MODULE 5
Business Valuation
Business Valuation
► A business valuation is a general process of determining the economic value of
a whole business or company unit. Business valuation can be used to
determine the fair value of a business for a variety of reasons, including sale
value, establishing partner ownership, taxation, and even divorce
proceedings. Owners will often turn to professional business evaluators for an
objective estimate of the value of the business.
Summary
► Business valuation is the general process of determining the economic value
of a whole business or company unit.
► Business valuation can be used to determine the fair value of a business for a
variety of reasons, including sale value, establishing partner ownership,
taxation, and even divorce proceedings.
► Several methods of valuing a business exist, such as looking at its market cap,
earnings multipliers, or book value, among others.
Contd..
► A business valuation might include an analysis of the company's management,
its capital structure, its future earnings prospects or the market value of its
assets. The tools used for valuation can vary among evaluators, businesses,
and industries. Common approaches to business valuation include a review of
financial statements, discounting cash flow models and similar company
comparisons.
Methods of Valuation
► Discounted cash flow method (DCF)
► Multiples Approach
► Market Valuation Method
► Comparable Transaction Method
What Is Discounted Cash Flow (DCF)?
► Discounted cash flow (DCF) is a valuation method used to estimate the value
of an investment based on its future cash flows. DCF analysis attempts to
figure out the value of an investment today, based on projections of how
much money it will generate in the future. This applies to both financial
investments for investors and for business owners looking to make changes to
their businesses, such as purchasing new equipment.
How Discounted Cash Flow (DCF) Works
► The purpose of DCF analysis is to estimate the money an investor would
receive from an investment, adjusted for the time value of money. The time
value of money assumes that a dollar today is worth more than a dollar
tomorrow because it can be invested. As such, a DCF analysis is appropriate in
any situation where a person is paying money in the present with expectations
of receiving more money in the future.
► DCF analysis finds the present value of expected future cash flows using
a discount rate. Investors can use the concept of the present value of money
to determine whether future cash flows of an investment or project are equal
to or greater than the value of the initial investment. If the value calculated
through DCF is higher than the current cost of the investment, the
opportunity should be considered
Contd..
► In order to conduct a DCF analysis, an investor must make estimates about
future cash flows and the ending value of the investment, equipment, or
other asset. The investor must also determine an appropriate discount rate
for the DCF model, which will vary depending on the project or investment
under consideration. If the investor cannot access the future cash flows, or
the project is very complex, DCF will not have much value and alternative
models should be employed.
Multiples Approach
► The multiples approach is a valuation theory based on the idea that similar
assets sell at similar prices. It assumes that a ratio comparing value to a
firm-specific variable, such as operating margins, or cash flow is the same
across similar firms.
Summary
► The multiples approach is a comparable analysis method that seeks to value
similar companies using the same financial metrics.
► Enterprise value multiples and equity multiples are the two categories of
valuation multiples.
► Commonly used equity multiples include P/E ratio, PEG ratio, price-to-book
ratio and price-to-sales ratio.
Basics of Multiple approach
► Generally, multiples is a generic term for a class of different indicators that can be
used to value a stock. A multiple is simply a ratio that is calculated by dividing the
market or estimated value of an asset by a specific item on the financial
statements. The multiples approach is a comparables analysis method that seeks to
value similar companies using the same financial metrics.
► An analyst using the valuation approach assumes that a particular ratio is applicable
and applies to various companies operating within the same line of business
or industry. In other words, the idea behind the multiples analysis is that when firms
are comparable, the multiples approach can be used to determine the value of one
firm based on the value of another. The multiples approach seeks to capture many
of a firm's operating and financial characteristics (e.g., expected growth) in a single
number that can be multiplied by a specific financial metric (e.g., EBITDA) to yield
an enterprise or equity value.
Common ratios used in the multiple
approach
► Enterprise value multiples and equity multiples are the two categories of
valuation multiples. Enterprise value multiples include
the enterprise-value-to-sales ratio (EV/sales), EV/EBIT, and EV/EBITDA.
Equity multiples involve examining ratios between a company's share price
and an element of the underlying company's performance, such as earnings,
sales, book value, or something similar. Common equity multiples include
price-to-earnings (P/E) ratio, price-earnings to growth (PEG)
ratio, price-to-book ratio and price-to-sales ratio.
Market Approach
► The market approach is a method of determining the value of an asset based
on the selling price of similar assets. It is one of three popular valuation
methods, along with the cost approach and discounted cash-flow
analysis (DCF).
►
Regardless of the type of asset being valued, the market approach studies
recent sales of similar assets, making adjustments for the differences
between them. For example, when appraising real estate, adjustments might
be made for factors such as the square footage of the unit, the age and
location of the building, and its amenities.
Comparable transaction
► The cost of a comparable transaction is one of the major factors in estimating
the value of a company that is being considered as a merger and acquisition
(M&A) target. The reasoning is the same as that of a prospective home buyer
who checks out recent sales in a neighborhood.
Summary
► Comparable transactions are used in assessing a fair value for a corporate
takeover target.
► The ideal comparable transaction is for a company in the same industry with a
similar business model.
► The fair value of the takeover target is based on its recent earnings.
Understanding comparable transaction
► Companies seek to acquire other companies in order to grow their businesses,
gain access to valuable resources, expand their reach, eliminate a
competitor, or some combination of all of these reasons. Companies seek to
acquire other companies in order to grow their businesses, gain access to
valuable resources, expand their reach, eliminate a competitor, or some
combination of all of these reasons.
► In any case, overpaying for that acquisition could be disastrous. So, the
company and its investment bankers look for comparable transactions—the
more recent the better. They look at companies with a similar business
model to the company being targeted. The more comparable transaction data
that are available for analysis, the easier it is to derive a fair valuation.
Contd..
► Conversely, a company that has become a takeover target does the same type
of analysis in order to determine whether an offer that is on the table is a
good one for its own shareholders.
► In either case, the comparable transaction method of valuation can help a
company arrive at a price for the acquisition that shareholders are willing to
accept.
Reference
► https://www.investopedia.com/terms/b/business-valuation.asp
► https://www.investopedia.com/terms/d/dcf.asp
► https://www.investopedia.com/terms/m/multiplesapproach.asp
► https://www.investopedia.com/terms/m/market-approach.asp
► https://www.investopedia.com/terms/c/comparable-transaction.asp
