Valuing a business – four common approaches

What is the value of your business?

Unlike listed companies trading on a stock exchange where the market value is readily available, information about private companies is limited, and often in a sale process, the most challenging aspect is the invest/buyer and business owner coming to terms with the business value. Therefore knowing the methods an investor would use for business valuation, and the pros and cons help ensure you maximise your investment.

There is no best way to value a business, as the appropriate method will depend on the business’s specific circumstances. Each valuation method has its strengths and weaknesses, and the best approach will depend on the type of business, the information available, and the valuation’s purpose.

Further, it’s important to note that valuing a business is an art and not a science. The methods and results will vary depending on the inputs used, the assumptions made, and the availability of information. It’s also important to remember that a wide range of values can be considered reasonable for a private business, and the final value will depend on the specific circumstances of the company and the buyer and seller’s negotiation.

What are the four basic ways of a business valuation?

• There are four main methods typically used by investors when valuing a business, including:
  Comparable Transactions: the sale prices of similar private companies in the same industry are used in estimating the value of the business.
• Discounted Cash Flow: the future cash flow of the business based on a set of assumptions is generated and discounted to the present value.
• Multiples: This method involves using simplified, industry-specific multipliers to value a business, such as a multiple of revenue or EBITDA.
• Asset-based valuation: the business is valued based on the underlying asset position of its balance sheet.

A combination of methods is often used to value a business, each providing a different perspective on the company’s value. The key is to understand the advantages and limitations of each method and use them appropriately. Additionally, it is important to consider the context of the business, the industry, and the economy as a whole.

1. Comparable Transactions

This method compares your company’s financial and operational characteristics against similar businesses recently involved in a transaction. It assumes that similar businesses should have similar values and, therefore, can be used in valuing a business.

Advantages

1. Relevance: This method uses data from transactions involving similar businesses, which is considered highly relevant in determining the company’s value.
2. Accessibility: Data on comparable transactions is often publicly available, which makes this method relatively easy to implement.
3. Objectivity: This method relies on objective data from transactions rather than subjective opinions or estimates.

Disadvantages

1. Limited applicability: This method may not be appropriate for companies that do not have similar companies that have recently been involved in a transaction.
2. Lack of control over data: The data used in this method may be limited or unreliable, as it is based on past transactions that the company being valued has no control over.
3. Limited insight: This method provides little insight into the underlying drivers of business value within a company and may not account for unique characteristics or circumstances of the company being valued.
4. Limited to specific industries: This method is commonly used in venture capital or private equity, where historical data on sales or IPO prices of similar companies can be used as a benchmark, but it’s not as useful in other industries such as service-based business where revenue streams are hard to compare, and assets are not as tangible
5. Limited to a specific time frame: The method is based on data from past transactions, which might not reflect the current market conditions.

2. Discounted Cash Flow

This method looks at the business’s future cash flow discounted to its present value. It requires input from business owners about future opportunities and risks in the enterprise. A detailed three-way financial model is typically required to forecast the cash flow.

Advantages

1. Flexibility: the DCF method can be used to value a wide range of companies and industries and can be adapted to account for unique characteristics or circumstances of the company being valued.
2. Forward-looking: the DCF method uses projected cash flows and growth rates to estimate the value of a company, providing a forward-looking view of the company’s potential value.
3. Insight into underlying drivers of value: the DCF method provides insight into the underlying drivers of value within a company, such as revenue growth and profitability.

Objectivity: like comparable transaction methods, DCF relies on objective data, this time on projected financials, rather than subjective opinions or estimates.

Disadvantages

1. Complexity: The DCF method can be complex to implement and requires accurate forecasting of cash flows and growth rates, which can be challenging to estimate.
2. Subjectivity: There is a significant degree of subjectivity in estimating the inputs, such as discount rate and cash flows, which can result in a wide range of valuations for the same company.
3. Data availability: The DCF method requires detailed financial information about the company, which may not be readily available.
4. Limited historical data: This method is forward-looking and relies on projections, so it doesn’t consider the company’s past performance, and the risk associated with the projections may not be fully captured.
5. Assumptions heavy: The method relies on assumptions about the company’s future performance, which, if proven wrong, can greatly impact the business valuation.

