basis is the business value. 

Income Approach

The Income based method of valuation is based on the premise that the current value of any business is a function of the future value that the Company can expect to receive. It is generally used for valuing businesses that are expected to continue operating for the foreseeable future.

Capitalization of Earning Method (PECV): In its simplest form, the capitalization method basically divides the expected stable earnings of a business by the capitalization rate. The first step under this method is the determination of capitalization rate – a rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). Earnings are then divided by that capitalization rate.

Discounted Free Cash Flow Method (DFCF): The DFCF method expresses the present value of the business as a function of its future cash earnings capacity. This methodology works on the premise that the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate. 

Market Approach

In this method, value is determined by comparing the company with its peers in the same industry of similar size and operating in a comparable region. Most Valuations in capital markets/M&A transactions are market based. This is also known as Relative Valuation Method.

Comparable Company Market Multiples Method (CCM) Comparable Company Market Multiple uses the valuation ratio of a publicly traded company and applies that ratio to the company being valued.

Comparable Transaction Multiples Method (CTM) With this technique of valuing a company for a merger or acquisition, the transactions that have taken place in the industry which are similar to the transaction under consideration are taken into account.

The real challenge lies in deciding which Valuation Approach and Methods to apply depending upon a number of factors like purpose, minority/ controlling interest, stage of business, financials, industry etc.

It is about understanding of the dynamics of the company and its Business, Industry, Economy and allied aspects.