Business Valuation Principles
Before discussing the different valuation methodologies, it is useful to take note of these basic valuation principles:
Value is as good as the information available.
Different sets of information can yield different valuation results. For example, a buyer relying on public information perceives value differently from a seller holding inside information.
Value is subjective, not objective.
The valuer may be influenced by external or internal pressures which we need to bear in mind. It is vital to distinguish between the party commissioning a valuation engagement and its intended audience.
Value is time dependent.
Valuation can change over time as new information emerges, and so the assessment of value is valid only as at the valuation date.
Value and current market price may not be the same.
A business’ market price may deviate from its value of cash flows due to a number of factors including market error/irrational behaviour, insider information not publicly available, and that the market price pertains to only a small free float (may reflect value minority shareholders only).
Value and cost are not necessarily the same.
Cost is the asset acquisition sum and is a known fact that is transparent. Value is one party’s opinion of what the price of a business should be. Measuring assets and liabilities using current value has been on the rise as a more relevant measure of “fair value” by financial reporting. Supporters of historical cost accounting counter-argue this method as being more reliable and conservative.
Value is centred around the valuer’s expectation of risk and return.
The more risky future cash flows are ascertained by the valuer, the higher the discount rate used. In addition, value to different potential buyers can vary widely as each may have different plans for the business being acquired.
Value is affected by liquidity.
The more prospective buyers there are for a business, the greater its value which typically improves the seller’s negotiating position relative to potential buyers.
Minority interest is generally worth less than controlling interest (and vice versa).
Control includes control over the board, influence over the business’ strategy and operations, the ability to appoint/remove management, access to financials and decision making information.
Main Approaches of Business Valuation
Benchmarking using market valuation multiples derived from comparable listed peers and precedent transactions. Typically, this is suitable for businesses that have ongoing operations that generate a fair return with an identifiable earnings trend. The valuer may need to make analytical adjustments to compensate for lack of comparability.
Discounting free cash flows or dividends to account for time value of money and riskiness of cashflows. This approach is suitable for startups, projects with limited life and businesses with reliable forecasted cash flows or dividends.
computing the replacement cost or reproduction cost of the business. This method is suitable for asset intensive businesses or when the business has been performing unsatisfactorily.
Industry Benchmarking and Rules-of-thumb
Benchmarking the subject of valuation using well-established industry-specific valuation metrics e.g. EV/Reserves and EV/Resources for commodity-related businesses. This approach is not appropriate to use this as a primary valuation approach as significant weight needs to have been placed on this approach by knowledgeable buyers & sellers.