Following are the some of the business valuation methods:
i. Discounted Cash Flow (DCF) Method:
The Discounted Cash Flow (DCF) methodology expresses the present value of a 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.
This method is used to determine the present value of a business on a going concern assumption. It recognizes that money has a time value by discounting future cash flows at an appropriate discount factor. The DCF methodology depends on the projection of the future cash flows and the selection of an appropriate discount factor.
When valuing a business on a DCF basis, the objective is to determine a net present value of the cash flows (“CF”) arising from the business over a future period of time (say 5 years), which period is called the explicit forecast period. Free cash flows are defined to include all inflows and outflows associated with the project prior to debt service, such as taxes, amount invested in working capital and capital expenditure. Under the DCF methodology, value must be placed both on the explicit cash flows as stated above, and the ongoing cash flows a company will generate after the explicit forecast period. The latter value, also known as terminal value, is also to be estimated.
The further the cash flows can be projected, the less sensitive the valuation is to inaccuracies in the assumed terminal value. Therefore, the longer the period covered by the projection, the less reliable the projections are likely to be. For this reason, the approach is used to value businesses, where the future cash flows can be projected with a reasonable degree of reliability. For example, in a fast changing market like telecom or even automobile, the explicit period typically cannot be more than at least 5 years. Any projection beyond that would be mostly speculation.
The discount rate applied to estimate the present value of explicit forecast period free cash flows as also continuing value, is taken at the “Weighted Average Cost of Capital” (WACC). One of the advantages of the DCF approach is that it permits the various elements that make up the discount factor to be considered separately, and thus, the effect of the variations in the assumptions can be modeled more easily. The principal elements of WACC are cost of equity (which is the desired rate of return for an equity investor given the risk profile of the company and associated cash flows), the post-tax cost of debt and the target capital structure of the company (a function of debt to equity ratio). In turn, cost of equity is derived, on the basis of capital asset pricing model (CAPM), as a function of risk-free rate, Beta (an estimate of risk profile of the company relative to equity market) and equity risk premium assigned to the subject equity market.
ii. Balance Sheet Method or the Net Asset Value Method:
The Balance sheet or the Net Asset Value (NAV) methodology values a business on the basis of the value of its underlying assets. This is relevant where the value of the business is fairly represented by its underlying assets. The NAV method is normally used to determine the minimum price a seller would be willing to accept and, thus serves to establish the floor for the value of the business. This method is pertinent where:
• The value of intangibles is not significant;
• The business has been recently set up.
This method takes into account the net value of the assets of a business or the capital employed as represented in the financial statements. Hence, this method takes into account the amount that is historically spent and earned from the business. This method does not, however, consider the earnings potential of the assets and is, therefore, seldom used for valuing a going concern. The above method is not considered appropriate, particularly in the following cases:
• When the financial statement sheets do not reflect the true value of assets, being either too high on account of possible losses not reflected in the balance sheet or too low because of initial losses which may not continue in future;
• Where intangibles such as brand, goodwill, marketing infrastructure, and product development capabilities, etc., form a major part of the value of the company;
• Where due to the changes in industry, market or business environment, the assets of the company have become redundant and their ability to create net positive cash flows in future is limited.
iii. Market Multiple Method:
This method takes into account the traded or transaction value of comparable companies in the industry and benchmarks it against certain parameters, like earnings, sales, etc. Two of such commonly used parameters are:
• Earnings before Interest, Taxes, Depreciation & Amortizations (EBITDA).
Although the Market Multiples method captures most value elements of a business, it is based on the past/current transaction or traded values and does not reflect the possible changes in future of the trend of cash flows being generated by a business, neither takes into account the time value of money adequately. At the same time it is a reflection of the current view of the market and hence is considered as a useful rule of thumb, providing reasonableness checks to valuations arrived at from other approaches. Accordingly, one may have to review a series of comparable transactions to determine a range of appropriate capitalization factors to value a company as per this methodology.
iv. Asset Valuation Method:
The asset valuation methodology essentially estimates the cost of replacing the tangible assets of the business. The replacement cost takes into account the market value of various assets or the expenditure required to create the infrastructure exactly similar to that of a company being valued. Since the replacement methodology assumes the value of business as if a new business is set, this methodology may not be relevant in a going concern. Instead it will be more realistic if asset valuation is done on the basis of the new book value of the assets. The asset valuation is a good indicator of the entry barrier that exists in a business. Alternatively, this methodology can also assume the amount which can be realized by liquidating the business by selling off all the tangible assets of a company and paying off the liabilities.
The asset valuation methodology is useful in case of liquidation/closure of the business.
v. Liquidation Value:
Liquidation value uses the value of the assets at liquidation. Liabilities are deducted from the liquidation value of the assets to determine the liquidation value of the business. Liquidation value can be used to determine the bare bottom benchmark value
vi. Capitalization methods :
This method calculates a business’s value by discounting the future business profits or dividends flowing to the entity’s owners, which is derived from future commercial profits (statement of earnings). There are two methods:
INCOME CAPITALIZATION VALUATION METHOD: First determine the 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. The earnings figure to be capitalized should be one that reflects the true nature of the business, such as the last three years average, current year or projected year. When determining a capitalization rate, compare with rates available to similarly risky investments.
DIVIDEND CAPITALIZATION: Since most closely held companies do not pay dividends, when using dividend capitalization consultants first determine dividend paying capacity of a business. Dividend paying capacity depends on net income and on cash flow of the business. To determine dividend paying capacity, near future capital requirements, expansion plans, debt repayment, operation cushion, contractual requirements, past dividend paying history of a business should be studied. After analyzing these factors, percent of average net income and of average cash flow that can be used for the payment of dividends can be estimated. The dividend yield can be also determined by analyzing comparable companies.