3. Multiples-based valuation

This valuation method involves using simplified, industry-specific multipliers to derive the value of a business, such as a multiple of revenue or EBITDA.

Advantages

1. Simplicity: This method is relatively simple to implement, as it relies on financial ratios, such as price-to-earnings or price-to-sales, which are easy to calculate.
2. Market-based: This method uses market data to estimate the business value, which can be considered a proxy for the value the market places on the company.
3. Accessibility: Data on comparable companies and their financial ratios is often publicly available, which makes this method relatively easy to implement.
4. Flexibility: This method can be used for a wide range of companies and industries and can be adapted to account for unique characteristics or circumstances of the company being valued.

Disadvantages

1. Limited insight: This method provides limited insight into the underlying drivers of value within a company and may not account for unique characteristics or circumstances of the company being valued.
2. Limited applicability: This method may not be appropriate for companies that do not have similar companies that have recently been involved in a transaction.
3. Limited to specific industries: This method is commonly used in venture capital or private equity. Historical data on sales or IPO prices of similar companies can be used as a benchmark, but it’s not as valuable for other industries.
4. Limited to specific time frame: The method is based on data from past transactions, which might not reflect the current market conditions.
5. Assumptions heavy: The method assumes that companies with similar financial ratios should have similar values, which may not be accurate in certain situations.
6. Subjectivity: The choice of the multiple and the comparable companies used can introduce a degree of subjectivity in the valuation process.

Asset value

The business is valued based on the underlying asset value of its balance sheet. In certain cases, it typically focuses on the value of physical assets, such as land and buildings, plant and equipment, stock, and intangible assets.

Advantages

1. Tangible assets: This method focuses on tangible assets, such as property, equipment, and inventory, which can be easily valued and provide a clear picture of a company’s value.
2. Ease of use: Asset-based valuation can be relatively easy to implement, as it relies on the value of assets that can be quantified and measured.
3. Objectivity: This method relies on objective data, such as the value of physical assets, rather than subjective opinions or estimates.
4. Transparency: Asset-based valuation can provide a clear and transparent picture of a company’s value, focusing on specific assets that can be easily identified and valued.

Disadvantages

1. Limited applicability: This method may not be appropriate for companies that do not have significant tangible assets, such as service-based businesses.
2. Limited insight: This method provides limited insight into the underlying drivers of value within a company and may not account for unique characteristics or circumstances of the company being valued.
3. Limited to historical costs: The value of the assets is based on the historical cost, not considering the current market value or potential appreciation.
4. Intangible business assets: This method may not consider the value of intangible assets, such as patents, trademarks, customer base, and reputation, which can be a significant source of value for a company.
5. Limited to specific industries: This method is commonly used in tangible-asset-heavy businesses such as mining, real estate, and manufacturing, but it’s not as valuable for other industries.

Why is the business valuation not the same as the price it can be sold for?

The value of a business is not the same as the price at which it can be sold for several reasons:

1. Market conditions: The price at which a business can be sold is determined by the current market conditions, including the state of the economy, interest rates, and the supply and demand for similar companies. A business valued at $10 million may only be able to sell for $8 million if the market conditions are not favourable.
2. Negotiations: The price at which a business can be sold is determined by the negotiations between the buyer and the seller. A buyer may be willing to pay more for a business if they see significant growth potential, while a seller may be willing to accept a lower price if they are in a hurry to sell.
3. Timing: The price at which a business can be sold can also be affected by the timing of the sale. A company sold during a recession may fetch a lower price than a business sold during economic growth.
4. Synergy: The price at which a business can be sold can also be affected by the potential synergies that a buyer can achieve with the acquisition, such as economies of scale, cross-selling opportunities and cost savings.
5. Financing: The price at which a business can be sold can also be affected by the buyer’s financing options, making it more or less expensive.

Looking to understand the value of your business?

Specialist skills are needed to assess the value of your business objectively. We can guide you through the process at Greenwich with our expertise and experience. Contact us today to learn more.