Business Valuation Methods
Business valuation methods can vary depending on the type of company, number of years in operation, company's value to potential acquirers and more. For example, an owner might be interested in selling his or her business while there are no potential acquirers. In this case, a discounted cash flow analysis is a good option for evaluating the business's value. However, if you want to invest in a particular start-up company with no track record yet you would be more inclined to rely on comparable sales analysis and other similar methodologies.
Business valuation methods are also heavily dependent upon the industry in which you wish to invest.
In general, the following approaches can be used to evaluate company's investments:
Units of production and assets are usually measured by their current values. Current values are often tied to income statements and balance sheets, but they can be estimated based on sales, revenues or growth rates. In a focused industry (e.g., auto manufacturing), current value might be measurable through relevant financial ratios such as return on invested capital (ROC), gross profit margin (% gross profit) and sales per employee (S/E).
Another popular method is the market approach, where current value is quantified using a comparable priced sales transaction. As for the comparable sales transaction, where to find it? It depends on your ability to identify the transaction that best resembles the business you are valuing. The most common sources of comparable transactions are:
The income approach is based on economic principles that link the income generated by an asset to its value. There are two ways in which you can use this approach to value a company:
Measurement of company's net future cash flows and discounting of those cash flows back to a present value can be used as a method for calculating free cash flow (FCF).
This method is useful when you are interested in a company's financial health and want to estimate the amount of cash that it would generate if it were liquidated.
Using all of the above methods, companies could be valued through multiples of free cash flow. Here at IGR we use Adjusted Free Cash Flow (AFCF) as our valuation metric.
This metric is calculated by adjusting FCF for external financial leverage (i.e., working capital) and internal financing structure (i.e., capital structure). If the adjusted FCF is positive, then the FCF could be interpreted as stable and/or increasing. If adjusted FCF is negative, then the FCF could be interpreted as stable but decreasing.
Financial leverage changes the weighted average cost of capital of a company's capital structure. The more cash a company has at its disposal, the lower is its weighted average cost of capital (WACC) and EPS multiple will be.
As with most financial models, financial ratios are used to compare specific companies in their industry to their own or some other companies' performance. Examples of financial ratios are:
Free cash flow to sales, free cash flow to equity, operating income margin, return on equity and net debt to EBITDA.
It is important to note that no valuation method is perfect. Each method has its own strengths and weaknesses that you should be aware of before selecting a particular method for your company's valuation.
Lack of data or unavailability of information are common challenges that investors face when attempting valuation analysis. While there may not be enough information available from the company itself on its financial performance and prospects, there may be plenty of other sources that could provide additional insight into the value of a company. These sources include: 1) SEC filings, 2) press releases, 3) press releases of company's competitors and 4) direct contact to the company.
It is important to remember that one of the main objectives in business valuation is not just to calculate a value but also to determine whether a particular value makes sense given the availability of information on the target company. For instance, if you think that the price that was paid for a target company by an acquiring firm seemed too high or too low relative to the multiple of FCF paid for the target company, then you need to dig deeper into the potential reasons that would justify why this would be a good deal for all parties involved.
Recent research in financial economics has shown that the value of a company may be very different based on how the company is valued. This phenomenon is called target price illusion and it explains why companies that are similar in all respects may have very different values assigned to them.
It turns out that the potential buyer's perception of a target company's value can sometimes be very different from reality, especially when there is a significant amount of optimism or pessimism regarding future prospects of the business. As an example, let's say that you are an acquirer and you would like to buy a certain small software development firm. Based on some recent growth projections, operating margin projections and an analyst's target price of $100 million, you think that you can buy this software development firm for a target price of $200 million.
You have done the due diligence but you realized that the target company's prospects are not as good as you had imagined that they would be and therefore you decide to pass on the deal.
However, if a competitor acquired this firm at $150 million (at a price to equity ratio of 30x), then its value would appear to be much higher than it actually is just because its potential acquirer valued it at such a high price to equity ratio. This is known as high vs low expectations effect. In fact, your competitor's perception of the same target firm is likely to be much more optimistic than yours.
In conclusion, it is important that you remember that there are no universal guidelines for determining value and what makes sense for you in your valuation analysis may not make sense for someone else. It is important to remember that valuing a company is not just a numbers game but rather it is an art of making informed decisions and interpreting information.
Mark Cuban said: "There are three questions you need to answer when creating or buying a business. 1) Can it be sold? 2) Can it be ran by a CEO better than myself? 3) Is the price right?"
Author: Irakli, Quantitative Analyst at IGR Capital.
Irakli Seresadze is an analyst with more than 15 years of experience in the capital market. He joined IGR Capital in 2012 and is currently focused on small cap research. Irakli has a BS in Economics and Mathematics from Georgian Technical University. He holds a Masters of Science degree in Applied Mathematics from Tufts University (Massachusetts). Contact: i.seresadze@igrcapital.com References:
http://en.wikipedia.
Conclusion:
According to the author, there are no universal guidelines for determining value and what makes sense for you in your valuation analysis may not make sense for someone else. The article seems to be a mixed bag of research and opinion. The two main issues that I found with the article were: 1. Business Value Misperception 2. Lack of data or unavailability of information It is important to remember that valuing a company is not just a numbers game but rather it is an art of making informed decisions and interpreting information. It's all about data and understanding the fundamentals behind the business Like most quantitative analysis, there is no definitive answer in this article as to which method will apply in your situation.